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America’s three key investment banks have now reported their third-quarter results. Beyond the revenues, earnings, provisions and the like, analysts are combing financial statements for details on bankers’ compensation; lower pay is seen as an important sign of cost control and, equally important, contrition in the face of public scorn.
As a percentage of net revenues, compensation ranged from 39% at JPMorgan to 43% at Goldman Sachs in the first nine months of the year. The year-on-year decline at Morgan Stanley was especially large, dropping from 60% last year to 42% so far this year. Absolute pay has fallen at all three banks, with a particularly steep 21% drop at Goldman Sachs. In terms of the average pay per employee at Goldman, the decline is an even more severe 30%. Still, few would consider an average wage of more than US$370,000 for nine months’ work a sign of major sacrifice.
Level 3 assets at large American investment banks may have “bottomed out”, according to a new report by Moody’s. The stores of these illiquid, difficult-to-value assets often housed many of the most toxic securities that battered banks’ balance sheets during the credit crunch. Any decline in Level 3 assets is considered positive for banks’ credit profiles, Moody’s claims. (For previous coverage of Level 3 assets, click here.)
Somewhat ominously, the ratings agency adds that further falls in Level 3 inventories are unlikely. Although risky and illiquid, these securities feature “attractive yields and wide bid-offer spreads.” Under pressure to boost shareholder returns, it will be difficult for bankers to shun them completely.
As in previous quarters, American investment banks continued their remarkable run of profitable trading days in the first quarter of this year. Bank of America, Citigroup, Goldman Sachs and JPMorgan recorded positive net trading revenues every day in the first three months of the year. Morgan Stanley, a laggard by comparison, lost money on only four days during the quarter. (Citigroup does not routinely report its daily trading results, but mentioned that it had no losing days in the first quarter.)
“Like peering through a grimy factory window, trading revenue histograms can provide a few clues as to what is happening down on opaque trading floors,” Moody’s writes in a recent commentary. Normally, a lack of negative trading days would be a positive sign of the “strength and diversification of customer franchises and risk management expertise,” Moody’s claims. But the stellar performance of banks’ trading operations is, perversely, becoming a risk as regulators and investors cast aspersions on the motives and methods that these market makers employ to generate bumper profits on their own accounts.
In a “noteworthy sign of returning liquidity to capital markets,” a report from Moody’s highlights a drop in Level 3 assets (L3) at the biggest American investment banks in 2009.
These assets cannot be valued easily because they are generally illiquid. Many of the credit boom’s newfangled financial instruments—subprime-linked securities, collateralised debt obligations and the like—were classified as L3 and marked to internal models when reporting their values on balance sheets. Subsequent write-downs of these assets called into question the judgment and competence of bank executives.
In general, creditors now prefer banks to hold less L3, with outright disposals preferable to transfers into the Level 2 or 1 categories. As a percentage of tangible common equity, cash L3 at five lenders with large investment-banking operations fell sharply in 2009; “good news for creditors,” according to Moody’s. (L3 derivative positions were excluded from the analysis due to inconsistent disclosure practices.)
Despite the decline as a share of equity, the absolute value of L3 at Bank of America and JPMorgan remained relatively flat in 2009. Bank of America reported the largest increase in value of L3 (US$9.4bn) in the sample, while JPMorgan was the only bank to disclose a net transfer into the L3 category. Morgan Stanley reported the largest absolute decline in L3, trimming its balance by some 38% during the year, largely through disposals.
Around half of European banks’ €3.3trn (US$4.5trn) of debt will mature over the next three years, with €550bn coming due this year alone. According to new research from Morgan Stanley, the cost of rolling over this debt will be more expensive than in the recent past.
Concerns about sovereign fiscal health are “increasing the ‘risk’ in the ‘risk-free’ rate,” Morgan Stanley argues. Some €1.6trn in gross government debt issuance this year also risks crowding out private-sector capital. In addition, banks shortened the terms of their borrowing during the financial crisis, so extending maturities will come at a cost. Greater issuance of non-guaranteed debt will also push up costs; in the fourth quarter of last year, government-guaranteed issues fetched spreads 40 basis points lower, on average, than the non-guaranteed variety. Even without widespread hikes in central banks’ policy rates, private-sector lenders’ cost of capital is on the rise.
As part of its bailout programme, the US government has spent some US$205bn on a range of securities from more than 700 banks. In recent months, some aid recipients have repaid Uncle Sam for this support.
Last week, the treasury department published a report on these repurchases. At the end of 2009, the government had collected US$2.9bn from 31 banks that repurchased warrants (long-dated options). Details of the bids these lenders submitted to the treasury before settling on a price make for interesting reading.
For one, it looks like Goldman Sachs overpaid. For each group of warrants, the treasury used three valuations to guide the negotiations—a composite market quote, a third-party’s model-based estimate and the treasury’s own internal evaluation. For Goldman, the average of these three estimates suggested a price of US$907m for the warrants. The bank ended up paying US$1.1bn, around 20% more than the purported fair-market value.
Compared to what others paid in relation to their warrants’ average valuations, the larger financial firms—including Goldman Sachs and Morgan Stanley—appear to have paid over the odds to buy back their warrants. Although Old National Bank of Evansville, Indiana no doubt employs many capable negotiators, it’s not often that the lender can say it drove a harder bargain than Wall Street’s finest.
Even though some of the big investment banks are raking in profits, a new report from Moody’s questions whether “reliable repairs” have been made to these companies’ business models. The ratings agency then runs through some of the key ratios it will be following to gauge the health of the wholesale investment banking units at the largest financial firms.
One of the simplest metrics, gross leverage, is also the most telling. The scale of deleveraging at the pure-play investment banks is striking, as is the fact that high-flying Goldman Sachs and Morgan Stanley (the green line in the chart) were once practically indistinguishable from credit crunch casualties Bear Stearns, Lehman Brothers and Merrill Lynch (yellow line) as far as gross leverage was concerned.
Among the investment banking survivors, “few managers have been willing to reset promises to shareholders for a less free-wheeling environment,” Moody’s warns. “As a result, some firms may be tempted to again increase risk and leverage to meet shareholder demands as the crisis recedes.”
An impressionistic chart today, taken from a research note by Morgan Stanley.
As economies recover, the stimulus pumped by states into financial systems will be withdrawn and, eventually, interest rates will be hiked by central banks (a process already underway in Australia). The period between the end of a bear market and the beginning of a tightening cycle is, historically speaking, a “sweet spot” when equities post robust returns, according to Morgan Stanley’s analysts. Although European shares have gained nearly 60% in the past eight months, the analysts’ study of history—running the rule over 19 similar bear-market cycles—suggests that the rally could have longer to run.
But once a tightening phase begins, shares typically lose a quarter of their value over the course of a year or so. This correction comes against a background of rising economic growth, falling unemployment and other indicators that many associate with a bullish equities outlook. Morgan Stanley’s 2010 forecasts call for 3.7% global GDP growth and a 50% rise in average earnings per share. “It may seem surprising that we expect high growth and weak equity markets in 2010, but history is on our side,” the analysts write.
In general, good news has been in short supply of late. But when it comes to third-quarter corporate earnings reports, optimists’ cups runneth over.
According to the European strategy team at Morgan Stanley, more than twice as many companies on its watchlist posted profits that beat analysts’ forecasts (148) than missed them (65). Banks, in particular, soared above analyst forecasts more often than the overall company average. Insurers also beat forecasts more often than not, but lagged the overall average.
Of course, companies sometimes go to pains to talk down future prospects in order to add gloss to results—and goose share prices—when they subsequently surpass forecasts. It may be wise to temper one’s expectations about the predictive power of data about expectations.
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