Merrill Lynch CDO Sale Proves Investment Bank Balance Sheets Can’t Be Trusted

Trying to value the investment banks based on book value is not an idea I would suggest if investors want to have any confidence in their valuation work. Today we learned that Merrill Lynch (MER) is selling $30.6 billion in nominal value CDOs for $6.7 billion, or 22 cents on the dollar, but that price is not all that surprising. What is surprising is what level Merrill valued those CDOs on their balance sheet when they reported second quarter earnings 12 days ago on July 17th.

That number was $11.1 billion. In less than two weeks, the CDOs lost 40% of their value? Highly unlikely. Of course, some will say the $11.1 billion value was supposed to be as of June 30th, so it was really four weeks of time that had passed. At the very least, we know that Merrill had no idea what the CDOs were worth, on June 30th, July 17th, or perhaps even today (we won’t know that for a long time).

There are some who think these ABS are being marked down too low and will eventually be written up. This could certainly happen in several years time as the underlying mortgages are repaid, but today’s news from Merrill certainly should not give anyone confidence in that thesis. Beware of using book values when trying to value portfolios of ABS. The company might come out and sell the things for 40% less than they thought they were worth less than two weeks before.

Full Disclosure: No position in MER at the time of writing

A Lehman Sale of Neuberger Berman Should Be A Last Resort

Five years ago Lehman Brothers (LEH) was trying to shake the image of being mainly a bond house and acquired asset manager Neuberger Berman for $2.6 billion. The deal was a great idea, not only because it increased Lehman’s equity exposure and was a very stable, predictable business, but also because NB is truly one of the best asset managers around.

Given Lehman’s recent troubles, the company is considering a sale of the unit and some are speculating that selling the entire division could fetch as much as $8 billion. Tripling their money would clearly be a coup, but in reality Lehman should hold onto NB if at all possible. The acquisition was a brilliant move and the current state of the investment banking world makes it clear that having a Neuberger Berman is a solid foundation in an otherwise shaky world for pure investment banks.

Now more than ever, diversification is going to be crucial for the industry, but being forced to sell NB would be a step in the exact opposite direction.

Full Disclosure: No position in Lehman at the time of writing. Peridot was invested in Neuberger Berman when Lehman announced the acquisition in 2003.

Citigroup Q2 Earnings Release Reaffirms My Prior Projections

It’s that time again. Our quarterly look at Citigroup (C) and how my breakup analysis is holding up. Citi reported a second quarter loss of $2.5 billion last week, halving its $5 billion first quarter figure. Due to continued writedowns and credit loss reserve building, it remains difficult to project what kind of profits Citi could have in a more normal environment.

That said, one way to look at it is to calculate Citi’s net income by segment before accounting for asset writedowns and credit provisions. Here are some figures for Citi’s 4 main businesses:

Citigroup – 2nd Quarter by Segment

Net Income/Reserve Build/Income ex reserve build

Global Credit Cards: $467M/$582M/$1049M
Consumer Banking: $(700m)/$1657M/$957M
Institutional Banking: ($2044M)/$367M/($1677M)
Wealth Management: $405M/$41M/$446M

The Institutional segment remains hard to project due to $7.2 billion of pre-tax writedowns for the quarter. The other segments, however, are tracking very close to my previous estimated ranges at ~$8 billion per year for banking and ~$2 billion per year for global wealth management. Institutional probably winds up in the $2-$4 billion annual range ultimately, which would peg Citi’s annual earnings at between $12 and $14 billion.

Assign a 10 to 12 multiple on that and you get fair value of between $120 billion and $168 billion, or $21 to $29 per share, versus today’s price of around $20 per share. In order for Citi to get back to the good ol’ days of earning $20 billion+ annually, it appears the economy would have to improve markedly, but that environment is likely several years away at least.

Full Disclosure: No position in Citigroup at the time of writing

 

Don’t Think All Bank Earnings Will Be The Same

Have you noticed that bank earnings reports so far have been pretty good? Wells Fargo (WFC) reported a good quarter and raised their dividend 10% yesterday, which sparked the market rally, despite the company’s large exposure to the California housing market. Today we got earnings above expectations from JP Morgan Chase (JPM) and PNC Financial (PNC). Does that mean that all the banks are out of the woods? Not really.

Unfortunately, the first banks to report were the better managed banks in the country (you can add U.S. Bancorp (USB) to the aforementioned three). Those four banks are very good at managing risk, hence their strong relative performance. The Wells Fargo report yesterday does not mean that other California-heavy mortgage lenders will be as fortunate. Wells simply had stronger underwriting criteria during the boom than other banks such as Washington Mutual (WM), National City (NCC), and Wachovia (WB), which can easily be seen in the underlying performance of their loan books.

Investors should continue to refrain from treating all banks the same. Companies like PNC, WFC, JPM, and USB are going to outperform the likes of WM, WB, and NCC for the second quarter and beyond simply because they have much better lending practices.

Full Disclosure: Long PNC and USB at the time of writing

Investment Banks Nothing More Than Black Boxes

Bear Stearns is gone. Lehman Brothers (LEH) is fighting to stay afloat as an independent company. Merrill Lynch (MER) is right up there with the investment banking operations of Citigroup (C) as the domestic firms with the most bad mortgage exposure. Goldman Sachs (GS) is seen as the cream of the crop, but they surely are being dragged down with everyone else too even though they reported pretty good numbers this morning.

Although the investment banks are down a ton, I have not been taking the contrarian side of that trade and scooping up any shares. And I do not plan to do so either. There are two main reasons I just do not feel comfortable investing in pure investment banks.

First, the highest margin products for these firms have either peaked this cycle already or have disappeared completely and will take years to recover. Structured products carried the highest levels of profitability, but many are no longer going to have a place within the industry. Others will take months or even years to regain their luster.

M&A activity has also peaked with the private equity boom. Deals are still going to get done, but 2007 was the peak of the cycle. As a result, overall margins at investment banks will decline as they de-lever and no longer sell as much of their highest margin products.

Second, the balance sheets at these investment banks really are black boxes from an investor prospective. Even though disclosures have improved in many cases over the last few quarters, we really do not know exactly how these firms make their money and what they are holding. Their financial statements break out categories such as sales and trading or principal transactions, but that really does not tell us what exactly they are selling and trading. Balance sheets remain quite opaque.

Without transparency and high margin products to keep profits growing (ROE’s will decline as leverage comes down) and investors informed, it is really hard for me to justify investing in these firms that have no core banking deposits like traditional banks do. The Wall Street business model is just a lot more complicated than a traditional bank. As a result, the latter group is far more attractive to me when bargain hunting in financials.

Full Disclosure: No positions in the companies mentioned at the time of writing

Citigroup First Quarter Update, As Promised

JoJo writes:

“Now that Citigroup has posted its first quarter earning for 2008, do you still stand by your original analysis, or you think you have to revise it?”

Thanks for getting my butt in gear for the update I promised, JoJo.

As many of you may know, Citigroup (C) reported a loss of $5.1 billion in the first quarter, which hardly makes it easy to figure out what a more “normal” quarter would look like for them. While the losses and writedowns did go down in Q1, versus Q4, there is still plenty of cloudiness in Citi’s results.

Nonetheless, there is no point in shying away from digging through the numbers, even if they are complicated, which is why I even bothered writing about Citi in the first place. The first thing I did was update my spreadsheet showing Citi’s quarterly income results by segment going all the way back to 2007. This allows us to see the trend for the last five quarters. Then I added my prior forecasts from February (For those who don’t recall, I projected three scenarios — conservative, moderate, and aggressive — each trying to pinpoint the possible earnings power for Citi post-credit bubble). Here is the data:


Now, let’s go through it. As you can see, the biggest obstacle to valuing Citi is the Markets and Banking segment. That division lost $5.7 billion during the first quarter, which accounts for all of Citi’s total loss and then some.

It is going to take some time to really pinpoint if my projected “normal” profit range for the investment banking operations of ~$2-$4 billion is accurate. The reason is that much of the losses right now are one-time events, not recurring costs of doing business.

For example, Citi wrote down $3 billion in Q1 just on auction rate securities and monoline insurance exposures. That accounts for more than half of the investment bank’s losses for the period, but those issues won’t be around long term, as they are simply due to the recent credit crunch. As of right now, I’m sticking with my estimates for the investment bank, as nothing we know now leads me to think they can’t earn several billion in say, 2010.

As for the other segments, the numbers are actually not that far off. The International Consumer division’s trailing twelve month profit figure is right in between my moderate and aggressive forecast. U.S. Consumer is clearly strained right now, though they are not too far off from my numbers ($6.5 billion in profit for the past year, versus a conservative estimate of $7 billion). Global Wealth Management is also not too far off, so all in all I don’t see the need to change much right now.

Now, you may be asking why I am using trailing twelve month profits rather than annualizing the latest quarter. Well, I’m thinking that just as 2006 and early 2007 profits were overstated due to the credit bubble inflating, the results from Q4 2007 and Q1 2008 are understated due to the extreme strain in the credit markets. By using a rolling four quarter average, I can get a better idea of what an entire year might look like rather than extrapolating just three months. That said, this formula isn’t perfect either, and we will see a lot of volatility as the strong numbers from 2007 are anniversaried.

Full Disclosure: No position in Citigroup at the time of writing

Business Week Reads This Blog Too

In the current issue of Business Week, dated 4/28, an article about Citigroup (C) mentioned my conservative $22 break-up value for Citigroup in an article entitled “Where Pandit Is Taking Citi.”

Although the piece failed to put the $22 number in context (it was the lowest of three projected scenarios I made – conservative, moderate, and aggressive), a special thanks to Business Week for reading this blog as part of their research.

If you would like to read the article online, I have included a link above. Links to my three Citi posts are below:

Citigroup Break-Up Analysis:
Part 1, Part 2, and Part 3

Full Disclosure: Neither a position in Citigroup, nor a subscription to Business Week, at the time of writing

Despite Writedowns and Loan Losses, Core Banking Businesses Remain Very Profitable

Since earnings season gets underway in full force this week, the headlines are going to look bad for the financial services industry as loan losses and asset writedowns lead to severe first quarter losses. However, investors need to focus on where these losses are coming from and how the core banking business is holding up during this mess.

I bring this up because the media would have you believe that the banking business is broken and loan defaults by consumers on their mortgages, credit cards, car loans, and student loans are crippling the banks. Interestingly, that is simply not the case.

Consider the first quarter earnings report from Wachovia (WB) issued this morning. The company reported revenue of $7.9 billion and a loss of more than $300 million, or $0.20 per share. That sounds bad, and it is, but digging deeper into the company’s income statement reveals that more than 90% of WB’s business remains extremely profitable, as you can see from the numbers below.

Why is this important? Because these three segments represent 93% of Wachovia’s business and all three are very profitable even in today’s economy. Now, should you simply ignore the losses from asset backed securities and leveraged loans? Of course not. Those losses are real and are resulting in capital infusions, equity dilution, and dividend cuts that are melting away shareholder value.

That said, the banking operations are here to stay whereas record levels of structured product issuance and leveraged loans are not. For those investors who are willing to take a long term view, these large banks are going to make a lot of money from their core businesses going forward, and investors need to take this into account when trying to value financial stocks. Wall Street will not ignore these short term losses in coming days, weeks, and even months, and they shouldn’t, but two or three years from now the core business segments highlighted above will be the driving force behind bank earnings, and as a result, bank share prices.

Full Disclosure: I do not have a position in Wachovia. I simply used their numbers as an example since they just reported this morning, before all of the other banks. Given that Wachovia purchased Golden West Financial and AG Edwards at the peak of the market, there are likely better investment opportunities in the banking sector, taking both fundamentals and senior management teams into consideration. That said, Wachovia’s numbers are relevant because most banks have similar profit margins in their core banking businesses.

Citi Announces Mini Break-Up Plan, But It Should Do More

Today we hear that Citigroup (C) has decided to split its consumer business into two. While not nearly as dramatic as the real break-up plan many, myself included, have discussed, it is a start. Citi will split the consumer business into two parts: consumer banking and global cards. The global card segment will include both U.S. and international credit card lending.

I think CEO Vik Pandit has the right idea here, but for Citigroup shareholders to really see full value realized for the company, they need to split off global wealth management, consumer banking, and corporate banking from each other.

Just my two cents…

Full Disclosure: No position in Citigroup at the time of writing


Related Posts:
Citigroup Break-Up Analysis – Part 1
Citigroup Break-Up Analysis – Part 2
Citigroup Break-Up Analysis – Part 3

Jamie Dimon Steals Bear Stearns

As if JPMorgan Chase (JPM) CEO Jamie Dimon needed to prove himself anymore. The banking giant has already navigated these treacherous waters better than their competitors and now they find themselves in a unique position to be the best situated to take over Bear Stearns (BSC). With a well capitalized bank being the only logical choice for a takeover, JPM was really the only one with a balance sheet strong enough to get a deal done. Without any real alternative bidders, Dimon was able to avoid bidding against himself and named its price: $2 per share, or about half the value of Bear’s NYC headquarters.

The Bear Stearns debacle, ending as an orderly liquidation, highlights how important management can be in determining a company’s fate. While that seems obvious, it is not always easy to figure out ahead of time that Jamie Dimon is a great CEO and Jimmy Cayne was not. Many investors like to visit management and ask lots of questions of company executives, but that strategy alone fails to really give you an accurate read on management’s capability. After all, company executives always will speak highly of their firm’s prospects and obviously make the bullish case to investors whenever given the chance.

To shield yourself from management bias, you need to compare what a company says to what it ultimately does. JPMorgan Chase has delivered on their claim of manageable sub-prime losses. Bear Stearns said last week everything was fine and days later they needed a Fed/JPM duo to keep them out of bankruptcy. If companies you follow/invest in consistently deliver what they say they will, you should feel comfortable banking with them. If disappointments become commonplace, be sure to keep that in mind.

So where do we go from here? Well, the investment banks are still vulnerable. They rely on short term funding and their asset base is littered with illiquid, low quality assets. When clients and funders decide to halt business with a firm like Bear, it’s game over. Remember, investment banks and deposit banks are not the same. Until the Fed’s recent changes, investment banks did not have access to liquidity like the banks did. Although that will change now, the Fed is being forced to accept junk collateral. Companies like Bear made almost all their money on M&A deal fees and underwriting structured products. Those markets are dead, and there is not much else a company like Bear has to prop itself up.

Given recent events, should every financial stock simply be sold? Unfortunately, it’s not that simple. As you can see, our markets aren’t really “free” markets. Bear Stearns needed help, so the Fed guaranteed $30 billion of Bear’s assets to entice JPM to take them under their wing. Whether it is tax rebate checks, Fed backstops, or mortgage bailouts, the government will step in and help curb the problems. As a result, the downside will never be as bad as the fundamentals would tell you they could be because intervention and workouts are always a possibility.

Full Disclosure: No positions in BSC or JPM

Update I (10:00AM CT):
BSC is trading between $4 and $5 per share today. Part of that is short covering and the other part is due to people speculating that someone could bid more than $2 for BSC. Don’t count on it. JPM is a logical fit since they are the bank with the closest relationship with BSC. This is not about finding the highest bid. It’s about finding the best partner for an orderly liquidation, since without the Fed/JPM plan, BSC goes under due to lack of financing. CNBC’s David Faber also just mentioned that JPM has the option to buy the BSC building should investors vote against the $2 per share offer, so they could always just kick BSC out in such a case.

Update II (2:00pm CT):
Lots of talk today about how employees own 30% of BSC and have seen shares worth seven figures last week now worth five figures today, and how much of their net worth has been wiped out. Have we not learned anything from Enron and Worldcom? Did these employees really have the bulk of their net worth in one company’s stock? If so, was it really unhedged? I definitely agree that it sucks that most of Bear’s employees will lose their jobs, but if some of them had millions in BSC stock disappear overnight because of a lack of diversification and/or hedging, they need to take responsibility for that aspect of this meltdown.