In the wake of the Bear Stearns bailout, investors are taking a closer look at the capital positions of other big investment banks
Bear Stearns' (BSC) liquidity shocker sounded a piercing alarm in financial markets on Mar. 14 and sparked nervous speculation about how thin other large investment banks' capital positions may be getting.
There seemed to be a broad understanding that Bear's dilemma stemmed only partly from its actual capital position, with a collapse of confidence in the troubled firm also a significant part of the issue. However large a part public perception played, the bank's desperation was real enough, prompting a call to the Federal Reserve on the night of Mar. 13 for an emergency bailout.
Bear Stearns shares lost nearly half of their value on Mar. 14, after investors knocked down the stock to an 11-year low, before finally closing down 47.4%, at 30. Even that sharply diminished valuation was unsustainable. On Mar. 16, Bear agreed to sell itself to JPMorgan Chase (JPM) for $2 a share, valuing the devastated firm at about $236 million. At the end of Friday, Bear's market capitalization was about $3.54 billion.
Other investment bank stocks were punished as well on Mar. 14, with Citigroup (C) tumbling 6.1%, to 19.78; Goldman Sachs (GS) falling 5.2%, to 156.86; and Morgan Stanley (MS) down 4.9%, to 39.55.
Diversified Firms Are Better Positioned
Despite the battering other banking stocks took on Bear's Black Friday, there are some critical distinctions between them and the beleaguered firm that are keeping most analysts sanguine, at least for now, that its liquidity crisis isn't in imminent danger of spreading across Wall Street. For one, Bear is essentially a single-line business. Unfortunately for the company, that business—mortgage-backed bonds—has been the center of the credit meltdown until recently.
"We've been telling clients since November that larger, more diversified financial-services firms that are well-capitalized are in a better position to weather this turmoil," says Tom Kersting, analyst who covers the major banks for Edward Jones & Co. in St. Louis, Mo. That statement probably rings true today even more than it did a few months ago, he adds.
Unlike some of its peers, Bear Stearns doesn't have a brokerage business and doesn't have the international presence that would have helped reduce its exposure to the subprime-based credit crisis, which has largely been concentrated in the U.S., Kersting says.
Not Just a Bear Problem
In a research note on Mar. 14, Standard & Poor's Equity Research said the liquidity crisis is specific to Bear Stearns, as concerns about ample liquidity have motivated other large banks to conserve capital within their various businesses and even raise money in some cases. Still, S&P upheld its negative outlook on the investment banking and brokerage group, citing the challenges these companies face across their business lines, particularly in investment banking volume and ongoing problems in the mortgage markets.
Although Bear Stearns had been particularly aggressive in expanding its prime brokerage business, which caters to hedge funds, its exposure to the toxic securities backed by subprime mortgages, such as collateralized debt obligations (CDOs), has hardly been unique. Citigroup wrote down a total of $24.5 billion of the asset value in its portfolios during the second half of 2007, much of it because of bad subprime bets.
But Citi has also raised about $30 billion in new capital to replenish its balance sheet. "The reason [Citi is] different is that they were very proactive about going into the market and getting that capital," says Kersting. And because it has a more diversified business model than traditional banks, he believes Citi is in a significantly better position to weather the credit crisis, vs. firms with a single line of business.
Lehman Brothers (LEH) shares some of Bear Stearns' characteristics, having once been thought of primarily as a bond house, says Bill Cline, founder and managing partner of the Cline Group, a financial consulting firm, in New York. Indeed, Lehman suffered the largest percentage decline of any Wall Street firm without "Bear" in its name on Mar. 14, sliding 14.6%. But Lehman has been more successful in diversifying into other businesses in recent years, Cline says.
More Writedowns Ahead
Another wave of writedowns for the first quarter of this year is inevitable, given how home values and confidence in the financial markets have continued to deteriorate since the year began.
But where last year's losses on banks' balance sheets were limited mostly to subprime-related bonds, the new charges will encompass additional asset classes such as commercial mortgage-backed securities, or CMBS, and leveraged loans—a by-product of the collapse of junk markets that has saddled banks with hefty bridge loans made to private equity firms for acquisitions, says Kersting. "We don't expect these writedowns to be as big as in the fourth quarter, but they're certainly going to be bigger than we expected and than most people expected," he says.
Kersting predicts Morgan Stanley will write down an additional $2.5 billion in assets in the first quarter, with $1.4 billion of that stemming from CMBS, $750 million from leveraged loans, and $350 million from CDOs. Citigroup is likely to take additional writedowns totaling $9.3 billion, with $5.9 billion related to CDOs, $2.2 billion to CMBS, and $1.2 billion to leveraged loans.
Beyond that, there's a potential ramp-up of defaults on consumer loans—from credit cards to auto loans—that could drive even more writedowns farther down the road, some analysts warn.
These writedowns won't immediately deplete banks' coffers, but they could result in damage over the longer run, Kersting says: "If you report an earnings loss of $3 billion, you're not growing your capital base the way you would be if you made $3 billion. So it does have an impact on your cash balance." Still, Kersting maintains buy ratings on shares of Citi and Morgan Stanley in recognition of their longer-term prospects.
Dividend Policies on the Table
Like other companies, banks always have the option of axing their dividends to conserve cash, but such moves usually invite rage from investors, who in many cases have held the stock for the dividend payouts.
Citigroup cut its dividend last fall after it reported bigger than expected losses. A bank such as Wachovia (WB), which is especially susceptible to a dividend cut now, Kersting says, could save about $1 billion a year by doing so. Indeed, Treasury Secretary Henry Paulson recently urged financial companies to revisit their dividend policies.
As long as they are laden with debt, the liquidity of other investment banks is sure to be more closely scrutinized by the market after Bear's bombshell. "People are testing these firms to determine whether they can repay their money or not," says Dick Bove, an analyst at Punk, Ziegel in New York. "I don't think the tests of these firms are over, and I don't think one can conclude that there won't be a need for another rescue relatively soon."