"I'm sure of one thing: No brokerage house or bank should sell at more
than 10 times earnings."
- Martin T. Sosnoff
Forbes.com
The Castration Of Bear Stearns
Martin T. Sosnoff, 04.01.08
I took a Valium on Sunday night, March 16. My sense of foreboding was
comparable with how I felt the eve of Black Monday some 20 years ago.
I needed 10 milligrams then, but 5 milligrams this time around, and I
slept.
If the U.S. Federal Reserve didn't step in and squeeze out Bear
Stearns, I told my countess, the market would tank 5% to 10%.
In 1987, Alan Greenspan intervened the night of Black Monday,
demanding that all the reserve city banks honor credit lines to major
Wall Street houses. Greenspan can be faulted for holding interest
rates too low for too long, pleasing the White House, but the morning
after Black Monday was his finest hour.
There were no adequate circuit breakers in 1987. Leveraged buyout
fever had driven broad sectors of the S&P 500 Index to scary over-
valuation.
Meanwhile, the insanity of ****tfolio-insurance trading created a
waterfall of sells as stocks plummeted on the Big Board. Traders
unplugged their phone consoles. There were no heroic buyers. I still
kick myself for cowardice, for not stepping in and betting at least
half the farm.
Fast-forward to the present time, and the trouble spots are of a
different color. Almost everyone knows the Street shot itself in the
foot. All the major houses carry frozen assets on their balance
sheets: tens of billions, tons of fixed-income paper and illiquid,
with valuations that remain a Kentucky windage *****sment.
There is nowhere to hide this inventory. You can't pack it away like a
retailer and stack it in the cellar. Major brokerage houses leveraged
net tangible assets at least 2 to 1 in paper that's somewhat toxic.
The Bear's competitors smelled blood, along with high-kicking short-
sellers. The house didn't have sufficient backup in liquid assets to
cover its illiquid paper. Overnight they turned dysfunctional. Nobody
would do business with them.
The mid-March weekend defined the Ben Bernanke Fed as it stepped in
and expunged contagion from everyone's scenario.
Without resolution of Bear Stearns' predicament, a mini financial
panic was stacked in the cards. Jamie Dimon, formerly Sandy Weill's
second in command at Citigroup, and now JPMorgan Chase's headman, was
induced to take over the Bear with a $30 billion put to the Fed
covering Bear's questionable paper--assets that may be good 12 months
from now, but currently toxic.
The Fed could have just as easily extended a $30 billion line of
credit to Bear--but it didn't, needing to kill any perception of
bailing out a weak house. Hence, the $2 a share valuation for Bear
Stearns was its punishment.
Morgan would have paid more, and later it did raise its offer to $10,
smoothing the ruffled feathers of aggressive bond holders and flu****ng
out a covey of short-sellers when the stock, post-deal, rose from $2
to over $6. If nothing else, the Fed confirmed the bad luck of the
Treasury's two dollar bill (R.I.P.).
Days later, the Fed followed through with a $200 billion credit line
for all of Wall Street, thereby saving Lehman from a looming bum's
rush. The Fed offered to exchange Treasury bonds for the Street's
illiquid assets. Lehman's stock on Monday, March 17, traded as low as
$22--down from over $40--but three hours later bounced back to over
$40.
Bernanke did right. We can't afford the major securities houses
imploding. The ability to raise capital on Wall Street and distribute
and actively trade equities is a precious national resource that fuels
economic growth.
On a micro basis, Bear Stearns has a complaint: "Why us?" Obviously,
it's not big enough to leave a gap in trading and underwriting
capacity.
Outside directors of major brokerage houses now must study the issue
of what's an optimum balance sheet for a high-risk business construct.
It sure ain't 30 to 1 leverage and insufficient liquidity to fund
investments. Maybe it's 15 to 1. You do need tons of working capital
to clear transactions.
Looking ahead, the return on equity for major houses stands diminished
as leverage is cut back. I'm sure of one thing: No brokerage house or
bank should sell at more than 10 times earnings.
I pulled some old annual re****ts for Merrill Lynch and Goldman Sachs
and talked to some of their old-timers on capital structure when Wall
Street was a much smaller enclave.
Merrill Lynch showed net income of $37 million in 1974, a horrendous
recessionary year with New York City facing bankruptcy and commercial
real estate selling for a song. At least a dozen medium-sized
brokerage houses suc***bed. Their back offices were a mess, and
negotiated commissions destroyed revenues.
Merrill's earnings got halved in 1973, but shareholder equity held up,
crossing $500 million in 1974, higher than in 1972. Although
commission revenues declined from 50% to 36%, investment banking and
principal transactions held firm. At the time, Merrill was a well-
balanced machine capable of a mid-teens return on equity in a fair to
good year.
Merrill's balance sheet in 1974, compared with today's construct,
makes it look like a timid widow. The house was leveraged 6 to 1 with
most of the debt-collateralized bank loans and securities sold in the
repo-market--what the company needed to do for its brokerage business.
Between then and now, risk management took a walk. Merrill's earnings
last year reversed from a 2006 pristine $7.1 billion to an $8.6
billion loss, and there's more coming this year. Between 2003 and 2007
Merrill's balance sheet ballooned to $577 billion from $197 billion,
with long term borrowings at $261 billion, up from $85 billion.
Curiously, its net worth hardly grew: $32 billion at year's end, but
$28.9 billion in 2003.
Merrill's book value per share hardly budged since 2003. This is
because of share buybacks to wash out stock options dilution and
because of the recent sale of stock to offset the $12.9 billion pretax
loss last year, which was more than the company earned in 2003 and
2004 combined.
Headcount swelled to 64,000 vs. 48,000 in 2003. Merrill, Lehman and
Goldman Sachs' generous stock option grants suggest the companies are
run for management and its employees, not outside shareholders.
When Goldman Sachs went public in 1989, its equity stood at $10
billion, with over 15,000 employees. John Thain, now running Merrill,
was president and co-chief operating officer. Henry Paulson, Jr. who
was the chairman, is the U.S. Secretary of the Treasury.
Goldman's initial 1989 annual re****t dealt with the many layers of
risk control, emphasizing excess liquidity to deal with adverse
markets. Illiquid investments were kept below the level of net worth--
not leveraged 2 to 1, where Goldman and Lehman find themselves today.
Some basics:
--Leverage on Wall Street is not a new construct. It started more than
a decade ago and has intensified in the past few years. Everyone
wanted to walk the walk and talk the talk.
--Security analysts paid scant attention to the mushrooming of
illiquid paper. Now everyone parses balance sheets when there is no
income statement worth talking about.
--Bear Stearns, without major profit centers in money management and
investment banking or a worldwide scope of bond trading and
underwriting prowess, was deemed expendable by the Fed. Long-term
credit lines could have saved them.
--Goldman Sachs devised the most comprehensive risk-management
schemata for the present hailstorm, but nobody is an unassailable
fortress.
--Without the Fed's $200 billion life saver, the last act of Hamlet,
the leading characters either poisoned or stabbed, was about to
unfold.
--I just bought Lehman and Merrill, maybe too early, so I keep a vial
of Valium bedside. Latent earning power, not stated book value is my
metric for valuation. As Scarlett said, "Tomorrow is another day."
Martin T. Sosnoff is chairman and founder of Atalanta/Sosnoff Capital,
a private-investment management company with over $8 billion in assets
under management. Sosnoff has published two books about his
experiences on Wall Street, Humble on Wall Street and Silent Investor,
Silent Loser. He was a columnist for many years at Forbes magazine and
for three years at the New York Post. Martin Sosnoff owns personally,
and Atalanta/Sosnoff Capital owns for clients, the following stocks
cited in this commentary: Goldman Sachs, Lehman, Merrill Lynch.
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