Sunday, August 10, 2008

Why Financial Services Losses Are Different This Time

This morning, over coffee, I had the occasion to discuss the current situation of publicly-held US commercial banks with two friends after playing squash. All of us have had, or currently have, positions with major US banks. And we all agreed that the long term outlook for the current crop of America's five large commercial banks- BofA, Chase, Citi, Wachovia and Wells Fargo, plus the investment bank Merrill Lynch, Lehman and Morgan Stanley- is dim.

I wrote about some elements of this recently, here and here.

For commercial banks, the reason they may finally be fatally wounded is that, this time, it's not loan portfolios against which reserves can be taken, and losses can be 'worked out,' that have wounded them.

Nor can historical values be claimed and the assets stuffed into 'investment' accounts to be written off over longer periods of time.

No, this time both investment and commercial banks jumped into marketable securities and got burned. Now hostage to 'mark to market' rules on illiquid securities, they are paying the price for hanging on to this toxic financial waste which they manufactured.

So the commercial banks can't just massage the loan loss reserves, chargeoffs and investment accounts. This time, they have to abide by market values.

And if someone like Merrill suddenly takes a huge haircut to purge its balance sheet, so must every other institution holding similar paper.

For example, take the ARS settlement of this past week. This has just put another expensive, multi-billion dollar whole in John Thain's Merrill Lynch balance sheet. Didn't he just raise another $8B recently to cover the losses of the sale, with reserve, of a bunch of bad mortgage paper to that Texas private equity outfit, LoneStar?

Which is why no CEO can claim to know that they have hit bottom on the valuation of these structured instruments. Nor have any control whatsoever, short of just basically giving the assets to some private equity shop for a few cents on the dollar.

So, who will be stupid enough to buy any more equity in the three parties to the ARS settlement- Citigroup, Merrill and UBS?

After demonstrating appallingly-bad risk management judgement for the past several years, why should anyone continue to keep these rotten, inept managements afloat? They've lost most of their capital in the past year. Schumepeter would probably observe that they should simply be allowed to perish, as more adept, better-managed competitors fill their niches in our financial services system.

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