Morgan Stanley's & Goldman Sachs' Quarterly Earnings

The past few days have seen some really fast dancing by Morgan Stanley's executives, and some financial sector pundits, concerning the firm's just-released quarterly operating results.

Some financial news networks were calling the firm's results stellar. It took a few more objective observers on both Bloomberg and CNBC to note how much so-called profit was due to the decline in value of the firm's debt.

A relatively new wrinkle, the thinking goes that when a firm's debt declines in value, it could retire it at a discount, which can then be booked as profit. In Morgan Stanley's case, concerns over its viability this past quarter sent insurance on its debt skyward, and its debt values plunging.

So the upshot is an unexpectedly large profit. Go figure.

Stripping that out, the real operating results aren't so pretty. In fact, the Wall Street Journal published an article on Tuesday detailing the ugly consequences of the firm's attempts to insulate itself from positions relating to MBIA. The crippled bond insurer's condition caused gyrations in the value for its debt, and insurance thereon, which, despite their best efforts, confounded Morgan Stanley's fixed income and derivatives strategists, causing a not insignificant loss.

Meanwhile, Goldman Sachs actually booked a quarterly loss. The Journal contrasted the firm's healthy old core business with its money-losing proprietary activities.

For both Morgan Stanley and Goldman, it's finally dawning on investors and analysts that these firms, despite their rush to secure bank charters in 2008, aren't truly commercial banks. They still market-fund short term, which is what led them to near-collapse three years ago, when Lehman's real collapse froze debt markets.

Looking at the three price charts in this post for Morgan Stanley, Goldman and the S&P500 Index for, first, 5 years, then 2, then 1 year, it's clear how investors have adapted their perspectives on these two firms.

Going into and coming out of the 2008 crisis, Goldman handily outperformed Morgan Stanley. But from early 2009, the two have essentially shared the same fate. The 1-year chart makes this crystal clear. Both are down 40% while the S&P has managed to stay roughly flat for the past 12 months. Morgan exhibits more volatility than its better-regarded peer, but they end up in the same place.

With the crisis now three years past, and the prospect of serious implementation of the Volcker Rule impending, investors and analysts are finally getting through their heads that the proprietary trading/investing profits of these two firms are largely history. Meanwhile, their continuing reliance on short term funding at a time when a Euro financial crisis of significant size is unfolding poses other significant risks.

Thus, both have been hammered over the past year, especially the past six months.

So much for what used to be the wildly-profitable component of the US financial services sector. The large commercial banks are either mired in post-mortgage-fiasco litigation and foreclosure problems, or wrestling with consumers who are deleveraging and repairing their own balance sheets.

Not much good news anywhere, Tom Brown and Dick Bove, who make a living out of touting this sector, notwithstanding.

Regarding UBS, Their Rogue Trader, John Mack, Morgan Stanley & Howie Hubler

Yesterday's two big financial stories, outside of the continuing soap opera "As The Euro Implodes," were John Mack's retirement from Morgan Stanley and the revelation that UBS rogue trader Kweku Adoboli lost $2B for the bank. Both stories dutifully appeared as prominent pieces in this morning's Wall Street Journal.

There is, however, a deliciously ironic link between the two tales. For me, it took finishing Michael Lewis' The Big Short to realize the connection. Here's the clue from the Journal piece,

"But in 2007, it hit a rough patch, losing $9 billion on a proprietary mortgage bet that cost the jobs of several of Mr. Mack's lieutenants, including Zoe Cruz, who was widely viewed as a top candidate to succeed Mr. Mack."

Now, it's tempting to think of the Morgan Stanley loss as not caused by a rogue trader. In fact, elsewhere in the Journal article on Mack, it contends,

"He's a battlefield commander who knows how to lead troops......Mr. Mack pushed traders to take more risk and sell more esoteric but profitable mortgage products. Briefly, that move paid off. In 2006, the firm enjoyed record results."

Funny, that's not at all how Michael Lewis described Howie Hubler's calculated $9B loss on mortgage-backed derivatives.

How do you suppose UBS suffered only a $2B loss and blamed it on a rogue trader, whereas John Mack presided over a $9B loss in 2007 and kept his job? In fact, he essentially lost the firm, as it required a federal bailout, plead to convert to a chartered commercial bank, and had to arrange other financing to remain solvent.

Yet Mack kept his job and never called Hubler's loss a rogue trade.

We don't yet know precisely how Adoboli accomplished his allegedly-undetected losing trade(s). One assumes, like Nick Leeson who brought down Barings Bank, he somehow fooled the various electronic systems purporting to monitor positions, desk P&Ls and risk.

But here's how Michael Lewis explains Morgan Stanley's star fixed income trader Howie Hubler's stunning $9B loss. For those wishing to follow along, I'm synopsizing Lewis' Chapter 9 in The Big Short (Norton, 2010), entitled A Death of Interest, pages 200-225. I'm not going to retype the chapter, nor major parts of it, as that would, I think, be a waste of my time, and probably violate Michael Lewis' copyright. Instead, I'm going to abstract the highlights of what went on at John Mack's (and Zoe Cruz's) Morgan Stanley during 2006 & 2007. But I heartily recommend, if you find any of this of interest, that you run over to Amazon and buy a copy (new or, as I prefer, used but 'like new' for only about $6) of Lewis's book.

Howie Hubler was a star trader of mortgage-backed bonds. Sometime in 2004, Hubler begins to realize that a lot of the bonds he's selling, for which Morgan Stanley, like Goldman Sachs, has built its own origination system to capture the entire profit stream, are of highly suspect quality. So he, in conjunction with a colleague, Mike Edman, hatch a proprietary swap which they convince some of their clients to sell to Morgan Stanley. This allows Hubler's desk to own protection, for a small annual fee, on billions of dollars of dodgy subprime-backed mortgage bonds.

Lewis writes,

"It's now April 2006, and the subprime mortgage bond machine is roaring. Howie Hubler is Morgan Stanley's star bond trader, and his group of eight traders is generating, by their estimate, around 20 percent of Morgan Stanley's profits. Their profits have risen from roughly $400 million in 2004 to $700 million in 2005, on their way to $1 billion in 2006. Hubler will be paid $25 million at the end of the year, but he's no longer happy working as an ordinary bond trader......"

Along the lines of my long-expressed belief, Lewis notes that "the best and the brightest Wall Street traders are quitting their big firms to work at hedge funds, where they can make not tens but hundreds of millions."

So Hubler wangles a deal with Morgan Stanley to set up his own proprietary trading group, take his existing desk's swaps positions with him, and get a sweet deal for his group to own a stake in the group, to be subsequently spun out from Morgan Stanley. In short, Hubler extorts Mack and Cruz to give his group a semi-private business and stake in its future value, in return for not bolting from Morgan Stanley.

Here is where the story becomes interesting as it relates to today's WSJ articles about a rogue UBS trader and John Mack being paid homage as a wise senior Wall Street CEO.

Hubler's new group is given a profit bogey of $2B, but is paying about 10% of that, or $200MM, in fees to maintain its swaps, or shorts on bad mortgage bonds. Hubler wants to eliminate this drain, so he sells credit default swaps on a much larger amount of allegedly higher-quality mortgage bonds. About $16B of bonds.

As Lewis puts it,

"In effect, Howie Hubler was betting that some of the triple-B-rated subprime bonds would go bad, but not all of them. He was smart enough to be cynical about his market, but not smart enough to realize how cynical he needed to be."

For some perspective, the original credit default swaps which Hubler and his colleagues sold to their customers only required a 4% default rate among the subprime mortgages backing the bonds, which Lewis writes was expected in good times, to allow the swaps to pay off.

Next, Lewis writes about how Zoe Cruz' risk management people ask for stress tests of Hubler's aggregate positions under scenarios involving a default rate of 10%. A rate Hubler's people, who, remember, are just traders- not PhDs in economics or seasoned mortgage industry researchers (like, for example, Lew Ranieri's original Salomon group contained)- protested would never occur.

I need to make a brief side point here on which I'll elaborate in a subsequent post. Value-at-risk is the main component of most trading desk risk management systems. I've worked on and been around these systems since my days at what is now Accenture consulting back in 1995. One of the problems with VAR systems is that, since they require and assume variance in valuation to impute the capital required for a position, and, thus the losses possible at some probability level, they don't work well with bespoke instruments. Like, say, credit default swaps or so-called 'off the run' fixed income instruments.

Since the entire credit default swap market, as it evolved among AIG, Goldman Sachs, Deutsche Bank, Morgan Stanley, et.al, was a telephone bid/ask market in which valuation was an exercise in judgement, variation in values was meaningless. As my old, sometime-business partner Bob Mankin is fond of saying,

"A model can tell you what something was worth yesterday or may be worth tomorrow. But the only way to know what it's worth today is to sell a piece of it in the market to someone else."

Thus Morgan Stanley's risk group's slow realization that its VAR reports on Hubler's groups risks were also meaningless.

The 10% stress test showed that Hubler's group wasn't short subprime mortgage-backed bonds. It was long, and the 10% default scenario would create a $2.7B loss. Lewis notes that the actual eventual default rate on the bonds on which Hubler sold swaps, i.e., went long, became 40%.

Again, to synopsize, by mid-2007, Deutsche Bank, which had bought the swaps Hubler sold to get a $200MM income stream to offset his negative carry on his base position of being long credit default swaps on allegedly-worse subprime mortgage-backed bonds, called Hubler to demand payment on the shifting, now higher value of the swaps Hubler sold. Again, because they aren't exchange-traded or continuously-quoted instruments, their value was the subject of what, in effect, became a verbal pissing contest between Deutsche and Morgan Stanley. By later in 2007, Morgan Stanley had paid Deutsche Bank at least $3.7B, eventually losing the net $9.2B. Hubler had, as Lewis writes,

"...been allowed to resign in October 2007, with many millions of dollars the firm had promised him at the end of 2006. The total losses he left behind him were reported to the Morgan Stanley board as a bit more than $9 billion: the single largest trading loss in the history of Wall Street......Hubler and his traders thought they were smart guys put on earth to exploit the market's stupid inefficiencies. Instead, they simply contributed more inefficiency."

To further add to today's trading loss/John Mack retirement irony, Lewis continued, on page 216,

"The other, bigger, buyer was UBS- which took $2 billion in Howie Hubler's triple-A CDO's, along with a couple of hundred million dollars' worth of his short position in triple-B-rated bonds.....A few months later, seeking to explain to its shareholders the $37.4 billion it had lost in the U.S. subprime markets, UBS would publish a semi-frank report, in which it revealed that a small group of U.S. bond traders employed by UBS had lobbied hard right up until the end for the bank to buy even more of other Wall Street firms' subprime mortgage bonds.....said one UBS bond trader close to the action, "It was a very controversial trade in UBS. It was kept very, very secret.....He further explained that the traders at UBS who executed the trade were motivated mainly by their own models- which, at the moment of their trade, suggested they had turned a profit of $30 million." "

Small world, indeed, eh?

Now with all this information, stop and reflect with me for a moment.

You are John Mack. It is 2006. You meet with your chief risk officer, Zoe Cruz, to ask for a complete examination of Howie Hubler's group's positions, strategies, assumptions, forecasts, etc., because that single eight-person desk is generating, according to Lewis, roughly 20% of Morgan Stanley's profits. You tell Zoe to set aside an entire day- maybe two. You surely want to understand in detail how these eight traders are producing 20% of your firm's profits, and what concomitant risks they are taking to do so.

Or maybe you don't.

The same thing would seem to apply to Zoe Cruz, would it not? Wouldn't she want to protect herself by conducting such a thorough examination of Hubler's group's business, in order to brief Mack prior to presiding over a blow-up of that desk's business?

Evidently not.

Instead, Lewis quotes verbatim from Mack's December 19, 2007 investor phone call. I won't republish the detailed exchanges between Mack and his questioners, including Goldman Sachs analyst William Tanona. Instead, here's what Lewis wrote about Mack's statements,

"The meaningless flow of words might have left the audience with the sense that it was incapable of parsing the deep complexity of Morgan Stanley's bond trading business. What the words actually revealed was that the CEO himself didn't really understand the situation. John Mack was widely regarded among his CEO peers as relatively well informed about his bond firm's trading risks.....Yet not only had he failed to grasp what his traders were up to, back when they were still up to it; he couldn't even fully explain what they had done after they had lost $9 billion."

In a footnote to the verbatim exchange on page 218, Lewis also wrote,

"What John Mack's trying to say, without coming right out and saying that no one else at Morgan Stanley had a clue what risks Howie Hubler was running, is that no one else at Morgan Stanley had a clue what risks Howie Hubler was running- and neither did Howie Hubler."

In an earlier footnote on page 210, Lewis provides a brief discussion of the differing explanations offered by those close to Hubler and Cruz regarding who was ultimately responsible for Hubler's positions' losses- Hubler or Cruz? Lewis sides with those who believe Hubler hoodwinked Cruz into believing the positions' net risks were minimal.

So, what is my point at the end of this very long post involving today's WSJ articles about yesterday's two big breaking stories at UBS and Morgan Stanley, and their mortgage-backed credit default swaps losses four years ago?

It's that, to me, John Mack shouldn't be retiring now as chairman of Morgan Stanley. He should have been fired by his board in 2007 for allowing Hubler and Cruz to lose $9B on one desk. Then Cruz should have been fired, and Hubler, Cruz and Mack all sued by the Morgan Stanley for fraud and breach of fiduciary duty to the firm's shareholders.

That if Howie Hubler was allowed to exit with tens of millions of dollars, and no criminal charges, after putting a $9B hole in Morgan Stanley's 2007 balance sheet, maybe UBS' Adibolo isn't guilty of anything, either.

Maybe both Hubler and Adibolo are rogue traders, or neither one is.

Now, I know that the foregoing story paints Adibolo as a trader trying to hide his known losses, whereas Hubler is portrayed as just too inept to realize what he thought was a net short position in derivatives was actually a net long position.

Personally, I have some trouble really belieiving Hubler was that stupid. Or, if he was, are we actually to believe that people that stupid can make $25MM a year? Plus, Cruz's people did the stress test which alerted them, and Hubler, to just how risky his positions actually were. So, from that point on, it seems unarguable that all concerned at Morgan Stanley could or should have known the truth about Hubler's positions.

But Lewis' book provides details of how Morgan Stanley dithered over exiting the worsening parts of the group's positions. Was that rogue behavior? By Hubler? Cruz?

Something doesn't add up. That's why I don't see a real difference between Adibolo and Hubler. They both were given license to risk their firms' shareholders' capital, and both lost it in positions which should never apparently ever been allowed to exist.

And, yes, Zoe Cruz did lose her job. But not quite the way I suggested above. And neither she, nor Mack, nor, of course, Hubler were sued for violating their fiduciary duty to their firm's shareholders through either gross incompetence, given their compensation and senior positions, or calculated deceit.

I think Lewis' account puts this week's comparatively paltry $2B UBS loss in perspective. And suggests that UBS has an evidently continuing cultural blind spot that makes it vulnerable to rogue trading, however you choose to define the term.

Lewis' book also begs the question, in my view, that Hubler was also a rogue trader. And perhaps Mack was a rogue CEO all the while.

I suspect, if you asked him, that Michael Lewis would say the whole lot- Mack, Cruz, Hubler, Adibolo, UBS's senior management, the boards of Morgan Stanley and UBS- are rogues.

And that anybody who buys shares in those firms, or any of their Wall Street ilk, are foolish and deserve what happens to them. Because for less than twenty bucks, any of those shareholders could buy both of Lewis' appropriately well-regarded books, Liar's Poker and The Big Short, and thus be warned of the risks of owning shares of formerly-private investment banks or brokerage firms.

GE, Morgan Stanley & Sustainable Growth

Recent Wall Street Journal articles reported improved performances for GE and Morgan Stanley. On these bases, pundits are now sending the equities of the firms skyward, as seen in the nearby price chart for the two firms and the S&P500 Index.

GE's revenues for the quarter were up 51% from the year-earlier period. The Journal piece noted that the firm,

"posted its first revenue increase in more than two years and its highest level of new orders since 2007."

Morgan Stanley reported a 35% rise in profits versus the fourth quarter of 2009. However, one observer was quoted as saying,

"They need consistent revenue growth. That's where they've let investors down."

Ah, yes. Consistency.

Well, here's a look at the two firms' price charts, along with the S&P500, over the past five years.

Looks quite a bit different, doesn't it?

Over that period, the Index easily outperformed the two firms.

What do you suppose are the chances that both firms have suddenly changed the character of their enterprises? That they will continue to consistently report such revenue and income changes in the year ahead?

My guess is that the 51% GE sales growth is a one-time event. Morgan Stanley was lauded as having outperformed Goldman Sachs for the period, but one wonders how likely that will be in the next year.

Elsewhere, some pundits are calling for GE's Immelt to step down from his CEO job if he is to lead the government's new jobs creation initiative. They note that Immelt misled the firm to require a multi-billion dollar capital infusion from the federal government, suggesting he's not exactly a managerial icon.

A Wall Street Journal lead staff editorial on Wednesday charitably excused his mismanagement of the GE Capital unit for seven years, from 2001-08. The piece firmly placed the outsized reliance of the industrial conglomerate on outgoing CEO Jack Welch, but failed to properly hold Immelt accountable for continuing to rely on financial services revenues and incomes to prop up the troubled firm.

Consistency is a curious quality, because you can observe it over time. It isn't created instantaneously. Thus, recent performances notwithstanding, I doubt either Morgan Stanley or GE has suddenly changed its striped and become a new company in the past quarter, or even 12 months.

The Need For A Simple Glass-Steagal Replacement Now

My friend, colleague and periodic business partner B sent me an email the other day including this passage,

"Yesterday, Morgan Stanley was reported to be bulking up its trading staff (adding about 350 people). Its major competition in trading is seen as JP Morgan Chase and Goldman. Today, the Journal headlined, “Property Loss Pounds Morgan Stanley Bank Says Battered $8.8 Billion Real-Estate Fund Stands to Lose Nearly Two-Thirds of Its Value”. "

B's point is that Morgan Stanley could, quite easily and quickly, now that it's a commercial bank, become a major systemic liability and source of risk- again.

When I had lunch with B on Tuesday, he remarked approvingly on the Volcker Rule. Like me, he sees it as a necessary step to segregate federally-, that is, taxpayer-insured banking activities from any financial activities in the areas of underwriting, proprietary trading or investment in non-Treasury assets.

B noted that, having narrowly escaped destruction under John Mack's questionable leadership, Morgan Stanley is far from chastened. Instead, it's hiring literally hundreds of traders and re-entering the proprietary trading arena. Meanwhile, the Wall Street Journal hails Morgan Stanley's leftover troubles with the headline announcing the sizable losses in its real estate investment funds.

Do you, as a taxpayer, really want a gang that lost so much money in real estate investing to be jumping back into proprietary trading in such a major way?

Forget the complex, mistake-riddled omnibus financial regulation bill discredited Senator Chris Dodd is trying to ram through Congress.

What we need, right now, is a simple, clear reenactment of Glass Steagal, as currently articulated by the Volcker Rule.

If this doesn't happen, there's no reason to doubt a repeat of Morgan Stanley's catastrophic, nearly-lethal risky behavior of earlier this decade. After all, it's not their money they are betting- it's yours. You just don't get the upside if they win. Only the downside, when they eventually lose it all.

Misplaced Hero Worship: Morgan Stanley's John Mack on CNBC

Yesterday afternoon I happened to catch Bill Griffeth's fawning, softball interview with Morgan Stanley retiring CEO John Mack.

I find myself unable to disguise my total disgust with CNBC's continued glorification of inept CEOs, including sympathizing over how, in this case, Mack struggled to avoid his firm's demise, while carefully avoiding any question over Mack's responsibility was in leading his firm to that brink of disaster.

In his questioning of Mack, all Griffeth could do was look on in reverence as Mack regaled him with tales of seeking Asian funding to avoid being closed down by the feds.

If you look at the nearby price chart of Morgan Stanley, Goldman Sachs and the S&P500 Index for the past five years, you can see that Mack had spent the better part of his tenure since mid-2005 mismanaging the investment bank onto an index-trailing path.

Much ink has been spilled over Mack's mistakes since his return to the firm at which Sears/Discover Card's Phil Purcell outmaneuvered him after the 1997 merger of the two firms.

If I recall correctly, Mack installed poor risk managers, then had the firm go for broke by diving into trading and underwriting mortgage-backed securities. Then held back in the last nine months while risk taking actually began to pay off again.

In contrast, better-led and -managed rival Goldman Sachs was performing far better even before the crisis of last fall.

So, instead of asking Mack questions about how he managed to lead his firm to the brink of insolvency and possible government takeover or enforced sale to a rival, Griffeth painted Mack as some sort of late-hour hero, beset by forces outside his control, desperately fending off Hank Paulson and Tim Geithner as he rescued Morgan Stanley with funding from new outside investors.

It makes me want to throw up when I see such shallow, gullible, misleading reportage. Much like Wall Street Journal veteran Peter Kann noted in an editorial on which I commented in this post, CNBC is rapidly heading down the road that led to the demise of printed newspapers.

Yesterday's interview of John Mack contained several aspects of that demise, e.g., shallow questions from Griffeth and a biased, flattering treatment of the subject, rather than hard-nosed questions that an intelligent, informed viewer would have posed.

Rather than champion capitalism and free markets, this sort of softball journalism at CNBC contributes to the weakening of our economic system. Griffeth breathlessly spoke about how narrowly Mack avoided Morgan Stanley going out of existence.

Guess what? Few financial service companies from thirty years ago are still around and independent. Poorly run investment banks and brokerages, such as Lehman- twice-, First Boston, Kidder Peabody and Salomon Brothers get taken over. Or perish.

Bill Griffeth needs to get a better sense of the reality of financial markets and the life-and-death cycle of those firms engaged in the rough-and-tumble world of securities underwriting and trading.

If a live televised interview on CNBC of the CEO of one of the less-well run investment banks doesn't feature questions about how Mack could have caused such massive, self-induced damage to Morgan Stanley, what will?

The Coming Financial Sector Troubles: Commercial Real Estate

Last week, in this post, I cautioned against becoming too optimistic over Goldman Sachs' recent blowout quarterly earnings.

Sure enough, yesterday's Wall Street Journal warned that Morgan Stanley is likely to report a loss this quarter, due in large part to bad commercial real estate performances.

This is precisely the sort of thing I had in mind when I wrote about Goldman. Goldman's earnings were trading-related, something at which the firm has always excelled. And it has been rather aggressive at writing down its commercial real estate holdings.

Morgan Stanley, however, seems to be reminding investors that it is an also-ran in investment banking, and, now, commercial banking, too. It plunged into real estate late and ineptly, being burned badly enough to have to plead for a commercial banking license, and actually consider behaving like one.

But, like most investment banks, Morgan Stanley doesn't really have a great deal of successful experience with holding physical assets like real estate for long term gains. This is now becoming clearer.

In fact, the drumbeat of commercial real estate troubles, which began some months ago, are growing louder and touching more companies, including GE.

I think it's way too early to declare soundness in the banking sector, or a healthy, recovering economy.

So long as joblessness continues to grow and federal spending fuels GDP, real estate lending of both types, residential and commercial, seems destined to limp along until prices finally fall to market-clearing levels.

Morgan Stanley's imminent disclosure of more real estate losses is probably just the tip of another expensive iceberg for the financial sector.

Citigroup Finally Considers Largescale Change

Today's business news is all a-twitter over the Citigroup-Morgan Stanley brokerage joint venture.

Forgive me if I yawn.

What, exactly, is all the excitement about? Two has-been financial giants with huge long term viability issues toss both their mundane, yesteryear personal retail, full-service brokerage businesses into a common pot?

For Vik Pandit, it's too little, too late. As the price chart for Citigroup in yesterday's post illustrated, the bank has lost nearly 80% of its equity price in the past twelve months. Surely, as others have also noted, Pandit would have gotten much more value for his shareholders had he done this early last year, rather than now.

This is precisely the sort of long term damage that results from in-denial, head-in-the-sand approaches to the actual condition of a business. By insisting on keeping Citigroup's unwieldy, difficult-to-effectively-manage business assortment intact, Pandit simply destroyed more shareholder value faster than he would have otherwise.

For this, alone, it should be time for him to go. And what more convenient time for the board, than in tandem with the guy who mistakenly hired Pandit, Bob Rubin.

Yes, there's also talk of selling Citigroup's Banamex unit. But with Citigroup effectively owned by the Federal government, dismantling it any further is probably academic.

With both Morgan Stanley and Citigroup having significant Federal government ownership stakes, I have trouble understanding how the brokerage joint venture is much different than two related businesses reorganizing units serving similar markets. This is one of the effects of Treasury's actions.

If anything, it probably argues that such combinations and consolidations should continue, until wholesale banking, retail banking, etc., are centrally managed, but dispensed to Americans via different old, familiar brands, e.g., Morgan Stanley, Goldman Sachs, BofA, Wells Fargo, Citigroup and Chase.

The names might differ, but the credit allocation policies, interest rates and such will be unvaried.

It's simply hard for me to take seriously the notion that two government-dependent commercial banks, each unable to prosper, let alone survive on its own, can effect much exciting, useful change for their shareholders anymore.

Let's be honest, even if the Wall Street Journal and CNBC won't. This is a government-owned sector now. It's no longer truly private enterprise.

Citigroup's actions are, at least, explained as being coerced by government officials who are now more owners than regulators.

How do you report that and still believe there's any private enterprise angle to these stories anymore?

A Strange Duality: Government Bailout of Banks Which Shorted Each Other's Equities

Rick Santelli of CNBC raised a very interesting point this morning regarding today's Wall Street Journal front page piece on the bear raid on Morgan Stanley in September.

Without trying to recount all the detail in the very long and well-written story, suffice to say that it has now been shown that Morgan Stanley's equity price was, indeed, affected by a sort of squeeze created by hedge funds and other investment banks buying credit default swaps, CDSs, on Morgan Stanley debt, along with shorting or buying puts on the firm's equity.

This activity pre-dated the TARP, and Treasury investments. However, Santelli noted the parallel of Morgan Stanley's troubles with those of Citigroup's recent problems, and wondered aloud how much taxpayer money was engaged in far-from-transparent speculation and similar squeezes on Citigroup's shares.

Upon being challenged by Squawkbox's Joe Kernen for suddenly being for more regulation, Santelli sensibly replied, to paraphase him (since I can't recall his exact words),

'Free and fair market capitalism doesn't mean no regulation. You need some regulation to keep things fair, and avoid insider and crony capitalism. We read today about the goings-on regarding Morgan Stanley's CDSs and equity in September. How about some transparency for today's activity in Citgroup instruments?'

As I wrote here last Thursday, in reference to AIG's troubles, the swaps market needs to become far more transparent, via a regulated, explicit exchange. Santelli raises an equally-valid reason for such an exchange.

As tools for squeezing and manipulating markets have multiplied, the old regulatory model of the 1930s is hopelessly, laughably outdated. The Journal piece indicated how a small purchase of CDSs to drive their prices up would yield outsized gains on short positions or puts of the same company's equity. Yet the former markets is completely opaque, consisting of phone calls and even IMs as its method of operating.

Santelli's concluding point was that, with taxpayer money in practically every large, remaining commercial bank, we can no longer risk having these institutions use 'our' money to engage in the activities which nearly triggered Morgan Stanley's demise and, certainly, forced its conversion to a Federally chartered commercial bank.

Lloyd Blankfein's Goldman Sachs: Same As It Ever Was?

In this post two weeks ago, I wrote about how merely obtaining a Federal commercial bank charter hardly makes Goldman Sachs and Morgan Stanley real, functioning commercial banks.

This past week, two articles in the Wall Street Journal demonstrated how these two former investment banks are already parting ways.

Goldman CEO Lloyd Blankfein was quoted as saying,

"We're going to consider everything," but won't do "something rash."

The article further noted, regarding Goldman Sachs developing a consumer banking business,

"Mr. Blankfein seemed to knock down that idea, stressing that Goldman has little, or no exposure to credit cards, auto loans, home-equity loans or other consumer loans, all of which could suffer if the U.S. falls into a significant recession."

On the subject of a merger, Blankfein remarked that he'd consider one,

"only if the deals keep Goldman's focus and culture intact."

Understanding that Goldman Sachs currently looks a lot like a hedge fund, it's difficult for me to see how Blankfein expects his firm to be able to simply exist unchanged.

If, as most observers expect, the FDIC and Federal Reserve mandate that the firm reduces its leverage and business mix to more closely resemble those of commercial banks, Goldman will have a very hard time finding non-consumer banking business volumes sufficient to retain its current size, expense and infrastructure bases.

If, on the other hand, it tries to merge with a commercial bank, there's just no way the vaunted Goldman culture will remain intact. Apparently, Blankfein's bid to outs Pandit at Citigroup and merge with that money center bank, came to naught.

Maybe, with the rumors of Citi's board's split over Pandit, Blankfein may have another shot at that merger. Maybe not.

Either way, it's just hard to see how Goldman can tread water and remain as profitable as it has been in the past, with a similar business mix.

Morgan Stanley, on the other hand, was written up on Thursday's Journal as cutting more than 2,000 employees while hiring two outside commercial bankers; Cece Sutton and Jonathan Witter, both formerly of Wachovia.

The two Wachovians are to become Morgan Stanley heads of retail banking and CEO of the retail banking group, respectively.

While in obvious contrast to Goldman Sachs, Morgan Stanley's more aggressive move to build a consumer business calls into question just what it can ever hope to add in an already-consolidating market.

Note that Mack hired two executives from a bank that essentially failed, due to its retail-oriented mortgage banking strategy. And Morgan Stanley took its own licks from mortgage finance, too.

As a consumer, would you have much reason to suddenly drop your current bank and take new credit cards, a mortgage, and open checking accounts with the former investment bank?

New entrants in a product market typically offer some new or unique value proposition. Morgan Stanley's seems to be something like,

'Hi. We used to be a highly-leveraged investment bank-cum-hedge fund. But that didn't turn out so well.

Now, we've decided to try to be a commercial bank, because we might survive that way.

Won't you please do business with us?'

Hardly compelling, is it? Somehow, the former loss-making investment bank is hardly in a position to cross-sell it's asset management/high net worth business skills anymore.

Which brings me to the point I made in that prior, linked post,

"Either way, if Goldman and Morgan Stanley don't soon sell themselves to some decent-sized banks, or buy various consumer loan and deposit-taking operations, they will lose their independence as federally-chartered entities the harder way, in forced marriages arranged for them."

Growing its own consumer banking from scratch is unlikely to do much for Morgan Stanley. Eschewing the segment totally probably won't help Goldman Sachs, either. Right now, based on existing information, I'd say neither is in particularly good, long term shape.

Your New Bank: Goldman, Morgan Stanley or GMAC?

If I tell you that tomorrow I intend to become a steel company, will that actually make me a competitor of Posco and Nucor?

Of course not.

When Lloyd Blankfein and John Mack changed their firms from investment banks to Federally-chartered bank holding companies, did that actually make them commercial banks?

No.

And, parenthetically, despite Wednesday's Wall Street Journal piece detailing GMAC's bid for Federal aid via a bank charter, the auto maker's finance arm won't magically become a real bank, either.

In two separate articles that day, the WSJ discussed the prospects for all three firms as commercial banks, rather than their former incarnations.

GMAC, of course, is simply searching for a way to feed at Treasury's bailout trough, as if the direct Federal "loan" to its nearly-dead parent is not sufficient. To suggest the auto loan and mortgage finance company could really function as a full-service bank, and profitably, is ludicrous.

But it does highlight the ingenuity of Americans. When our government ladles out cash, we figure out how to qualify in a flash.

Goldman Sachs and Morgan Stanley have more options, because they aren't really dead yet.

Goldman's Blankfein displayed his chutzpah by offering to merge with Citigroup, if novice CEO Pandit would kindly step aside and let the veteran investment bank's management run things.

Rumors swirled about a Morgan Stanley-Citigroup merger, too, with the alleged common heritage of Citigroup's CEO and the investment bank supposedly greasing the deal.

Truth is, as the WSJ article about them hinted, but failed to describe in detail, merely saying they are now commercial banks does not, by any stretch, make Goldman Sachs and/or Morgan Stanley commercial banks.

Can you imagine a Goldman staffer guiding you through a consumer loan or credit card application? Handling your electronic transfer or opening a safe deposit box for you?

Me neither.

In fact, as the Journal piece suggested, these two late converts can't really be commercial banks in any meaningful, consistently profitable way, so long as they remain as bloated, publicly-owned hedge funds.

Sooner or later, the Fed will force them to shrink or spin off those assets which make them, well, too risky to be a commercial bank in these times. What's left at either company is essentially asset management, some trading and underwriting.

No credit cards. No mortgages. No consumer loans. No transactions processing businesses. No basic commercial loan businesses.

That's why Blankfein and Mack, being smarter than the average real commercial bank CEO, are looking to infect/invade an old-line money center or regional bank much as a virus invades its host.

Rather than buy and bolt on, for example, Capital One, a medium-sized deposit-taking bank, and some out-of-work mortgage, consumer and commercial loan officers, it would be far easier for Goldman to merge with the likes of Citigroup or even PNC. The former, ailing as it is, might accept the marriage as a way to further disguise its true lack of progress on returning to health, while the latter could be vaulted into the ranks of high finance overnight.

Either way, if Goldman and Morgan Stanley don't soon sell themselves to some decent-sized banks, or buy various consumer loan and deposit-taking operations, they will lose their independence as federally-chartered entities the harder way, in forced marriages arranged for them.

Some Observations On The Current Financial Market Crisis

There is so much one could write about the events of the last week in our financial markets. And, no doubt, in weeks to come, I'll touch on many of them, in retrospect.

This morning, however, I have a collection of reflections I'd like to convey.

The first is my reaction to an article discussing the MUFJ rescue of Morgan Stanley. In this morning's Wall Street Journal, there is a long piece purporting to describe how, now that it has linked itself to MUFJ, Morgan Stanley and it's embattled CEO, John Mack, can go about 'repairing' its financials and 'righting' itself.

C'mon, who are they kidding?

Mack mismanaged the one-time investment bank, now newly-minted commercial bank, into near-oblivion. If Morgan Stanley had been perceived by regulators as the same sort of buccaneers as Lehman, with an equally-dislike able CEO as Fuld, and as narrow a range of businesses, it, too, might already be out of business.

Is it too much to ask people to realize that, despite the fresh capital, the same boneheads are in place at Morgan Stanley? The gang that brought them to the brink of insolvency are now recharged with more billions to squander.

No, I'm not arguing that we tank the international financial system to punish Mack and his mismanagement team.

Rather, let's not all lose perspective with respect to the firm. A large, slow-moving, capital heavy foreign bank has rescued the brand franchise of a once-storied American investment bank. It would be surprising if Morgan Stanley doesn't meet the same fate as its erstwhile competitor, First Boston Corporation, now merely a fragment of CSFB.

The fact is, what were, some twenty years ago, fast-moving, lightly-capitalized underwriters, M&A advisers and corporate financial advisers, with smallish, client-oriented trading operations, became unsustainably-leveraged, thinly-veiled publicly-owned hedge funds.

Don't expect what is left of Morgan Stanley to be anything to write home about when it comes to future performance.

Now to my other thought for this morning.

Roughly 90 minutes ago, President Bush announced the expected headline measures that the US government will take, via the Fed, Treasury and FDIC, to join its European G8 and G20 allies in insuring inter-bank lending, business DDA balances, and forcibly taking non-voting, temporary equity positions in major banks.

Both Bush and his Treasury Secretary, Hank Paulson, emphasized how distasteful it is to them, personally, and, they believe, to most Americans for the government to be owning shares of otherwise-publicly-held companies.

It ostensibly flies in the face of our brand of free enterprise capitalism and free market ideology.

But, before we all visit a Jesuit retreat, self-flagellate, and wear hair shirts, let's remember how we got to this point.

Our financial markets are in the shape they are in because of government intervention and mandates on the free market.

We began nationalizing the financial sector when we created Fannie Mae and Freddie Mac. These institutions implemented Congress' force-feeding of capital markets with low-income borrower, low-quality residential mortgages. As time passed, Congress continually set the goal for securitized low-quality mortgages ever higher. As high as 50% of the GSE's pass-through volumes!

Then we have the CRA. Government mandated commercial banks to lend to poor credit risks for low-income housing. Again, we, through our government, already screwed around with our financial system.

We allowed our government to override private credit risk controls.

This isn't Act One of the nationalization of our financial system.

In reality, it's Act Two: The Cleanup.

What will Act Three be? Exit? Or 'fascism?' And I mean fascism, technically defined.

In any case, before we all moan and groan about this new nationalization of banking by a Republican administration, let's be honest.

Congress and two Presidents- Clinton and Bush- pushed our financial sector to make badly-considered loans for homes to people who were too poor to afford them.

That was the nationalization of our financial system.

Despite what many believe, 'Wall Street greed' simply fed into the system that the government had already set in motion.

The Fates of WaMu & Morgan Stanley

As of this morning, news stories still report Wachovia considering the purchase of Morgan Stanley, while, somewhat comically, in relation to the reports of Citigroup considering merging with WaMu, the former's CFO, Gary Crittenden, was quoted as saying,


"People view us today as being a source of the solution, instead of part of the problem."


Only in a rapid consolidation like the current one would so badly managed a bank as Citigroup be considered as a 'source of the solution.'


Perhaps it's just a matter of relativity. As inept as Citi's management is, WaMu's was worse.


Would the financial system be worse off with WaMu's assets slapped together with Citigroup's? Probably not. In this environment, it's not clear what WaMu's other options are, besides orderly sale of its non-mortgage consumer business to some other large bank, while shareholders keep the damaged mortgage assets to offset whatever equity remained.


As to Morgan Stanley's China option, one wonders how that would work? A country whose army still employs prison labor in its commercial manufacturing businesses would now also one one of America's larger investment banks? Not to mention a country whose ownership rules for foreigners doing business in country are so restrictive as to be laughable? Where does the issue of trust enter here?


(At this point, I had written substantial additional material which was published earlier this morning, but has now, inexplicably disappeared. I shall attempt to reprise those additional thoughts.)

But, the larger point is this. Most of the publicly-held US investment banks failed to adequately understand the environment in which they were operating for the past twelve months.

Despite the ranting of CNBC financial hothead Jim Cramer to the contrary, most of these banks did, indeed, debauch their own franchise values. Cramer, only this morning, was nearly breaking his arm while attempting to pat himself on the back for calling for an RTC-style entity in July. In the next breath, he alleged that it was unfair that Bear Stearns, Lehman, Merrill Lynch and, probably, Morgan Stanley have or will vanish as independent entities.

He also contended that Morgan Stanley and Goldman, in his opinion, were in danger of going insolvent yesterday.

I disagree. Those two investment banks, as I wrote here, had options. And still do. But that doesn't mean each should remain as a publicly-held, independent entity.

If it takes today's, and the past two weeks' efforts by the Treasury, Fed, SEC, and other Federal regulatory agencies to rescue a raft of large US financial service entities, then it's fair to question how ably these companies were being run in the first place, isn't it?

They all- or almost all- clearly misunderstood the current financial environment, and failed to take adequate steps in sufficient time to avoid bankruptcy or sale to another firm. Their risk management efforts were terrible.

Why should anyone want those managements to continue to operate in our financial services system? Doesn't the existence of such inept management teams- risk and general- put our entire financial services system at risk?

Yes, it does.

You may argue, as Zachary Karabell did in yesterday's Wall Street Journal, that this is all due to the Enron-era Sarbanes-Oxley legislation which mandates 'mark to market' of thinly-traded, poorly-understood structured financial securities.

So be it. But the whiz kids at these Wall Street houses, and AIG, all knew the rules, or should have. What they apparently didn't know, in reality, was what could really happen to complex instruments, and the values of their firms, which held so much of this paper, when markets for such instruments simply vanished.

Ironically, we saw the same miscalculations when the same firms used 'portfolio insurance' approaches to risk management in the crash of 1987. It didn't work.

Wall Street is, in truth, littered with past crises and market crashes during which the predominant risk management solutions of the day failed to anticipate the next risky environment.

Part of the reason, of course, is the concept of the 'fallacy of composition.' I first learned of it in Paul Samuelson's classic text, "Economics," in my undergraduate economics courses.

What the typically-young, inexperienced risk management model-builders on Wall Street usually fail to anticipate is that, when a market is composed of firms operating similarly-run risk management functions, then they will all behave similarly in the face of the same price information. What happens next falls under the fallacy of composition. All desks try to sell at once, and prices plummet even further, triggering even larger sales of even more instruments.

Of course, it has worked on the upside, too, occasionally. But, on the downside is where crippling side effects like margin calls and capital inadequacy appear.

Think what you may, but John Gutfreund recently and sagely noted the inability of firms such as Lehman to come to terms with the new realities of highly-leveraged investment banking operations in a world of overcapacity and too-thin margins.

Thus, as the moderating economy of the US caused the first ripples of doubt among holders of structured financial paper backed by subprime and alt-a mortgages last summer, the die was effectively cast ending either the independence, or existence of most US investment banks.

Poor risk management and the denial of reality by boards and senior management delayed the inevitable recognition of declining value of many assets held by these firms. And by several large commercial banks.

What's happening now, frankly, ought to occur. Everybody knew what SarBox meant for marking balance sheets to market. And everybody knew that the last batch of securitized mortgages were of lower quality than those of five, or even three years ago.

WaMu's and Morgan Stanley's fates are comparatively strokes on a larger canvas of ineptitude of risk and general management by many large, publicly-held US investment and commercial banks in the past few years.

As a society, we own these behaviors. We can't let the them destroy our financial system. Thus, today's governmental actions which have either nationalized some aspects of, or curbed the operation of free markets in US finance, may be temporarily necessary.

In the longer term, some simpler, clearer means of firewalling leveraged activities needs to be developed, so that, with minimal oversight, natural human behaviors to seek to maximize opportunities for profit, and misunderstand concomitant risks, won't bring a repeat of this financial services sector debacle.

John Mack's Old & Tired Ideas For 'Refocusing" Morgan Stanley

The weekend edition of the Wall Street Journal carried an article describing John Mack's efforts to 'refocus' Morgan Stanley.

The lead sentence in the piece tells you the trouble Mack is courting,

"For two weeks in July, Morgan Stanley Chief Executive John Mack moved into an office near the research analysts who work at the Wall Street firm's headquarters in New York's Times Square. He had two goals: boost morale in a unit hit hard by layoffs and figure out how to squeeze more value out of stock research."

John, do you recall a guy named Elliot Spitzer? Do you remember what he charged many Wall Street firms with doing? Including your own, Morgan Stanley, regarding Mary Meeker?

As I recall, Spitzer reached a major, sector-changing settlement with your firm, and others, for ....squeezing more value out of stock research!

Mostly by improperly attaching it to trading and investment banking, so access to star analysts, and their involvement in boosting firms underwritten by their own firms, shifted their work from independent, objective research, to mere marketing on behalf of clients and trading desks.

A friend of mine, formerly a senior communications systems management at Lehman, now at a major tech firm, confirmed this for me last summer. He regaled me with stories of 'research analysts' getting in on the pitch to prospective underwriting clients on how they would support the new client via opinions to institutional clients and their own trading desks.

This is the sort of thing that the storied settlement was supposed to change.

Now, John Mack is reportedly,

"Since having dinner with research division leaders and informal chats with analysts as part of his two-week immersion, Mr. Mack has been talking with lieutenants about what should be changed in research. One challenge: quantifying the value generated by good ideas used by both the firm and its clients. The topic has come up several times at recent weekly management-committee meetings."

First, isn't that the holy grail of Wall Street? And has been since time immemorial? Please tell me, John, that you don't really think this is new ground you are plowing.

"Quantifying the value...." of research is the age old quest of brokerages trying to figure out what those expensive eggheads actually do to make money for the firm.

And, since the modern brokerage has three major businesses- institutional sales/trading, proprietary trading and underwriting- the analyst must be adding value to one or more of these, if s/he adding value at all.

The first and third businesses are exactly where Spitzer's hunt focused- improper use of analysts to win underwriting and then lever those products into institutional trading clients.

Using analysts to improve proprietary trading is, of course, an obvious path. But if this were simple and effective, wouldn't it already have been done? Then, again, the really good analysts, eventually, become money managers. So maybe that's not as simple as it seems. And it puts great pressure on analysts to produce consistently and well. Maybe that, too, doesn't work so well in practice as in theory.

It just strikes me, from the Journal article, that none of Mack's alleged new ideas is actually new at all. And if they are known to work, wouldn't the article note that, too?

As the nearby five year price chart for Morgan Stanley and the S&P500 Index indicates, it's been a terrible 18 months or so for Mack and his battered shareholders.

It seems to be another stumble of John Mack's on the long journey through the desert of bad performance on which he has led Morgan Stanley these past few years.