ON his tombstone, Morgan Stanley’s John Mack could have the maxim “take more
risks” etched into the marble. It has been a refrain during the former bond
salesman’s 35-year career, used to coax top-drawer performances from the
legions of Wall Street traders he has led.
Only this week did his legendary risk-taking come home to roost – Morgan
Stanley is the latest Wall Street bank to count the cost of the
rollercoaster lending binge.
Its $3.7 billion (£1.8 billion) loss from investments linked to sub-prime
mortgages pales into insignificance compared with the rivers of red ink at
Merrill Lynch and Citi. However, Mack must grapple with the vast gulf
opening up between what big banks are saying and what investors fear is the
truth about their exposure to billions of pounds of toxic debt. Betting the
wrong way on the American housing market could cost him up to $6 billion.
Unfortunately, it is too soon to tell precisely.
But as Friday’s fresh market slides demonstrated, the day of reckoning for an
investment-banking sector suckled on excess is getting close.
Since Northern Rock threw itself on the mercy of the Bank of England on
September 13, the top 15 lenders on both sides of the Atlantic have taken a
hammering. Some £120 billion has been sliced from their market value – the
equivalent of an institution the size of HSBC going up in a puff of smoke.
Fear is gripping investors and the bears are roaring. Denials from Barclays
that it faces a hefty £5 billion write-down or that either chief executive
John Varley or Bob Diamond, the supremo at Barclays Capital, were for the
chop, did not prevent the bank’s share price going into a tailspin once
again. On Friday, trading in its shares seized up for 20 minutes as the
London Stock Exchange struggled to cope with sellers heading for the exit.
This is particularly galling for Diamond. As long ago as August, his comments
that early sub-prime jitters had been “a necessary repricing of risk” and
that he “would be surprised” if credit markets “weren’t back at more normal
levels by October” look pathetically optimistic today.
The bank is grimly vowing to hang on. It does not plan to comment on its
finances until a scheduled trading update on November 27. However, Anthony
Broadbent at Sanford Bernstein set the tone, forecasting that the credit
crunch could dent annual profits at Barclays by £3 billion and at Royal Bank
of Scotland by £3.5 billion.
The constant drip-drip of write-downs has only fuelled market whispers that a
disaster is around the corner. While banks stumble through the autumn season
of reporting, analysts are looking further out for the true cost of the
meltdown.
Bob Janjuah, chief credit strategist at Royal Bank of Scotland’s global
banking and markets arm, reckons banks, particularly in America, are hiding
behind “Level 3 accounting”. This lets them tot up the value of billions of
dollars of stranded securities according to their best estimates.
Rather than marked to market, he calls it “marked to make-believe” – but new
rules coming in shortly will make it harder to go down this route.
In a stark note to clients, Janjuah said: “Forget $50 billion or $100 billion.
This credit crisis, when all is out, will see $250 billion to $500 billion
of losses. And for all those who think it’s all priced in, Wake Up. We are,
at best, not only still in the first half of the game, we are still in the
first 15 minutes of a 90-minute game. And this game could go to extra time
and penalties before we have a resolution.”
Mike Mayo, an analyst at Deutsche Bank in New York, estimates that charges
from banks and brokers will reach $50 billion in the second half, mostly
related to collateralised debt obligations (CDOs). Backed by
sliced-and-diced mortgage securities, they have quickly gained pariah
status. Higher credit costs could leave balance sheets at their weakest in
two decades.
As the storm gathers, those that sense the whiff of a quick profit are
circling.
“There is a great opportunity just around the corner, although not just yet,”
said Frits Prakke, partner in Alchemy’s Special Opportunities Fund, which
raised £300m last year to buy up distressed assets. “We believe that
sub-prime is only the first shoe to drop.”
He predicts a crunch for leveraged loans, of which almost $400 billion remain
undistributed by originator banks. In total, he sees bad loans and
structured investment vehicles (SIVs) totalling up to $500 billion that need
to be tackled – the same as Janjuah’s worst estimate. Along the way,
insurance groups and pension funds that have sat on the sidelines so far,
will have to feel some pain as well.
Prakke adds: “A month ago, we all thought the banks were ‘kitchen sinking’ it.
Now we have a very different opinion. As a rule, they had taken the least
pain they could get away with.”
American commentators agree that the crisis is far from over. Donn Vickrey,
co-founder of the analysis firm Gradient Analytics, has his eye on some
colourful accounting practices at two of the biggest lenders –
Washington Mutual and Countrywide.
Vickrey said both banks have been shifting huge amounts of sub-prime property
away from their sales lists, where they should be, and into their investment
category.
“Basically, they are making their income statements look healthy and shifting
the category of deteriorated loans,” he said.
That could be the next blow to hit Washington Mutual after its share price
slumped this month on news that it is being investigated by the New York
attorney-general.
Investigators have said the company may have colluded with mortgage agencies
when assessing the price of homes for sub-prime mortgages.
At a recent meeting with analysts, however, Kerry Killinger, Washington
Mutual’s chief executive, was the voice of the common man. “The first
priority for us is to try to keep [customers’] homes out of foreclosure if
at all possible, because keeping people in their homes in this kind of a
market is the absolute first priority,” he said.
Countrywide is also trying its best to fend off criticism, despite a
class-action lawsuit and a hard-hitting attack from an investment firm that
accused it of paying executives too much.
James Fotheringham, a Gold-man Sachs analyst, said in an investor note that
Countrywide could be in deeper than the $200m it has set aside to deal with
its sub-prime exposure.
Brian Gendreau, a strategist at ING Investment Management, said such inexact
loss calculations are making it difficult to predict who is next for the
chop.
He said financial institutions are writing off losses piecemeal and then
coming back with new announcements the next week. “It raised some serious
questions about their ability to judge what their losses are,” he said.
For Gendreau, there is an underlying problem here. Financial institutions
don’t know the value or even location of the asset-backed commercial paper
on which so many sub-prime loans were traded in dizzying complex
transactions.
It has led to a crisis of confidence that has stretched too far, he believes.
“Nobody wants to touch real-estate paper, but now they won’t touch any
asset-backed paper. That’s unfair, but in a crisis, people run for the
exits.”
Peter Plaut, an analyst with the hedge fund Sanno Point Capital Management,
said the situation is going to get a lot worse. The major issue this quarter
will be ratings downgrading, with even Citi and Morgan Stanley at risk
because they are so heavily leveraged, he said.
With the 30 largest SIVs holding between $300 billion and $1,000 billion, that
is an awful lot of margin for write-offs and market confusion, he added.
Like many, he is deeply concerned about the insurance giant Ambac Financial
Group, which acted as financial guarantor in many sub-prime contracts.
In an extraordinary admission, Morgan Stanley research analyst Ken Zerbe said
in a recent note to investors that Morgan Stanley had seriously
underestimated Ambac’s exposure.
“We misjudged the speed and breadth of the deterioration in the credit
markets. We acknowledge that our prior call on the industry and the Ambac
stock was simply wrong,” he said.
However, at a meeting with analysts which the company said would “restore
faith” and clear up misunderstandings, David Wallis, Ambac’s managing
director of portfolio risk management, sought to play down the company’s
exposure. “You’re talking about a massive meltdown in terms of the
trillion-dollar sub-prime market,” he warned, while telling analysts that
Ambac's role is not as extensive as some say.
At Morgan Stanley, John Mack has been saved so far because his bank has not
been put on the critical list by Wall Street analysts.
He was, however, the man who took Morgan Stanley into the sub-prime market
last year. Mack was racing to catch up with Wall Street rivals that had
already begun playing fast and loose while his more cautious predecessor,
Philip Purcell, was at the helm.
For now, he has been fortunate to hang on. But as the crisis deepens,
virtually every banking boss is looking nervously over his shoulder.
Additional reporting: Sean O’Driscoll
