Finance Ind II(Readings): Fundamental Breakage in the BM
Let's keep cranking on trying to take apart the current situation and strategic outlook for the Finance Industry. But first we should note that BM stands for "Business Model". Not what you thought it stood for but, nontheless, the pun was intended. And gets to the heart of our argument - which is that the business models of key sectors of the Finance Industry are flawed to badly broken, and we believe that many of the readings support that. The extent of the breakage depends on the sector but those which depended on leveraged trading and investment are most exposed for multiple reasons which are discussed below. Those closer to traditional banking and finance practices have lots of room to improve but equally a good dose of sound business practice, a little innovation and an increased focus on marketing and customer service would go a long way. If you are a stakeholder in any of these you need to walk thru the blueprint and use it as a checklist for assessing their statii and outlook.
The chart at right will be no surprise of course. It shows the Industry as a whole (XLF), the Broker-Dealers (IAI), the Insurance sub-industry (IAK) and Regional Banks (IAT). If you buy the arguments of the last three posts (Market, Economy, Finance I) we've had a bull rally with terrible misjudgments on valuations and earnings outlooks with a weakening economy which has yet to tip over into a real downturn. Consumer demand has been weakening in any case, and that was before factoring in the implicit tax of energy and food costs surges, which would feedback destructively to hiring and investment spending (per the normal causal linkages). And as a result we were about to see many more boulders topple into the credit pond with a series of feedback loops between deteriorating economics and worsening delinquencies. Net net the question would therefore be how much farther on that chart - over and above where we think the markets are going ?
Well we could let you just skim the readings excerpts and reach your own interpretations. Which we urge you to do. BUT...we'd also like to testfly the framework we deployed against our strategic evaluation of Citi as a way of thinking about the industry as a whole. Both because we think the general enterprise framework works and because the work that Pandit and his team have done strikes us as capturing 80-90% of the total industry situation (excluding the Insurance industry of course). (Poster-child II: Citi's Potential Turn-around as Performance Examplar) You'll find the readings below collected in various takes on the Strategic Outlook, specific companies (including one that shows AIG's writeoffs and capital raising changing radically in a week as well as UBS's huge discounted rights offering...shocking though nobody appeared shocked...numbness setting in all over ?). The final section gets to the heart of the matter by providing various readings on thinking about the futures of the industry...that is does their business model and strategies still work, if they ever did ? 
Based on those readings, all the prior posts which basically dealth with the same question and the strategic assessments in Citi's presentation we end up with the graphic at right. After two decades of innovation in the '70s and '80s which provided tremendous value-add and new services for consumers and business the industry shifted its' emphasis to leverage, complex products and trading on its' own account. That worked, apparently, since the mid-90s til last year. And then broke badly despite bringing us an unprecedented series of booms and busts for the same underlying structural reasons.
Now we're in a regime where de-leveraging will be the dominant macro-environmental theme and as a result capital requirements will be raised, explicitly by regulation or implicitly by investment returns. So instead of being able to reap the profits from being leveraged 30x, or 40x or 70x the banks, brokers/dealers are entering an era where they'll have to return to fundamentals. Hence our judgements in the various shade of warning indicators as to whether the business models of the last decade are sustainable going forward.
We could argue thru each sector individually and then discuss each of the major players but won't - though we do think this is the kind of evaluation any employee, investor or stakeholder needs to do for each and every one of them. What we will assert though is that these fundamental re-thinkings aren't widely recognized, acknowledged or accepted though several key commentators have made similar observations. And this kind of re-thinking is clearly implicit in Citi's new strategic framework. So apply the Buffett test - which of these are businesses you'd want to own a piece of as businessess ? Our answer - not many until these re-structurings are begun. On the other hand as Rubenstein, Buffett, Jubak, et.al. are pointing out there will be lots of gems to be sorted from the rubble. Once the rubble all falls down...which point we are IOHO a long way from.
Strategic Outlook
De-leveraging dilemma Investment banks like Goldman, Lehman Brothers and Morgan borrowed more and more money in recent years and used that to accumulate assets. That left the firms leveraged more than 30 times at the end of 2007, a record, analyst Michael Hecht noted. But the mortgage-fueled credit crunch is now forcing investment banks to sell assets and cut borrowing, in a de-leveraging process that Hecht thinks has only just begun. If investment banks cut leverage to 20 times, down from 30, that would slash return on equity in the industry by 24%. Return on equity, or ROE, is a closely watched measure of how efficiently companies use the money they get from shareholders. Lehman could be the worst hit, suffering a 55% slump in ROE in Hecht's de-leveraging scenario. Goldman and Merrill would see the smallest declines in ROE, the analyst added. Reducing leveraged to 20 times from 30 may also slash net income in the industry by 27% and imply an 11% reduction in total assets. That's a reduction of more than $370 billion in assets across Wall Street, something that "would undoubtedly put some pressure on asset prices," Hecht warned.
- Wall St. Compensation Disaster? All of Wall Street has to prepare for a compensation disaster that will make Citis layoffs and pay cuts look like small change, according to CNBCs Charlie Gasparino.
- Brokerages Under Fire Cutting rates on a few financials, with Dick Bove, Ladenburg Thalmann and Co analyst and CNBCs Carl Quintanilla
Plastic's Uncertain Future A growing feeling that stand-alone credit-card lenders will weather the economic slowdown has started to lift shares in firms like American Express Co., Discover Financial Services and Capital One Financial Corp. But recent credit-card data indicate that none of the big card companies -- including the large card units at banks like Bank of America Corp., Citigroup Inc. and J.P. Morgan Chase & Co. -- are in the clear. Rising defaults could weigh on earnings for longer than expected. But two key data points indicate defaults climbing higher, not falling fast. First, card borrowers are starting to pay back less of their outstanding balances each month. Analysts at Oppenheimer & Co. say that a sustained decline in the amount borrowers repay each month, compared with a year-earlier, can be a leading indicator that borrowers will start to fall behind on payments. Also worrisome are data from Moody's suggesting that borrowers are finding it harder to become current on credit-card loans once they fall behind. The ratings firm notes that the amount of loans on which borrowers have skipped three or more payments has started to rise more quickly than loans that have missed one or two. Once borrowers are three payments behind, fewer of them ever catch up.
Investors see one Wall St., while bankers and brokers see another Investors see sunshine; bankers, rain. No one seems to be on the same page. Or are they? In this case, the diverging opinions of the industry and the investors who stake their fortunes on it aren't mutually exclusive. The idea that Wall Street -- or any industry, for that matter -- can get leaner and meaner when business slows isn't radical thinking. Banks and brokerages operate in a cyclical business. Things will turn around. Investors may be wise to buy when prices are relatively low. The issue, then, isn't if profits will return to the industry, but when. And here's where the two sides diverge. Wall Street is bracing for a long slumber, and investors think a rebound is already here. Unfortunately, there's ample evidence that the Street has this one right. Since first-quarter earnings hit in March, there's been little to suggest a turnaround is imminent. Jamie Dimon, J.P. Morgan's chief executive and the last banker standing without foreign ownership or diluted shareholders, has been among the most pessimistic when it comes to forecasts.
UBS's Magnus Sees `Long Way to Go' for Recovery of Banks May 23 (Bloomberg) -- George Magnus, senior economic advisor at UBS, talks with Bloomberg's Naga Munchetty in London about inflation risks in the global economy, interest rates in the U.S., U.K. and Europe and the outlook for banks recovering from the credit crisis. The world's biggest financial companies have posted at least $383 billion in writedowns and credit losses since the start of last year after the subprime mortgage market collapsed. The resulting economic slowdown has prompted the Fed to lower its benchmark rate 3.25 percentage points since September to 2 percent.
Key Players
Mary Had a Little Lamb and a Jumbo Mortgage Once upon a time, there lived a King who granted each subject enough money to make his home his castle. Sound like a fairy tale? It isn't. It's basically what happened last week, with Fannie Mae, the largest mortgage lender, doing an about-face, easing loan standards after tightening them in December following an increase in defaults and dislocations in the mortgage, housing and securitized loan market. Specifically, Fannie announced it will now accept mortgages with a loan-to-value (LTV) ratio of up to 97 percent on a primary, single-family residence, even in areas where prices are declining. ``I'm not even sure this makes sense as public policy,'' says Michael Carliner, an independent housing economist in Potomac, Maryland. ``Fannie should be making loans, but the underwriting standards shouldn't be lowered to that extent.'' Just think about it: With home prices in a handful of hard- hit areas of California and Florida down 10-15 percent last year, according to data from the Office of Federal Housing Enterprise Oversight, or Ofheo, Fannie's regulator; and with widespread expectations that prices will continue to fall to attract buyers, Fannie Mae is loosening down-payment requirements when a house in these areas could be worth less than its loan value in a matter of months?
Freddie Mac Suffers Bout of Temporary Insanity: Jonathan Weil That new twist on an old joke goes a long way toward explaining Freddie Mac's net loss last quarter of $151 million, which was smaller than analysts' estimates. In reality, Freddie is gushing much more red ink than that. Yet hardly any of it is showing up on the company's income statement. That's mainly because the government-chartered mortgage financier has deemed $32.4 billion of paper losses from mortgage- related securities as ``temporary.'' Freddie's big sister, Fannie Mae, is in a similar, though less extreme, position with $9.3 billion of such losses. Most of these losses are on securities backed by subprime mortgages. About $13.2 billion of them are on securities that have been valued below Freddie's cost for a year or longer. Some of the losses stretch back more than two years. All this has occurred under the tolerant eyes of Freddie's feeble regulator, the Office of Federal Housing Enterprise Oversight. To put this in perspective, $32.4 billion is more than double Freddie's $16 billion of shareholder equity under generally accepted accounting principles. It's almost twice as much as the company's $17 billion stock-market value. And it's infinitely greater than the fair value of Freddie's net assets, which at March 31 was negative $5.2 billion.
AIG Capital-Raising Will Total $20 Billion, Chief Executive Sullivan Says American International Group Inc. will raise a total of $20 billion, 60 percent more than the New York- based insurer originally said it needed to protect against further writedowns, Chief Executive Officer Martin Sullivan said. AIG, the world's largest insurer by assets, raised at least $13 billion through last week selling common stock and units that can convert into shares, Sullivan told investors and analysts at a conference in London today. A sale of hybrid bonds is underway. The new capital ``enables us to take advantage of a lot of the attractive emerging markets we're in, as well as obviously be well-positioned for any continued volatility in the credit markets,'' Sullivan said. AIG said May 9 its capital cushion became ``too low for comfort'' after a record $7.81 billion first-quarter loss. Banks and securities firms have raised or announced plans to seek more than $260 billion since July to replenish capital depleted by the collapse of the U.S. subprime market, according to Bloomberg data. AIG to Pare Costs, Offload Units
UBS Raising $15.5B at Deep Discount UBS AG said Thursday that it would raise $15.5 billion in a rights issue at a 31 percent discount below the current share price. UBS, hard hit by its exposure to the U.S. mortgage market, said it will sell new shares at 21 francs ($20.09) each to existing shareholders, compared with the closing price of 30.64 francs on the Zurich exchange Wednesday. Shareholders will receive one subscription right per share held, with 20 of the rights entitling the holder to buy seven new shares. The new rights will be tradeable, the bank said. Vontobel's Claudia Meier said the price was cheaper than she expected and the total issue of 760,295,181 new shares was fewer than she anticipated. Helvea's Peter Thorne noted that the amount of the issue was larger than the 15 billion francs initially targeted. "Every little bit helps," said Thorne, adding that the new share price was in line with tepid market expectations.Thorne said he expects a sizable turnover in the new shares because UBS' traditional investors bought the stock as a risk-free investment, and UBS has not become a bank recovery stock.
Broken Business Models & Strategies
Citi’s Weill admits flaw in 2003 succession Sandy Weill, Citigroup’s former chairman and chief executive, has acknowledged that the planning that led to the choice of Chuck Prince as his successor in 2003 was flawed and turned out not to be the “right thing” for the company. In an interview with the Financial Times, Mr Weill said he and the board should have fostered competition among Citi’s top managers for the chief executive post rather than handing the job to Mr Prince. The technique has been used by large companies such as General Electric, which selected Jeffrey Immelt as Jack Welch’s successor after a race with two other executives. Mr Weill did not mention Mr Prince by name but said: “I certainly have responsibility for working with the board in devising a plan of succession and I would not give myself very good grades on that. At the time, I thought I was doing the right thing but it did not turn out to be, did it?” A number of critics have called for a break-up of Citi. Even John Reed, the other architect of the 1998 merger that created Citi, recently told the Financial Times the deal had turned out to be a mistake. “I do not agree [with critics of the model], whoever says that does not know what they are talking about,” Mr Weill said. “Citi has raised $44bn ... in the last six months, that’s more equity than most companies have. The company would not have been able to raise that kind money had it not had a model people could believe in.”
Ken Griffin, and Thoughts on Fixing Wall Street Kenneth C. Griffin, who runs one of the biggest and most successful hedge fund firms, has a blunt assessment: “We, as an industry, dropped the ball.” The breakdown happened, Mr. Griffin contends, when big investment banks gambled away money and jobs during the late great credit boom. The bosses let all those young gung-ho traders take far too many risks and now everyone is paying the price. But the answer is simple, in his view. The entire industry needs to overhaul its thinking and, believe it or not, perhaps even accept greater regulation. He is upset that the investment bank Bear Stearns ran aground. He is annoyed at the big-name chief executives who took too much risk and then watched as billions of dollars of value vanished from balance sheets. He is anxious about high-priced finance jobs moving abroad. And he is particularly galled with regulators in Washington who have overseen what he calls “the great depression on Wall Street.” But Mr. Griffin isn’t just a serial complainer. He has thought about solutions. First, “the investment banks should either choose to be regulated as banks or should arrange to conduct their affairs to not require the stop-gap support of the Federal Reserve,” he says.But that’s not all. He also wants new government oversight of the arcane world of credit default swaps, a business with a notional value and risk of $50 trillion. “Everyone is missing the elephant in the room,” he said. It was the interlocking relationships between thousands of investors and banks over credit default swaps that pushed the Fed to help rescue Bear Stearns. In particular, Mr. Griffin wants the government to require the use of exchanges and clearing houses for credit default swaps and derivatives.That way, instead of investment banks playing matchmaker between parties, an exchange will do it with strict rules in place, eliminating billions of dollars in exposure and creating more transparency.
5 financial stocks for the long term The financial sector got hammered in 2007. Want to buy a financial stock?You should, but maybe not today. The mortgage crisis isn't over. Banks are still hoarding cash to buttress their balance sheets. And there's a better than good chance that bad credit card debt, bad car loans and bad commercial loans will take another bite out of the sector. And you probably don't want to own any of the stocks I've mentioned here. These companies have each taken an invaluable global franchise and turned it into a burned-out shell through greed, stupidity and mismanagement. The long-term reasons to buy financial stocks are intact. First, in the developing economies, rising global incomes are creating huge markets for financial products, such as credit cards and life insurance, that we in the United States take for granted. Second, an aging global population of hundreds of millions of baby boomers in the world's developed economies and hundreds of millions of newly comfortable Indians, Chinese, Vietnamese, Russians and Brazilians are socking away money for retirement and need somebody to manage it. The meltdown in the financial sector in 2007 and 2008 gives investors a chance to get in on that long-term opportunity at bargain prices.