Lesson Learned from Failed Investment Banks: Leverage Feels Great Until It Bankrupts You

How do companies with such great assets go belly up within days once a cascade of bad things start happening? At the outset of 2008 we had five major independent investment banks and now we have two (Goldman Sachs & Morgan Stanley). A core reason is that the leveraged finance business model is a very poor one. It allows you to make a killing when times are good, but on the flip side it can bankrupt you within days when the tide turns. That is not a risk-reward scenario that companies should embrace.

Imagine how easy it is to get caught up in the leverage game. Pretend you have $10 and are allowed to borrow $300 against it, for a leverage ratio of 30-to-1 (a common ratio for investment banks in recent years). If you are paying 5% interest on the loan and can earn just 6% on the $310 in capital you now control, you can earn a profit of $3.60 ($18.60 less $15.00 in interest) on your original $10.00 in capital for a return of 36%. Pretty cool, huh?

Well, only when you actually make money on what you are investing the money in. Consider the same example when your investment loses 5% of its value. After paying interest on the loan, you only have $279.50 left but still owe $300 to the lender. Now you are in trouble. To pay back the loan you need to borrow another $21.50 (if someone will lend it to you) and even if you can do that, you have lost your original $10 in capital.

The leveraged finance game, at least at the level these investment banks were playing it (leverage ratios of 25, 30, or 40 to 1) is very, very dangerous. Investors beware.

A final note about business models. AIG (AIG) is trying to sell assets in order to raise at least $40 billion in new capital because the ratings agencies may downgrade their credit rating if AIG can't come up with the new money. Reports are that a ratings change could bankrupt AIG within days if that downgrade should occur.

What kind of business model is this? Moody's and S&P downgrading your credit rating results in your company going bankrupt in 2-3 days? Not only is that simply ridiculous in terms of relying on one party to remain solvent, but even more unreal is that these are the same ratings agencies that don't have a clue how to rate anything. Remember, they had triple A ratings (the highest possible) on packages of subprime mortgages! If subprime mortgages are of the highest credit quality, what would prime mortgages be considered?

Short term, the unraveling of these firms will hurt, but long term, from what we are learning about these business models, maybe they should never have been anywhere near as big as they were to begin with.

Full Disclosure: No position in AIG at the time of writing

What BofA Gets By Passing on Lehman, Gobbling Up Merrill

We can certainly second-guess Bank of America (BAC) deciding to buy Merrill Lynch (MER) today rather than tomorrow or next week, when the price could have been meaningfully cheaper. There is speculation that the government pressed Merrill do to a deal now, so as to avoid another weekend bailout session later. Not only that, but by acting now BAC ensures they get Merrill, rather than having to pass up on a chance that may not come along ever again.

While the price they paid (and whether it proves justifiable based on long-term profitability at the Merrill unit) will be one of the key factors in the deal's ultimate success, my job as a portfolio manager and a BAC shareholder is less about speculating on whether they could have paid less tomorrow and more about what they are getting for the deal they actually announced, a stock swap of 0.86 shares, valued at $29 per MER share based on Friday's closing prices.

While the bad assets are abundant at Merrill's investment banking arm, it is important to remember that the crown jewel of this deal is the Global Wealth Management division, not the investment bank. MER owns 50% of Blackrock (BLK) and has a network of nearly 17,000 financial advisors.

The BLK stake is publicly traded, so we know that is worth $14 billion. The Merrill Private Client Group does about $3 billion per year in pre-tax net income, so a conservative multiple on that division of 10x gets valued at another $30 billion. In sum, that comes to a $44 billion valuation for about 45% of MER's revenue base, which excludes their entire investment banking operation.

Bank of America shares are trading around $29 each this morning, which values the Merrill deal at ~$43 billion. As a result, BAC shareholders are getting MER's investment bank for free. There is a price to pay for that luxury, however, because further writedowns of Merrill's bad assets will now be incurred by BAC. Long term though, it is hard to argue that BAC can't make this deal successful over a multi-year time frame. Jut how bad future writedowns are will play a big role in determining such success.

Even Oppenheimer's Meredith Whitney, the extremely bearish analyst on the banks, today pegged Merrill Lynch fair value at between $27 and $35 per share. At today's prices, BAC is paying less than what Wall Street's most bearish analyst thinks the company is worth. That can't be a bad thing...

All in all, this deal is much like the Countrywide one. BAC is accepting near-term problems for the possibility of tremendous long term upside. I would much prefer that strategy to the one a company like Wachovia (WB) implemented when they bought a mortgage company (Golden West) and an investment firm (AG Edwards) at the top of the market. At least BAC did so when the firms were in distress, and might have gotten a bargain as a result. Time will tell.

Full Disclosure: Long shares of BAC at the time of writing

BofA's Lewis Still Making Deals, But Now Aiming For Distressed Assets

Lots to get to this morning, so I'll be writing on several topics throughout the week, but first let me address a reader question re: BAC.

Shepherd writes:

Chad,

If the wires are correct, it looks like Lewis paid a premium to purchase Merrill Lynch. I'm curious why you hold BAC, given that he seems to have an almost emotional need to acquire things, which gets in the way of negotiating the best price for his shareholders. My guess (admittedly from afar) is that he could have done better...

Shepherd, your characterization of BofA CEO Ken Lewis and his love of acquiring things is spot on. Earlier this decade BAC has acquired companies like FleetBoston, MBNA, and U.S. Trust, and paid full prices for all of them. As a result, BAC rarely traded above 10x earnings since most of their growth was coming from acquisitions, not organic growth.

During that time Peridot clients did not hold BAC shares. It was only after the subprime crisis started to bite the big banks that I invested in BAC. There were a couple of reasons I chose BAC. First, relative to their size, BAC had less subprime exposure than their large cap bank peers. They did take writedowns, but given they are the largest bank in the nation, firms like Citigroup, UBS, and Merrill Lynch had far more exposure. On that front, BAC's losses were manageable, and they were forced to dilute shareholders far less than others via capital raises.

The second reason was that BAC is the largest bank by deposits in the country. As we have seen with the investment banks like Bear Stearns and Lehman Brothers, without deposits to fund your business, capital can dry up overnight and a freefall can result.

On the acquisition front, people have criticized the Countrywide deal, but Lewis actually bought them on the cheap. Time with tell if he gets a decent return on the investment (I suspect he will over the long term, despite short term losses), but buying distressed assets on behalf of shareholders is far better than what he used to do (pay a huge premium for assets that were already fully priced).

The Merrill Lynch deal is a similar situation. We can argue if the price he paid was fair, but at least he is buying on the cheap. That will increase the odds of a very successful deal. I'll have more on the Merrill deal in another post to examine exactly what BAC is getting for their money.

Full Disclosure: Long shares of BAC at the time of writing

Ken Lewis Mulls Another Deal as Lehman Reaches Brink

As soon as Lehman Brothers (LEH) shares hit $4 today and reports came out that the company is up for sale to try and survive, only one name came to my mind as a potential buyer; Bank of America (BAC) CEO Ken Lewis. The guy loves doing deals. Who else would have bought Countrywide?

Since Peridot is long BAC, one of the two things I am worried about (the first is obviously Lehman's ugly balance sheet) is the price that Lewis might agree to pay for Lehman should a deal be reached. Lewis isn't shy about overpaying for firms he really wants, and he loves to grow by acquisition. FleetBoston, MBNA, U.S. Trust... not a bargain among them (Countrywide is still a question mark).

Now that Lehman CEO Dick Fuld has completely blown it (even after seing exactly how things played out with Bear Stearns!), BAC is likely the most probable suitor at this point, and thus I am not surprised their name is already being mentioned in press reports this evening.

Don't overpay, Ken!

Full Disclosure: Long shares of BAC at the time of writing

Update Friday 9/12 9:05AM ET
Rumors today are that the U.S. government will not provide public funding to aid in a takeover of Lehman, as was the case with Bear Stearns. In that case, Bank of America should balk at buying the whole firm. I would love if they just bought a stake in Neuberger Berman, which was the kind of deal LEH was seeking several weeks ago. NB is the crown jewel of Lehman and would be a great asset for BAC to buy in order for LEH to get much needed capital.

Sorry Fortune, Meredith Whitney Is Just An Average Analyst (You Even Said It Yourself!)

Remember when Henry Blodget made his $400 call on Amazon stock back in the late 1990's? He will be known forever for that call more than all the other ones he made combined. Fast forward nearly a decade and Oppenheimer banking analyst Meredith Whitney has achieved similar rock star status. The August 18th issue of Fortune Magazine has her on the cover.

Now, I like Fortune a lot. In fact, aside from an online subscription to the Wall Street Journal, my subscription to Fortune is the only periodical I actually pay for. But this Meredith Whitney hoopla is really getting old, and quite frankly, it's too much.

Like Blodget, whose $400 price target came to fruition despite the controversy surrounding it, Whitney's early warning on Citigroup (C) stock last year definitely deserves kudos. She got death threats after suggesting the banking giant would be forced to cut their dividend and raise capital. At the time it was a minority opinion, but she was right and deserves credit for a very bold and correct call.

That said, let's not get carried away. Investors and the media should not judge an analyst on a single call, but rather the entirety of their work. There are great analysts out there, but the track records of most are mediocre at best. When I have the chance to guest lecture undergraduate and MBA students, I often refer to a study that showed the stock picks of sell-side analysts, like Whitney, consistently underperform the market and do so with more volatility.

So, does Meredith Whitney deserve all the attention she has been getting lately from investors and the media (she is on CNBC all the time)? I have nothing against her, but I doubt it. She should be commended for the Citigroup call, but treating her as the "go-to" analyst on banks would only be reasonable if her track record beyond that one call was overly impressive. Unfortunately for investors, it isn't.

In the Fortune cover story, in fact, it is mentioned that according to Starmine (a company that tracks the performance of analyst recommendations against their industry peers), Whitney's stock picking ranked 1,205th out of 1,919 analysts in 2007 (the year of the Citi call). During the first half of 2008, Whitney's picks ranked 919th out of 1,917 analysts.

The only conclusion I can draw from those numbers is that Whitney is no better than an average bank analyst. In the world of sell-side research, "average" is hardly something to get excited about.

Does this mean you should completely ignore what Whitney and other analysts say? No. They put in long hours and often can provide a lot of information that is helpful in conducting stock research. Still, we should not drop everything and hang on every word whenever Whitney is on CNBC or lands on the cover story of a magazine. She just isn't going to make us rich.

Need proof? Consider her recent downgrade of Wachovia (WB). Whitney downgraded the stock on July 15th from "market perform" to "underperform." For those who prefer to translate Wall Street lingo, that means she went from a "hold" to a "sell." Good call? Umm, hardly.

Wachovia stock actually bottomed that same day at $7.80 and closed at $9.08 per share. It never traded lower than that, completely reversed course, and traded as high as $19.48 on August 1st. That is a gain of 150%, peak to trough, in just 13 trading sessions! Just imagine if you shorted Wachovia because Whitney put a sell on it!

Just as we should not judge Whitney solely on her Citigroup call, we also should not judge her solely on the terrible Wachovia downgrade. Still, since her stock picks rank her as an "average" analyst within a mediocre group of stock pickers, I can safely say the attention she is getting these days is a little over the top.

I still love Fortune and CNBC and all the other outlets going gaga over Meredith Whitney. I just think she's pretty overrated and want people to understand the facts along with the hype. People just love a good story on Wall Street and right now, she's it.

Full Disclosure: No position in Citigroup or Wachovia, long a subscription to Fortune at the time of writing

Merrill Lynch CDO Sale Proves Investment Bank Balance Sheets Can't Be Trusted

Trying to value the investment banks based on book value is not an idea I would suggest if investors want to have any confidence in their valuation work. Today we learned that Merrill Lynch (MER) is selling $30.6 billion in nominal value CDOs for $6.7 billion, or 22 cents on the dollar, but that price is not all that surprising. What is surprising is what level Merrill valued those CDOs on their balance sheet when they reported second quarter earnings 12 days ago on July 17th.

That number was $11.1 billion. In less than two weeks, the CDOs lost 40% of their value? Highly unlikely. Of course, some will say the $11.1 billion value was supposed to be as of June 30th, so it was really four weeks of time that had passed. At the very least, we know that Merrill had no idea what the CDOs were worth, on June 30th, July 17th, or perhaps even today (we won't know that for a long time).

There are some who think these ABS are being marked down too low and will eventually be written up. This could certainly happen in several years time as the underlying mortgages are repaid, but today's news from Merrill certainly should not give anyone confidence in that thesis. Beware of using book values when trying to value portfolios of ABS. The company might come out and sell the things for 40% less than they thought they were worth less than two weeks before.

Full Disclosure: No position in MER at the time of writing

A Lehman Sale of Neuberger Berman Should Be A Last Resort

Five years ago Lehman Brothers (LEH) was trying to shake the image of being mainly a bond house and acquired asset manager Neuberger Berman for $2.6 billion. The deal was a great idea, not only because it increased Lehman's equity exposure and was a very stable, predictable business, but also because NB is truly one of the best asset managers around.

Given Lehman's recent troubles, the company is considering a sale of the unit and some are speculating that selling the entire division could fetch as much as $8 billion. Tripling their money would clearly be a coup, but in reality Lehman should hold onto NB if at all possible. The acquisition was a brilliant move and the current state of the investment banking world makes it clear that having a Neuberger Berman is a solid foundation in an otherwise shaky world for pure investment banks.

Now more than ever, diversification is going to be crucial for the industry, but being forced to sell NB would be a step in the exact opposite direction.

Full Disclosure: No position in Lehman at the time of writing. Peridot was invested in Neuberger Berman when Lehman announced the acquisition in 2003.

Citigroup Q2 Earnings Release Reaffirms My Prior Projections

It's that time again. Our quarterly look at Citigroup (C) and how my breakup analysis is holding up. Citi reported a second quarter loss of $2.5 billion last week, halving its $5 billion first quarter figure. Due to continued writedowns and credit loss reserve building, it remains difficult to project what kind of profits Citi could have in a more normal environment.

That said, one way to look at it is to calculate Citi's net income by segment before accounting for asset writedowns and credit provisions. Here are some figures for Citi's 4 main businesses:

Citigroup - 2nd Quarter by Segment

Net Income/Reserve Build/Income ex reserve build

Global Credit Cards: $467M/$582M/$1049M

Consumer Banking: $(700m)/$1657M/$957M

Institutional Banking: ($2044M)/$367M/($1677M)

Wealth Management: $405M/$41M/$446M

The Institutional segment remains hard to project due to $7.2 billion of pre-tax writedowns for the quarter. The other segments, however, are tracking very close to my previous estimated ranges at ~$8 billion per year for banking and ~$2 billion per year for global wealth management. Institutional probably winds up in the $2-$4 billion annual range ultimately, which would peg Citi's annual earnings at between $12 and $14 billion.

Assign a 10 to 12 multiple on that and you get fair value of between $120 billion and $168 billion, or $21 to $29 per share, versus today's price of around $20 per share. In order for Citi to get back to the good ol' days of earning $20 billion+ annually, it appears the economy would have to improve markedly, but that environment is likely several years away at least.

Full Disclosure: No position in Citigroup at the time of writing 

Don't Think All Bank Earnings Will Be The Same

Have you noticed that bank earnings reports so far have been pretty good? Wells Fargo (WFC) reported a good quarter and raised their dividend 10% yesterday, which sparked the market rally, despite the company's large exposure to the California housing market. Today we got earnings above expectations from JP Morgan Chase (JPM) and PNC Financial (PNC). Does that mean that all the banks are out of the woods? Not really.

Unfortunately, the first banks to report were the better managed banks in the country (you can add U.S. Bancorp (USB) to the aforementioned three). Those four banks are very good at managing risk, hence their strong relative performance. The Wells Fargo report yesterday does not mean that other California-heavy mortgage lenders will be as fortunate. Wells simply had stronger underwriting criteria during the boom than other banks such as Washington Mutual (WM), National City (NCC), and Wachovia (WB), which can easily be seen in the underlying performance of their loan books.

Investors should continue to refrain from treating all banks the same. Companies like PNC, WFC, JPM, and USB are going to outperform the likes of WM, WB, and NCC for the second quarter and beyond simply because they have much better lending practices.

Full Disclosure: Long PNC and USB at the time of writing

Despite Recent Weakness, Buffett's Berkshire Hits Buyout Trifecta

UPDATE: 7/14 11:45AM

It has been brought to my attention that Berkshire does not own shares of Rohm & Haas. For some reason I incorrectly thought it did. Maybe Buffett used to own some of it, or maybe I just got confused some other way. At any rate, my apologies. Obviously, 2/3 of this post still applies, but just ignore the ROH part. Sorry for the confusion!

Things have not been great lately for Warren Buffett and Berkshire Hathaway (BRKA) shareholders. BRK stock has dropped more than 20% since December and large Buffett holdings in the financial services area such as American Express, Wells Fargo, Moody's, and U.S. Bancorp are hurting his equity portfolio. Buffett has also taken some heat for publicly bashing the use of derivatives, but privately writing billions in credit default swaps.

Despite the recent headwinds, you may have noticed that Buffett is still hitting some home runs. Just this year three Buffett investments have received takeover offers, all at significant premiums of 50% to 80%. What is amazing to me has been the prices offered for some of these companies. For instance, Mars is paying 32 times 2008 earnings for Wrigley (WWY). Dow Chemical (DOW) just offered a staggering 11.5 times EBITDA for chemical company Rohm and Haas (ROH).

Those are hefty prices by any measure, so I will be interested to see how smart those deals turn out to be several years from now. Buffett, for one, seems to think $80 per share is a bit steep for Wrigley. He is selling his stake to Mars for $80 per share, providing financing for the deal, and after the deal closes he inked a deal to buy a stake in the Wrigley subsidiary at a discount to the $80 purchase price. Not a bad deal if you can get it.

Full Disclosure: The author and/or his clients were long shares of Anheuser-Busch and U.S. Bancorp for investment purposes, and Wrigley as a merger arbitrage play, at the time of writing