Abigail Hofman: Stay with the strong
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Abigail Hofman: Stay with the strong

Only a curmudgeon would quibble. Goldman Sachs’s first-quarter results were good. The firm reported net revenues of $9.43 billion and net earnings of $1.81 billion, up 20% year on year and far better than the fourth-quarter 2008 net loss of $2.1 billion. Admittedly, Goldman recorded a net loss of $1.4 billion on principal investments and made a pre-tax loss of $1.3 billion in the stub period of December 2008 (which was reported separately because of a move to year-end reporting). The fixed-income, currency and commodities (FICC) division was the star of the show, generating record quarterly net revenues of $6.56 billion, 34% higher than its previous record. Investment banking ($823 million) and asset management ($949 million) also reported creditable revenues, albeit lower than the first quarter of 2008.

These results enabled Goldman to raise $5 billion of new equity in mid-April, at a price of $123 a share, the same price that they raised equity at some seven months earlier. The firm stated that its average first-quarter global core excess liquidity was $164 billion, up substantially from the fourth quarter, and that it wanted to repay as soon as possible the $10 billion of taxpayers’ money that it received last October. So is it business as usual at Goldman? Is Goldman the firm that proves that a stand-alone investment bank can survive in this harsh new world of reduced leverage and increased regulatory supervision? Maybe. It would, though, be reckless to predict smooth sailing based on one quarter’s results, and trading revenues are inherently unpredictable.

One of my former bosses used to say: "Business begets business." This will be the case for Goldman: its strong first-quarter results and robust capital position will attract business. It is no coincidence that HSBC, faced with raising a large amount of capital in a difficult market, turned to Goldman and JPMorgan Cazenove. If you were a CFO, you would probably make the same choice – stick with the strong and nobody will criticize you. So Goldman partners have reasons to feel smug. Nevertheless, they should remember that they are still wards of the state. And this will be the case even if they do repay the Tarp money as long as they continue to issue in the debt markets with a FDIC guarantee. The fact that the premier global investment bank continues to rely on such assistance shows how dislocated the credit markets are. It also reminds us to remain sceptical about the so-called burgeoning recovery.

Chammah, Gorman and Kelleher are highly competent internal contenders to replace Mack as chief executive. But there might be fallout if one is elevated above the othersMorgan Stanley is a different story. The firm reported a bigger than expected first-quarter net loss of $177 million, and cut its dividend. The firm also reported a large loss for the fourth quarter of 2008, which was restated on a calendar basis because of the change in the company’s fiscal year-end. Net revenues for the first quarter of 2009 were $3 billion, 62% below last year’s first quarter. The recent results suffered from a $1.5 billion charge related to a tightening of Morgan Stanley’s outstanding debt and a $1 billion loss on real estate investments. Investment banking, however, delivered strong results. Fixed-income sales and trading net revenues were disappointing compared with other top firms (even if you discount the impact of the accounting loss from Morgan’s own debt). Equity sales and trading net revenues were also disappointing (half of what Goldman achieved).

The key point is that the implosion of investment banking last autumn caused Morgan Stanley to reconsider its business model. In January 2009, the firm announced a joint venture of its wealth management division with Smith Barney, Citi’s retail brokerage operation. The new entity, Morgan Stanley Smith Barney, will be a "game changer", and the dominant force in wealth management, according to Colm Kelleher, Morgan Stanley’s CFO. In a recent survey of the top 100 US financial advisers conducted by financial weekly Barron’s, seven out of the top-10 advisers worked for either Morgan Stanley or Smith Barney.

Morgan Stanley’s senior management are focused on decreasing risk and they have ferociously deleveraged the balance sheet. The firm’s tier 1 capital ratio is one of the strongest in the industry at 16.4% (according to Basle 1), or 12.9% without Tarp funds. Banking analyst Richard Bove of Rochdale Securities described Kelleher as a "genius" for shrinking the Morgan Stanley balance sheet by more than $300 billion in nine months. On the other hand, Brad Hintz, an analyst at Sanford Bernstein, criticized the firm for reducing leverage at a time when relatively low-risk, flow trading was highly profitable. As with Goldman, we need to see another quarter’s results before we can pronounce definitively whether Morgan Stanley is on the right path.

I am still not convinced that the firm has the right top team in place in its fixed-income trading and sales operation. There is also the lingering question of a successor to chief executive John Mack. Mack will be 65 later this year. Although an insider whispers that Mack might remain at the helm for another two years, I still believe the market would welcome a clear succession plan and time-line for the transition. The good news is that there are several highly competent internal contenders: co-presidents Walid Chammah and James Gorman, for example, as well as Kelleher. The bad news is that there might be fallout if one contender is elevated above the others. Nevertheless, Mack needs to address this issue in the next six months. One thing Morgan Stanley cannot afford, as it tip-toes its way to recovery, is another management meltdown along the lines of the internecine struggles seen during the Philip Purcell era.

Does Barclays sale indicate brighter times?

The fear is fading. Recently, the equity market has witnessed a Herculean struggle between the bulls and the bears. In mid-April, as the first-quarter reporting season began, the Standard & Poor’s 500 index surged above 850 and spring had suddenly arrived. Pessimists, such as George Soros, Nouriel Roubini and Nassim Taleb, seemed shrill, discordant notes in a melodic aria as the Greek chorus of chattering commentators chanted about green shoots of recovery in the economy and profitable flow trading in the banking sector.

This tale of two tugs has been perfectly illustrated by Barclays. "Barclays is binary," a mole argued. "You either admire them intensely for doing everything possible to avoid taking the government shilling, or you are critical because they are turning a lot of somersaults to tap-dance their way out of trouble." On March 9, as the bears won the battle and we all believed the world was ending, Barclays’ share price retested the all-time low and hovered in the 60 pence range. Unexploded land mines lay everywhere. The UK economy was limping towards the 2012 London Olympics with limited credit, weak house prices and rising unemployment. Barclays, as a leading UK bank, was in the midst of all that. HSBC had announced a £12 billion rights issue. This underlined the notion that Barclays might need to raise more capital and prompted the question: "Where from?" At the back of everyone’s minds was the looming March 31 deadline for the UK’s Asset Protection Scheme and how this would affect Barclays.

Fast forward a mere month and we are in a completely different landscape. Barclays’ share price has tripled since the March low. Having passed a stress test conducted by the Financial Services Authority, and rejected the government’s Asset Protection Scheme, Barclays sold its highly regarded iShares business. This enabled it to bolster capital ratios.

"Barclays is a lucky bank," a friend commented. "I’m holding for the long term." Others are less sure. Société Générale, in late March, issued a sell recommendation on the stock, which it downgraded from 100 pence to 46 pence, citing a relatively weak core tier 1 capital ratio. Market strategist Albert Edwards was at his contrarian best when he wrote: "My goodness I laughed when I read that Barclays Bank had been given the all clear after being stress tested by the FSA... Quite frankly after everything that has happened, the likelihood of the FSA spotting the elephant – or even a woolly mammoth – in the room is pretty low." Edwards may be negative but I think Barclays’ chief executive John Varley will be breathing a sigh of relief.

Barclays’ sale of its profitable iShares business means that I have suspended my normal mantle of Cassandra-like gloom. An interesting phenomenon is that banks tend to buy at the top and sell at the bottom of a cycle. If Barclays is selling a good business, the end of the downturn might be in sight. Remember that Barclays announced the purchase of non-prime mortgage originator EquiFirst in January 2007. In hindsight, this was the summit of the banking party. Similarly, Merrill Lynch purchased the sub-prime originator First Franklin in early 2007 and sold itself in December 2008 to Bank of America. Credit Suisse purchased Donaldson, Lufkin & Jenrette in late 2000 near the previous top and sold part of its asset management business in December 2008. Based on my "banks don’t do timing" index, might brighter times lie ahead? What do you think?

Perma-bear analysts

One thing I do know, both in the case of Barclays, and in the case of the markets as a whole for early 2009, is that short-sellers have been on the rampage: a sort of replay of the predators’ ball. These exaggerated swings can only be caused by short-selling and then speedy short covering. On April 9, when Wells Fargo announced that its profits would be better than expected, Bank of America’s share price rose by 30%. Come on, that’s not an investment opportunity, that’s gambling.

Of course, the past two years have seen the rise and rise of the perma-bear analyst. In this era when the unimaginable has occurred, we tend to look not only for saviours but also for prophets. Alas, there have been no saviours: tree-hugging Hank Paulson and Tiny Tim Geithner have had difficulty rising to the occasion. And most senior management incumbents at leading financial institutions have floundered, paddling pathetically from one crisis to the next.

 
But we have had a few prophets and they are now cloaked in an aura of invincibility. It is interesting that my three chosen analysts are all on the move. Is this a coincidence or is it that having become stars in a black sky, they can name their own terms? My favourite, as devoted readers will know, is David Rosenberg, the departing chief north American economist at Merrill Lynch. Dave is not only erudite, approachable and amusing but has also had some great market calls. He remains gloomy and is cautious about the current rally. Rosenberg will leave Bank of America in May to return to his native Canada where he will work for the Toronto-based wealth management firm Gluskin, Sheff & Associates. I think I will enjoy learning more about Gluskin, Sheff. The firm shares my humorous attitude to the banking business. The strapline on the home page of its website is: "Money talks. Occasionally, it yells for help." The loss of Rosenberg is a serious setback for Ken Lewis and Bank of America. The gloomy Rosie has a huge global following with investors. Many private clients rely on his research. Merrill’s strong wealth management franchise must have been a key attraction of the Merrill Lynch acquisition for Lewis. It’s not a good sign that essential cogs in the franchise are breaking off so early in the journey.

And talking of attraction, blonde, glamorous Meredith Whitney is the bank analyst who rose to fame at Oppenheimer & Co. Whitney called it right in October 2007 by stating that Citi would need to raise more capital. Whitney remained pessimistic about banks as the market plummeted and has become a household name. Featured in Forbes, Fortune and the Wall Street Journal, Whitney was also one of the Abigail with attitudecolumn’s heroes of 2008. In February 2009, Whitney parted company with Oppenheimer to set up her own firm, Meredith Whitney Advisory Group.

 
There is nothing low-key about our Meredith. What does it say about you if you and your firm share the same name? It might imply that you are extremely confident. It might also imply that you are a punchy self-promoter. A quick review of MWAG’s new website reveals it’s a little bit Meredith-heavy. On the home page, there is a large photograph of magnificent Meredith gazing serenely at the viewer and wearing a foxy, black satin jacket. And under the "team" section, there is a lone curriculum vitae featuring (you’ve guessed it) Maid Meredith herself.

"Oh come on, Abigail," a bank chief executive chided. "She’s gorgeous and she’s bright. This is a female rivalry thing." I hate to be a party-pooper but I did note that, in an interview with Steve Forbes on April 6, Whitney said she was "staying away from bank stocks still". She might be proved right in the long run. But if you had followed her advice you would have missed out on a big rally in US bank stocks starting three days later when Wells Fargo signalled stronger than expected first-quarter profits.

Meredith is not alone in warning investors that continued caution is the way to go. The well-known bank analyst Mike Mayo recently left Deutsche Bank Securities and joined Calyon’s US broker/dealer operation. In early April, he initiated coverage of 11 US banks with an underperform or sell rating on all of the institutions. In a report entitled Seven deadly sins, Mayo talks about a "rolling recession by asset class" believing that capital market losses will be followed by loan losses. Mayo also predicts that loan losses as a percentage of banking loans "will likely pass the level of the Great Depression". Mayo told investors to sell Citi slightly ahead of Meredith and he won admirers for challenging Merrill’s former chief executive, Stan O’Neal, and the CFO, Jeff Edwards, regarding the level of the company’s CDO exposures during Merrill’s third-quarter 2007 conference call. In an interview with Fortune magazine in November 2007, Mayo stated: "There is an outside chance that Merrill may be taken over." Mayo demurs that he has not always been bearish on bank stocks and had mostly buy ratings during the 1990s. Nevertheless, if Mayo and Meredith are correct in their current view to avoid big bank stocks, there could be a lot of blood on the carpet as the earnings season progresses.



Mole mentioned this interrogation to a colleague. ”Interesting,” mused the colleague. “I had exactly the same question at immigration and when I said that I was staying at the Ritz-Carlton, the official barked: ‘JPMorgan has taken taxpayer money. Why aren’t you staying at a cheaper hotel?’”Investment banking fun

Is fulfilling the new fun? In April, a colleague and I lunched with a Wall Street chief executive. There was a healthy exchange of views on markets, leading financial institutions and developments in Washington peppered with a sprinkling of industry gossip. As we lingered over coffee, my colleague asked the killer question: "But is it still fun?" Chief looked startled, "Fun?" he said slowly as if the word were an alien concept. And then, with a rueful shake of the head, Chief responded: "Well at the moment, the business isn’t exactly fun. Of course, it’s still intellectually challenging and fulfilling to be at the centre of things. But I couldn’t honestly say it was fun." I was intrigued by this discussion. It always struck me as bizarre that, in the investment banking heyday, middle-aged men would rush around assuring each other that they were having fun in the office. I would bite my lip hard to prevent the words: "Do get a life," from tumbling out. Of course this smug: "I’m in with the in-crowd doing big deals and having fun" attitude contributed to the clubbish, machismo culture of Wall Street where fun-loving, (usually male) employees ratcheted up risk and pocketed large rewards at the expense of shareholders.

In 2009, mainstream investment banking is no longer fun. A mole employed by JPMorgan reports flying in to New York’s Kennedy airport. An immigration official asked him where he was spending the night. Mole was understandably a little flustered. "Well actually I’m here on a deal," he replied. "And I will fly home tonight." The official looked grumpy and stamped Mole’s passport. At the office, Mole mentioned this interrogation to a senior British colleague. "Interesting," mused the colleague. "I had exactly the same question at immigration and when I said that I was staying at the Ritz-Carlton, the official barked: ‘JPMorgan has taken taxpayer money. Why aren’t you staying at a cheaper hotel?’"

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