Financial Services Industry

“He who has capital in a period of illiquidity is sitting pretty.”

So says a writer at the Daily Deal. I cite it here because it makes a very good point.

Citigroup, in its quest to raise cash, reportedly agreed to sell $12 billion worth of its leveraged loans for 90 cents on the dollar. But the Deal is saying the loans are being bought back from some of the same private equity firm who landed them on Citi’s books the first place.

Buyout veterans have been openly salivating for months at the chance to snap up debt they view as wildly underpriced. Until now, however, it was hard to find willing sellers… The firms reported to be taking the leveraged buyout debt off Citi’s books — Apollo Management LP, Blackstone Group LP and TPG — all have experience investing in turnarounds.

Yes, that’s the same Apollo that filed to go public this week in one of the least friendly IPO markets in years.

Some observers saw in this announcement the deft moves of a shell game. Mish’s Global Economic Analysis had this to say:

What this did was muddy the waters. Citi had to indemnify the buyers from the first 20% of the loss so Citi effectively got somewhere between 70 and 90 cents on the dollar for those loans. We will not know the exact amount until a later date … It appears that Citi is setting up a con game in which they may pretend they got 90 cents on the dollar when they really didn’t.

Yes, there is a market, at the right price. There’s a market for anything, anytime, at the right price. And the price in this case was a 10% guaranteed markdown plus a free PUT option that has the potential to make the total markdown as high as 30%. And Citi had to agree to finance that!

This is the way that a financial bubble ends, not with a bust but a whimper.

One of the most thankless jobs on Wall Street has to be the securities analyst. You have to dig up fresh information on a company that may not want it to be known, and often the company is a client of your employer. You have to sift through a lot of metrics, but too often at the end of the day people just want to know about one — the earnings per share.

Then you have to deal with blog posts like this one from Investor Insight (via Big Picture). It’s a piece written by James Montier, head of equity research at Societe Generale based in London, who offers some compelling proof that, when it comes to forecasting earnings, analysts are very much behind the curve. In fact, they make an excellent rear view mirror.

Montier sums up his peers’ predictive skills pretty harshly,

The chart makes is transparently obvious that analysts lag reality. They only change their minds when there is irrefutable proof they were wrong, and then only change their minds very slowly.

But he faults the practice of calling up CFOs and asking them for their thoughts. The real blame belongs at the office doors of those CFOs. A Duke University survey showing CFOs as a lot consistently more pessimistic about the economy than their own companies. They are more often right about the economy.

Analysts often get a bad rap for being bullish about companies that are their clients. That has happened a lot less since the early 2000s. The real problem is more subtle: They are too reluctant to challenge the (natural) optimism of corporate execs. It’s a classic exception to the rule that you should act as if the customer is always right.

When a troubled market comes back, the news is usually not good for everyone. Such is the case for mortgage lending, according to American Banker, a banking trade publication. This time, though, the big banks are seeing the gains.

The publication, working with research firm Greenwich Associates, conducts a regular survey of financial executives. According to the survey, there are more executives saying, for the first time in more than three years, that they are not planning to expand overall consumer lending this year than there are saying they will do so.

But when broken down among size of banks, there is a discrepancy in forecasts. More than half - 51 percent - of small financial companies said they don’t plan to do more consumer loans, especially mortgages and home-equity loans. While only 33 percent of big companies said they won’t.

American Banker quotes analysts and banking executives as saying that the lenders who were more aggressive in making ill-advised sub-prime loans had already dropped out of the market, and that some well-capitalized banks are finding mortgage lending a potentially attractive area again.

Mortgages, though seen as most negatively affected by the recent credit and economic environment, surpassed home equity lines of credit as the consumer finance product most likely to fuel growth.

This year, 34% of companies surveyed said that mortgages were their best opportunity for consumer lending growth; 20% gave that ranking to home equity lines, which had been by far the most popular growth vehicle in previous years’ surveys.

For anyone looking for signs of a market bottom, this is encouraging. It’s often the case that the earliest signals of such bottoms are misleading, so it’s easy to read too much into this. It’s important to weigh it against other evidence, and watch for signs that this is indeed a trend.

The list of technological species endangered by new innovations is growing long: First 8-track tapes and VHS, then printed newspapers and the compact-disc album. Now we can add the checkbook to the list.

Or that’s the word from the Federal Reserve. In an interview with “American Banker,” Richard Oliver, an executive vice president at the Fed’s Atlanta branch, said,

“The pace of decline in paper checks, what we call legacy checks, is going to continue if not accelerate… We have to continue to accelerate the downsizing of our paper processing infrastructure.”

The Fed’s Financial Services Policy Committee issued a study this week showing that 58 percent of checks written last year came from consumers, either as payments for things like utilities or in retail check-out lines.

And it’s those consumers who are increasingly using credit or debit transactions or electronic checks, which are processed by automated clearing houses, not old-fashioned check-processing facilities. Oliver is saying those facilities are less and less necessary - at a rate that is a little settling for the industry. The Fed oversaw 45 full-service check processing sites in 2003, and that number will fall to four in two years, the magazine said. As he noted,

“The whole industry is facing that dilemma. The volumes are running off faster than you can strip out the assets. You’re going to have the issue of wrestling with profitability because of all these stranded assets.”

In the midst of all the pain wrought by the mortgage meltdown, some regional banks believe they see an opportunity to expand mortgage operations, the American Banker is reporting. Encouraged by the reduced competition, small and mid-sized banks are being as aggressive in expanding mortgage desks as they have been in a decade.

Some small banks such as Iowa’s American Banks and Trust and AmericanWest Bank in Washington state are hiring mortgage brokers away from larger banks stung by the mortgage turmoil, including Washington Mutual and Countrywide Financial.

One executive at Pennsylvania’s American Home Bank rattled off a list of reasons why the mortgage paradigm has shifted in favor of banks, including a steady deposit base as a source of funding, preemption from licensing requirements, the ability to outsource secondary-market execution and reliable funding through the Federal Home Loan Bank System.

Some regional banks are seeking the kind of loan pricing available to bigger players like Wells Fargo and Bank of America. To help them, they are joining forces and selling loans through Fannie Mae and Freddie Mac, the paper said.

That might create some alliances that could lead to consolidation when competition heats back up. But for now, smaller banks looking far ahead enough to position themselves for a recovery. When and how strong that recovery will be is another question.

The dire times in the financial industry is starting to hit Wall Street where it really hurts: right smack in the bonuses.

Financial News reports that cash bonuses for senior management at JPMorgan are down. They used to make up half of bonuses (the other half being restricted stock), but now they only make up 25 percent. The new bonus structure was detailed in proxy filed with the SEC by the company. JPM has emerged as one of the stronger Wall Street houses, but things are tough even there.

Elsewhere, there are signs that even the more successful traders at big securities houses are seeing their bonuses trimmed. The blog Fierce Finance spelled it out, citing the publication Trader Monthly.

At top banks, a lot of traders also bet correctly but ended up with less in bonuses. The reason: Their banks struggled overall, and that forced some changes in the bonus structure. Normally, you keep a percentage of what you generate. However in these times, some traders, despite great performance, earned less. In essence, they took a bullet for the team.

It seems if you want a big bonus you need to head for the hedge funds. John Paulson, a hedge fund manager who played the market turmoil to good effect brought home $3 billion, according to Trader Monthly.

To get a snapshot of how messed up things have gotten in the financial industry during the credit crunch, consider this little parable in the news Wednesday.

UBS analysts issued a report on the firms that rated the subprime mortgage. The analysis seems sound enough. However, it comes only a year or two too late. These were the same ratings agencies - Moody’s, Standard and Poor’s, Fitch - that gave many a high five to a lot of the securitized loan packages that later blew up, nearly sinking the entire industry.

Moody’s comes up by far the biggest loser.

Moody’s assigns Caa2 or lower ratings to just 12 percent of the 292 bonds underlying benchmark Markit ABX indexes that UBS analysts expect to default. Both Fitch and Standard & Poor’s tag 57 percent of the bonds with equivalent rankings, according to a report from the New York-based analysts yesterday. A rating of Caa2 or CCC is eight levels below investment grade.

Just how bad is a 12 percent success rate? Bad enough to make a 57 percent success rate look excellent. And 57 percent is terrible.

But Moody’s isn’t the kind of dozy watchdog to take that kind of criticism sitting down. On the very same day, it downgraded UBS’ credit rating. (And Fitch did to, the ingrates.)

All of which is a simple reminder to unplug your market research and buy in a dartboard instead.