And Then There Were None

Peter Demirali is a portfolio manager and heads Cumberland’s taxable fixed income area and is a long time veteran of taxable fixed income markets. He is a member of Cumberland Advisor’s Management Committee. His bio may be found at www.cumber.com. Comments on this article may be directed to peter.demirali-at-cumber.com.

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A little over a year ago I wrote a piece on the earnings and prospects of the brokerage industry. Little did I know that I’d be writing an obituary for the group at the end of 2008. The list of calamities and casualties is quite long. I will try to summarize them and give our thoughts on how the coming quarters will unfold as we navigate through this credit crisis.

Bear Stearns

Bear Stearns was the canary in the coal mine. It was Bear’s hedge funds that ran into trouble in the summer of 2007 with exposure to subprime mortgages and other illiquid, difficult-to-value assets. Over time, whispers and rumors caused clients and customers to take their business elsewhere. Fixed-income trading revenues declined and the mortgage inventory carried on its books quickly lost value. Marching the two hedge funds’ managers in handcuffs in front of television cameras did nothing to instill confidence in Bear as an ongoing concern. Most importantly, Bear Stearns was a one-trick pony. They were known for their trading acumen in esoteric fixed-income securities but did not have much of a presence in equity trading. There was an absence of international exposure either in trading or investment banking. Currency and commodity trading was also nonexistent. Fortunately for Bear, the Federal Reserve thought they were too big to fail and engineered a takeover by JPMorgan Chase. Most investors and economists thought that event was probably the end of Wall Street’s problems. Little did anyone expect that the L.L.C. Model called “Maiden Lane” would be replicated many times by the Fed during the ensuring financial turmoil.

Lehman Brothers

No sooner did Bear Stearns wind up in JPMorgan Chase’s lap, than Lehman’s name was mentioned as having problems. Lehman had a better business model than Bear Stearns. Over the last several years they had invested heavily in expanding equity trading, investment banking, and asset management. It seemed to work. However, Lehman held large positions in illiquid Level 3 assets. Those are assets for which there is no reliable market price, and management is allowed to put a value on the securities (model-based, of course). The environment got steadily worse for Lehman as Fannie Mae and Freddie Mac unraveled and were effectively seized by the federal government. Events overwhelmed not only market participants but also regulators (the Secretary of the Treasury, Fed Chairman Bernanke, and others), and in the end there was no one willing to buy Lehman or bail them out, as they did with Bear Stearns. The flight to quality was in a full-fledged sprint. Lehman’s failure took the firm specific period of this financial turmoil and made it systemic and global.

Merrill Lynch

The same weekend that Lehman ran out of options, Merrill Lynch realized it had one last chance at survival. It was apparent Merrill was in the same bind as Lehman. John Thain, recently hired to rescue Merrill and now rescued by Bank of America cut the deal for the sake of survival. Time was not on anyone’s side, and Thain realized it. Merrill had gone through a tumultuous period with Stanley O’Neal at the helm. Seasoned veterans and risk officers were dismissed or left. O’Neal left under a cloud, as he was able to walk away with approximately $180 million in deferred compensation. If anyone hit the Mega-Millions jackpot lottery, it was Stan. Shortly after his departure, a major capital raise was announced and toxic securities were sold at roughly 22 cents on the dollar. It still didn’t help. Merrill was another victim of the credit crunch and haphazard government programs.

Morgan Stanley & Goldman Sachs

I’ve lumped the two premier investment banks together, since they survived but in another form. For all intents and purposes, both institutions ceased to exist when they were forced to become bank holding companies. Goldman Sachs avoided much of the trouble that plagued Lehman, Bear, and Merrill. In fact, Goldman profited by shorting subprime mortgages and other exotic debt. However, it did not go unscathed and recently announced a $2 billion loss for the last quarter. It was forced to shore up its capital position by taking on Warren Buffett as an investor. Goldman’s shares are off almost 70 percent from its high of 2007.

Morgan Stanley was also infected by this ebola-like virus that hit the financial sector. Morgan had made some bad trading decisions but had acted quickly to stop the bleeding. Investment banking revenues offset the declines in trading profits. It received a capital infusion from a Japanese bank of several billion dollars and did all it could to assert its viability. The effects of Lehman’s failure on top of Fannie Mae, Freddie Mac, and AIG’s problems did not help the atmosphere. Several times there were rumors Morgan was going under.

Federal officials strongly urged Morgan and Goldman to change their charters to become banks. What this did is cause these two firms to become regulated entities and force them to reduce their risk profiles significantly. This has long-term implications for their profitability. They will be run much more conservatively and will not generate the profits they did over the last several years. The culture of these firms will never be the same.

2009 Outlook

We are currently experiencing an unprecedented rise in risk premiums. Today, investment-grade bonds trade at yields that high-yield bonds traded at only a short time ago. High-yield (junk) bonds trade at distressed debt levels, and distressed debt just doesn’t trade. There are some powerful deflationary forces at work in the economy. Ultimately, Cumberland Advisors expects the environment for the investment-grade corporate bonds and agency mortgage-backed securities to improve over the coming quarters. Our view is that corporate profits will rebound in 2010 after a bottoming and then tepid recovery start in 2009. We believe that the facilities and programs put in place by the Treasury and Federal Reserve will alleviate many of the stresses in the credit markets. We continue to avoid housing related companies and underweight our bond exposure to many of the financial services firms. Portfolios still have a longer than benchmark duration to take advantage of the very high yields available to investors in the investment-grade area.

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Cumberland Advisors supervises approximately $1 billion in separate account assets for individuals, institutions, retirement plans, government entities, and cash management portfolios. Cumberland manages portfolios for clients in 42 states, the District of Columbia, and in countries outside the U.S. Cumberland Advisors is an SEC registered investment adviser. For further information about Cumberland Advisors, please visit our website at www.cumber.com.