Credit and liquidity risk hammer earnings

Firms began to file their third-quarter financial results in September, shedding some light on the true extent of losses arising from the commotion in global credit markets. Collectively, Bear Stearns, Goldman Sachs, Lehman Brothers and Morgan Stanley, wrote down some $5 billion in assets during the quarter, according to Standard & Poor's (S&P).

The scale of these US losses fed intense debate among analysts about which of those firms still to report - especially Merrill Lynch, Deutsche Bank and UBS - would be most affected. "For the European banks operating in the same markets, we're expecting the same sort of thing," says Richard Barnes, London-based analyst at S&P.

Deutsche Bank, which is not due to file its next financial report until October 31, has perhaps been the European institution around which most speculation has focused. Last month, it announced that turbulent market conditions had affected its earnings.

"Market corrections, triggered in part by the drying up of liquidity, have been significant and impacted mark-to-market valuations in our trading books and leveraged loan book," it said in a statement. Josef Ackermann, Deutsche Bank's chief executive, has in recent weeks admitted the bank made mistakes during the crisis and called for the industry as a whole to fully disclose losses to restore investor confidence.

In a September 25 report, analysts at Merrill Lynch cut their third-quarter earning estimates for Deutsche Bank by 15%, thanks to its estimate that the bank would face EUR1.2 billion of write-downs on leveraged finance debt. The analysts also cut forecasts for earnings from debt sales and trading by EUR500 million to capture "likely losses in relative value trades, correlation trading and the impact of ineffective hedges". However, in the face of market volatility, the Merrill analysts' forecasts for equity trading-related earnings were increased by EUR350 million to EUR1.15 billion.

Of those firms that had actually filed their third-quarter results at time of Risk going to press, Bear Stearns was proportionately the worst hit. The bank appeared to suffer as a result of its heavy reliance on fixed income and geographical concentration within the US. It unveiled third-quarter net income of $171.3 million, a year-on-year drop of 61%.

Bear's fixed-income revenues dropped by 88% year-on-year, to $118 million. "A general repricing of risk in the market led to significant reductions in both mortgage- and credit-related revenues, as volumes decreased while asset values declined," the bank said.

In addition to forfeiting approximately $200 million due to the failure of two hedge funds run by its Bear Stearns Asset Management unit, Bear Stearns' wealth management division recorded a net loss of $38 million, compared with a profit of $233 million for the previous year.

The size of losses at Bear Stearns and Lehman Brothers, whose third-quarter fixed-income net revenues were down by 47%, to $1.1 billion, is partially attributable to the level of vertical integration in their mortgage-trading operations, says Leslie Bright, senior director at Fitch Ratings in New York.

"They had exposure running the entire gamut, whereas other banks don't do origination," she says. "And since both hold leading market shares in US mortgage-backed securities, any significant deterioration in the mortgage market would have a greater impact on these entities in comparison with Morgan Stanley or Goldman Sachs, for example."

However, Morgan Stanley was not completely shielded from the market turmoil. The firm reported third-quarter net income of $1.47 billion, 7% down on the corresponding period in 2006.

So far, Goldman Sachs has been most successful in turning the tumult to its advantage, partly due to an early bet that mortgage values would decline. This helped it attain record earnings of $2.85 billion, up 79% over the corresponding quarter last year. "Significant losses on non-prime loans and securities were more than offset by gains on short mortgage positions," the bank says.

Net revenues in the dealer's fixed-income, currency and commodity unit rose by 71% to $4.89 billion, but it lost $1.71 billion on credit products related to non-investment-grade credit origination activities. "They have diversity of revenue sources within their franchise, in addition to having a large capital base," says Fitch's Bright.

That large capital base was exemplified by its ability in August to inject $2 billion of its own capital into the loss-making Global Equity Opportunities Fund run by its Goldman Sachs Asset Management arm (Risk September 2007, page 11).

Goldman Sachs says the fund represented an objectively good investment opportunity that happened to present itself internally, and that the cash injection did not constitute a rescue, as some analysts had claimed. The investment and risk management savvy that Goldman has apparently demonstrated in the third quarter perhaps puts those analysts' scepticism in a somewhat different light.

- Mark Pengelly.