Happy New Year for Investment Banks?

Fiscal 2007 closed at the end of November for major investment banks like Morgan Stanley, Goldman Sachs, and JPMorgan Chase. They will probably announce preliminary financial results in the next couple of weeks.

Large write-offs for mortgage exposure and other credit crunch losses wouldn't surprise anyone. The problems in the financial markets are known to just about everyone who has a pulse and is literate. Moreover, unlike the third quarter results announced this past September, the year end results will be audited. So the investment banks may tread cautiously in terrain now known to contain mines.

Look at what the banks do with their Level 3 assets. These are the financial assets for which there is virtually no market information--in other words, they're the derivatives that have been valued according to computer models. As we know, there have been problems with the models. (See http://blogger.uncleleosden.com/2007/07/pricing-fog-in-cdo-market.html.) A substantial dose of management discretion goes into establishing the values of Level 3 assets. Finding bona fide cash buyers for these assets hasn't been so easy lately. Management will have to be careful in exercising its discretion, lest it be accused of indiscretion.

Level 2 assets can also present interesting challenges. These are financial assets for which some market information exists, but management discretion also plays a significant role. For level 2 assets with mortgage exposure, the market information is probably not encouraging. So management must proceed with care. Taking a highly optimistic outlook when the outside world is frowning may, for accounting purposes, not equate to the better part of valor.

Perhaps one of the most interesting developments, if it occurs, would be a report of strong financial results. Goldman Sachs issued such report this past September. Goldman has a goodly share of Level 3 assets, more than its capital. But it apparently was able to hedge its exposure to the mortgage mess. Good for Goldman. But bad for its counterparties.

Whenever a market player like Goldman hedges a risk, someone else takes the opposite side of the transaction. If Goldman wins on the hedge, the counterparty loses. Since Goldman did so well in the third quarter, a lot of counterparties must have done rather badly. Goldman appeared smart and a bunch of other people appeared dumb.

It's not a good idea in the financial markets to appear too smart. If other market participants think you're way ahead of them, they'll be less likely to trade with you, for fear that your superior information will put them at a disadvantage. And if they do trade with you, they may demand a larger premium for the risk you could present. Credit default swaps for mortgage-backed securities aren't exactly cheap any more. And if the counterparty is dealing with a Goldman, who may have superior information about the risks involved, the trade might not happen at all.

Perhaps Goldman's hedges are still in place and it can still announce solid gold results. On the other hand, perhaps some of its hedges have expired and it's needed to replace them. That may have proven more difficult in the last couple of months. Perhaps some of its counterparties have been so badly crippled by mortgage losses than their creditworthiness has been impaired and their ability to stand behind their losing positions vis-a-vis Goldman has come into question. If so, Goldman's financial performance may glow less brightly now.

Anyway, time passes and we move on. 2008 is a new year. Maybe things will be sunny and bright. But then again, if all the predictions have even a modicum of accuracy, 2008 is likely to be another year in which we'll have to scrutinize the financial results of the investment banks closely.

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