Are Some Wall Street Firms Worthless?

Several months ago, the Wall Street Journal printed an article, “U.S. Investors Face an Age of Murky Pricing.” The authors pointed out explicitly that many securities trade outside of the securities exchanges, and thus lack third party verification. While the authors failed to point out that today municipal bonds, government bonds, and corporate bonds might not trade on exchanges, their prices are tracked pretty accurately. However, trillions of dollars involved in tranches of collateralized mortgage obligations, private equity investments, certain loan commitments, collateralized debt obligations, derivatives, credit swaps, uniquely structured securities, etc. remain in the twilight zone. That is, they are classified as Level 3 securities, and their pricing involves “marking to model.” This pricing is mostly guesswork, and is based upon “management’s best judgment, and “management’s “own assumptions about the methodology that buyers and sellers would use to purchase or sell the security.” In essence, since the dollar value of Level 3 securities held in inventory by such firms as Lehman Brothers, Morgan Stanley, Merrill Lynch, and many hedge funds grossly exceeds their net equity, “The Wall Street Tycoons could be as naked as a jay bird.”

As of last Friday, November 2, 2007, the market capitalization of some major Wall Street firms, and Commercial banks dropped $120 billion. So far this week, these stocks have dropped further. Every dollar decline reduces market value and every dollar of write off reduces book value. Thus, given the high leverage of these institutions, each decline exacerbates the problem. With the exception of Bear Stearns, the following companies all have trillion-dollar balance sheets, filled with illiquid securities. Thus, any forced liquidation will result in further write-downs. These write downs can lead to stock market declines as well as book value reductions.

Changes in Market Caps

The recent forced departures of the Chairmen of Merrill Lynch and Citicorp as well as other high placed executives reflect failure of fiduciary oversight.

The Wall Street Journal reported that between 60-80% of investors found the pricing of corporate bonds, commercial mortgage-backed securities, high-yield bonds, mortgage-backed securities, leveraged loans, collateralized loan obligations, asset-backed securities and structured credit to be off the mark.

The Wall Street Journal article gave specific examples of the Alice and Wonderland World that pervades Wall Street. They pointed out that one manager at UBS, Mr. Niblo, was fired earlier this year, because “his superiors” felt that his pricing was too conservative and contradicted their more optimistic assumptions on similar securities. In the past few days, UBS marked down their portfolio by $3.2 billion. In essence, Mr. Niblo “got the axe” because he was right. My guess is that while a few more heads at UBS will be chopped, the top executives will remain safe in their perches despite mismarking for at least three months.

Over the past few months, Wall Street has written down some $30 billion dollars. However, is this tip of the ice berg? The dollar value of Level 3 securities could approach a trillion dollars; thus, 3% mark down seems paltry. Recently, Wachovia took on its books a Collateralized Debt Obligation that was valued at $600,000. Subsequently, the bank lowered the value of this security first to $300,000 and then ultimately sold it for $60,000, some ten cents on the dollar.

Merrill Lynch recently wrote down $8.5 billion dollars of securities and fired the two senior executives of its fixed income division. The newspaper revealed that a more conservative executive was dismissed one year ago, because he warned against Merrill’s growing exposure to sub-prime mortgages. Merrill is expected to write down another $5-10 Billion. Fortunately, the proposed elevation of Larry Fink, the current Chairman of Black Rock, represents the type of well qualified executive that Wall Street firms need to keep their ships afloat.

In essence, Wall Street has promoted and fired executives who could not walk the fine line of being aggressive traders, meeting their escalating demands for huge trading profits, and not running up red ink. Stated differently, the Wall Street mania for owning twenty-five room co-ops in Manhattan, earning multi-million-dollar bonuses has created a monster. That is, Wall Street executives are prepared to take enormous risks in order to earn for one-year huge bonuses. Moreover, this greed permeates the entire Wall Street hierarchy. Stated differently, the Chief Executive Officers of Wall Street firms demand escalating trading profits to keep the stock prices of their companies high. Since I was a trader for most of my thirty-five-year Wall Street career, I like Boston Blackie know full well the evil (GREED) that lies in men’s hearts. The board of directors of Merrill Lynch, Morgan Stanley, Lehman Brothers, Bear Stearns, and UBS should be asking the big question of their Chief Executive Officer “What steps did you take to make certain that the pricing on your Level 3 securities was reasonable!” Moreover, since the value of these Level 3 securities changes with the volatility of the market, how have these firms coped with changing market conditions?

Also, the Federal Reserve needs to revalue the amount of leverage employed by investment and commercial banks. I propose that starting January 1, 2008, the Federal Reserve significantly raise margin requirements over a twenty-four-month period. Stated differently, each quarter the Federal Reserve could raise reserve requirements on Level 1, Level 2, and Level 3 inventory. Also, the Federal Reserve and the Treasury should review the proposed changes involved in Basel II in order to make sure that our financial institutions operate more conservatively.

Originally published in the Sarasota Herald-Tribune