Subprime Problems Hit Both Goldman and Bear Stearns

[Andy Nguyen]

Subprime Problems Hit Both Goldman and Bear Stearns
By MICHAEL J. de la MERCED
Published: June 15, 2007

Turmoil in the subprime mortgage market took its toll on two Wall Street investment banks today, as second-quarter profit at Bear Stearns dropped 33 percent and Goldman Sachs squeezed out a modest 1 percent rise in profit.

Bear Stearns said it earned $362 million in profit, or $2.52 a share, over the quarter that ended May 31, after the firm took a one-time noncash charge relating to its Bear Wagner Specialists unit. Excluding the charge, the firm reported a profit of $486 million and earnings of $3.40 a share, down 10 percent from a year ago.

Earnings fell short of the average estimate of $3.51 a share in a survey of 14 analysts by Bloomberg News.

The firm said its net revenue for the quarter was $2.5 billion, a 0.5 percent rise over the period a year ago.

Separately, Goldman Sachs, the world's most profitable investment bank, reported earnings of $2.33 billion, modestly higher than the $2.31 billion it reported last year. It earned $4.93 a share for the quarter, beating analysts' average estimate of $4.78, as surveyed by Bloomberg News.

Goldman Sachs' revenue rose to $10.2 billion from $10.1 billion.

Though Goldman Sachs's results were hardly disastrous, they suggest that the firm's string of spectacular gains — one of the most remarkable runs by an investment bank in recent memory — last year may have paused for now.

Both firms suffered from the implosion in the subprime mortgage market, as borrowers with poor credit histories defaulted on their loans in record numbers. As one of Wall Street's biggest underwriters of mortgage-backed securities, Bear Stearns felt the brunt of the impact: its fixed-income business reported revenue of $962 million, a 21.3 percent drop from the period a year ago.

Goldman Sachs's fixed-income business reported a drop in revenues of 24 percent from a year ago to $3.37 billion in revenue. Beyond the weakness in the subprime mortgage market, the firm attributed the decline to a gain in its commodities business in the previous year.

Bear Stearn's investment banking revenues jumped 28 percent to $357 million, as the firm continued to benefit from the prolonged boom in deal making, while earnings from its Global Clearing Services unit rose 10 percent to $317 million. Revenue from wealth management surged 123 percent to a record $341 million, driven by higher fees and investment performance.

Goldman Sachs reported investment banking revenue of $1.72 billion, a gain of 13 percent over last year and a record for the firm.

In contrast to the results posted today, Lehman Brothers on Tuesday reported second-quarter profits of $1.3 billion, a 27 percent increase over the period a year ago. Morgan Stanley will release its results next Wednesday.

 

[Bridgett]

It's an interesting time, isn't it... Morgan Stanley is set to report earnings Wednesday... watch out guys...

 

[Andy Nguyen]

Bear Stearn's investment banking revenues jumped 28 percent to $357 million, as the firm continued to benefit from the prolonged boom in deal making, while earnings from its Global Clearing Services unit rose 10 percent to $317 million. Revenue from wealth management surged 123 percent to a record $341 million, driven by higher fees and investment performance.

At least, their Tobacco Bond group is doing extremely well. #1 by far :D

 

[Bridgett]

At least, their Tobacco Bond group is doing extremely well. #1 by far :D

Ok, ok, Andy... I know where you are coming from... you just can't hide your exitement, can you?

 

[Andy Nguyen]

you just can't hide your exitement, can you?

Just being able to see some positive news out of the bleak picture is pretty nice.
Here is a follow up article on NYT. Interesting read.
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WASHINGTON, June 14 — Delinquencies and foreclosures among homeowners with weak credit moved higher in the first quarter, particularly in California, Florida and other formerly hot real estate markets, according to an industry report released on Thursday.

Randall Kroszner, a Federal Reserve governor, said the Fed “must walk a fine line” in curtailing mortgage abuses without choking credit.

The report, published by the Mortgage Bankers Association, came as the Federal Reserve held a hearing on what regulators could do to address aggressive abusive lending practices. Also Thursday, the latest survey showed that mortgage rates this week reached their highest level in almost a year; the national average for a 30-year mortgage was 6.74 percent, up from 6.53 percent last week, according to Freddie Mac, the mortgage giant.

The delinquency report presented a mixed picture. It indicated that more homeowners with tarnished, or subprime, credit are likely to have trouble making house payments, especially as interest rates rise. But it also suggested that, at least so far, the problems have not extended very far into the larger pool of prime borrowers, whose interest rates are lower because of their stronger credit.

At the end of March, the percentage of all loans that were delinquent or in foreclosure, 6.12 percent, was little changed from the end of last year and up from 5.39 percent from March 2006.

The national numbers benefited from a decrease in the defaults among loans insured by the Federal Housing Administration. The agency and the lenders it works with have been restructuring two out of every three loans in foreclosure, said Douglas Duncan, chief economist with the Mortgage Bankers Association. And it appears similar efforts to renegotiate mortgages to keep borrowers in their homes may also be holding down defaults overall.

“We are seeing more loan modifications and foreclosures and once loans go through either of those processes the loans go out of those databases,” said Mark Zandi, chief economist at Moody’s Economy.com. But he cautioned “they might come back. The recidivism on those loans is very high.”

For subprime borrowers, the outlook remained bleak.

Nearly 19 percent of all subprime loans, or 1.1 million mortgages, were either delinquent by more than 30 days or in foreclosure, up from 17.9 percent at the end of last year. About 140,000 subprime mortgages entered foreclosure, a process that can last several months, in the first three months. About 20,000 of those were in California.

“The storm of foreclosure is happening silently across the country,” said Martin D. Eakes, chief executive of the Center for Community Self-Help, a nonprofit organization based in North Carolina that operates a credit union and the Center for Responsible Lending.

Mr. Eakes, who was speaking at the Fed hearing, criticized the central bank for failing to use its authority over mortgage lending to curb practices that, he said, caused the current problems by giving people loans they could not afford.

Fed officials did not directly respond to the complaints. But in opening remarks, Randall S. Kroszner, a governor on the Fed’s board, said the central bank shared responsibility over mortgage lending with other state and federal regulators.

“Rising foreclosures in the subprime market over the past year have led the board to consider whether and how it should use its rulemaking authority to address these concerns,” Mr. Kroszner said. “In doing so, however, we must walk a fine line. We must determine how we can help to weed out abuses while also preserving incentives for responsible lenders.”

The Fed first heard from a panel of mortgage lenders and non-profit housing groups and in the afternoon from a panel of state regulators, attorneys general and academics.

In the morning, representatives from mortgage companies and an association of mortgage brokers parried, mostly in good humor, with people representing nonprofit housing groups that are the leading advocacy voice speaking on behalf of subprime borrowers.

The opposing sides appeared to agree that the mortgage industry got carried away in the recent housing boom but disagreed sharply on the scope of the problem and what should be done.

The nonprofit housing advocates attacked no-documentation loans, in which lenders do not verify that borrowers earn incomes listed on loan applications; prepayment penalties, which make it more expensive to refinance; and underwriting practices that overlook whether borrowers can ultimately repay their loans.

Lenders generally argued against new regulations, saying that most of the practices being criticized may have been abused but can be very effective in helping lower-income borrowers if used prudently.

“There are folks that do this business the right way,” said Pablo Sanchez, a national mortgage production specialist with JPMorgan. “I would hate to have this as the last record that this is all the lenders’ fault.”

 

[Andy Nguyen]

Another article painting a more detailed pictures of where the subprime crisis hits.

Mortgages Give Wall St. New Worries
By VIKAS BAJAJ and JULIE CRESWELL
Published: June 19, 2007

After the first cracks in the subprime mortgage business appeared late last year, several large lenders were forced into bankruptcy.
Now, the stress is sending tremors down Wall Street, as investment funds that bought a stake in those loans are starting to wobble.

Industry officials say they expect this second act to be longer and slower, unwinding over the next 12 to 18 months. The fallout could further constrict consumers with weak, or subprime, credit while helping to prolong the housing downturn.

On Wall Street, the impact could be far more significant: It could force banks, hedge funds and pension funds to acknowledge substantial losses, which had been tucked away in complex investment vehicles that are hard to evaluate. In turn, that could limit the money available for mortgage lending.

Yesterday, two hedge funds operated by a division of Bear Stearns, an investment bank that is a dominant player in mortgage bonds, fought for their survival as three lenders — Merrill Lynch, Citigroup and JPMorgan Chase — asked Bear Stearns to put up more capital.

The funds appeared to have won a reprieve after executives at Bear Stearns Asset Management told creditors that they had lined up $500 million in new capital from a consortium led by Citigroup and Barclays, the British bank, according to a person who had been briefed but was not authorized to speak publicly. Last week, the fund sold about $3.6 billion in high-grade securities backed by subprime mortgages.

It remained unclear whether the new financing, with the details expected to be worked out today, will be enough to put off plans by Merrill Lynch to seize and auction $400 million of the Bear funds’ assets.

“Basically, Bear is trying to prevent the great unwind of their fund,” said Janet Tavakoli, president of Tavakoli Structured Finance, a consulting firm that helps investors gauge risk. “The reason people are watching this carefully is because they’re wondering whether this is going to lead to others doing the same, or will this be contained.”

Bad bets on risky subprime securities and the direction of an index that tracks subprime bonds caused the High-Grade Structured Credit Strategies Enhanced Leverage fund of Bear Stearns to tumble 23 percent in the year through the end of April. A related fund has fallen less.

The leveraged fund, which had raised $600 million in investments when it was started 10 months ago, leveraged itself, or borrowed, about $6 billion from numerous Wall Street banks and brokerage houses. When losses began mounting this spring, some investors stepped forward to redeem their money. In May, the fund stopped allowing redemptions.

So far, the distress has been muted, which has surprised some investors and analysts who believed that rising defaults by homeowners would have left investors with sizable losses by now.

But Ms. Tavakoli and other industry specialists noted that the housing market moves slowly, much more so than, say, the stock market. Also, subprime mortgages are packaged in securities that are structured to withstand relatively high rates of default before most investors lose any money.

“Mortgage finance occurs in slow motion compared to other parts of the financial markets,” said Jeffrey Gundlach, chief investment officer at the TCW Group, an investment management company that manages $85 billion in mortgage- and asset-backed securities. “This isn’t an Enron corporate bond that goes into default overnight. This is a process that takes 30, 60, and 90 days of delinquencies before it goes into foreclosure.”

The riskiest portions of mortgage bonds — which also hold the promise of higher returns — are held by a small group of investors. The biggest holders of that risk are investment funds known as collateralized debt obligations, or C.D.O.’s. The holdings of these funds, which are once or twice removed from the underlying loans, are often hard to value because it is often unclear what portion of a bond they may own.

Until the end of last year, many large institutional investors were willing to bet on subprime bonds and C.D.O.’s without even trying to value the underlying assets, said Louis Pizante, chief executive of Mavent, a firm that helps investors analyze thousands of mortgages at a time. Many simply placed investments in assets based on their credit ratings.

Mr. Pizante recalled what one customer said last year as he asked for only a basic assessment of mortgage loans: “The broader your review is, the more reasons you are going to tell me why I can’t buy these loans.”

Now, he said, “that attitude has definitely shifted,” and investors are asking for more comprehensive reviews.

Now, ratings agencies are increasingly downgrading bonds or signaling that they are watching for more downgrades. The activity is driven in large part by delinquency rates among borrowers, the value of their homes and the degree to which the structure of the bonds will protect investors, said Nicholas Weill, chief credit officer of the asset finance team at Moody’s Investors Service.

Moody’s says that on average most investors in bonds backed by mortgages will be protected if losses do not exceed about 10 percent.

The picture is different for C.D.O.’s, which have strategically invested in the riskiest portion of the mortgage bonds. They have also done so with a lot of borrowed money.

“We don’t really know the ripple effects,” said one industry official who spoke on the condition of anonymity because of the sensitivity and gravity of the situation. “It is causing a revaluation of the securities, some of which may lead to additional liquidations. That’s possible, but it’s not set in stone.”

 

[John]

This week's ABS weekly research paper from JPMorgan (attachment) also makes reference of Goldman and Bear's declining revenues in the subprime market.

Included also are some interesting pieces concerning subprime ABX index trade recommendations as well as valuation of ABX BBB- index as credit IO.

 

[GusTsahas]

I knew we were in bubble territory in 2000 when one of my construction partners wanted to invest $500K of our money in a dot com out of Manhattan.

I knew we were in bubble territory in 2005 when my under 30 year old office administrator was able to buy two 6 family apartment buildings in LIC Queens within six months of each other and then went looking for a private home for herself as well.

Moral of the story is there are times to be trend followers and there are times to be a contrarians. For investments, it is far better to be a contrarian first and buy something that no one wants, and wait to ride for the trend up, than the other way around….

 

[Erica]

Interpreting the news...

I think of a CDO as a essentially a mortgage backed security with severe internal(vs. external) credit enhancements, namely a multi-tier structure including the equity tranche. (I realize that a traditional pass-through has only extension /contraction risk whereas other structured products also entail credit risk)

Without knowing details of how the fund was structured, say it was a $100mm with only $70mm in actual underlying assets. Upper tier tranches should still be relatively stable with the hits being taken in lower tranches as well as in the equity tranche. Implication is equity may very well have seen a total wipeout.

The point is, Bear was the structurer of the deal and risk factors should have been presented by a ratings agency. As bonds are rated by a ratings agency(S&P, Moody's or Fitch) each individual issue of a structured product comes with a rating. Due to unique pools of assets homogenizing the ratings across multiple issues is not feasible.

Is the problem now that lower tiers are seeing losses not anticipated via the prospectus? If this is the case, why is the heat on Bear and not the ratings agency responsible??Did Bear not disclose the risks or did firms(read institutional investors) not understand the risk?

If anyone has a reasonable information source on this I'd love to know more. Also, if I am wildly off-based wrt my understanding of the underwriting process, I do (heart) to learn.

 

[RussianMike]

I think of a CDO as a essentially a mortgage backed security with severe internal(vs. external) credit enhancements, namely a multi-tier structure including the equity tranche. (I realize that a traditional pass-through has only extension /contraction risk whereas other structured products also entail credit risk)

Without knowing details of how the fund was structured, say it was a $100mm with only $70mm in actual underlying assets. Upper tier tranches should still be relatively stable with the hits being taken in lower tranches as well as in the equity tranche. Implication is equity may very well have seen a total wipeout.

The point is, Bear was the structurer of the deal and risk factors should have been presented by a ratings agency. As bonds are rated by a ratings agency(S&P, Moody's or Fitch) each individual issue of a structured product comes with a rating. Due to unique pools of assets homogenizing the ratings across multiple issues is not feasible.

Is the problem now that lower tiers are seeing losses not anticipated via the prospectus? If this is the case, why is the heat on Bear and not the ratings agency responsible??Did Bear not disclose the risks or did firms(read institutional investors) not understand the risk?

If anyone has a reasonable information source on this I'd love to know more. Also, if I am wildly off-based wrt my understanding of the underwriting process, I do (heart) to learn.

If you look at latest(maybe 1 month ago now) bloomberg magazine they discuss subprime cdo's etc.

Basically rating agencies provide a rating(get paid to do so) but only as information. An investor should not rely on that exclusively.

A prospectus will only have info at time of issuance but these deals are very fluid. Everything cant/wont be anticipated. You have to see in great detail how the deal works(btw not much info is available on these things).

 

[Andy Nguyen]

It's an interesting time, isn't it... Morgan Stanley is set to report earnings Wednesday... watch out guys...

Here you go. Morgan Stanley reported today, looks pretty good

Morgan Stanley, driven by its trading and investment banking divisions, reported a robust second quarter today with a 41 percent increase in net earnings.

The results, which surpassed analyst estimates and set a record for the firm, were a vivid demonstration of the investment bank's ability to overcome the subprime problems that have plagued its rivals.

Like other banks on Wall Street, Morgan Stanley has recently invested money building up its subprime operations, but the performance of its institutional securities division has tempered any effect from the market shake-out.

David H. Sidwell, Morgan Stanley's chief financial officer, attributed this success to the fact that the firm had less exposure to the market for originating mortgages than peers like Bear Stearns.

The institutional securities business, which includes trading and investment banking, has traditionally been the firm's engine, even more so after the spinoff of Discover.

Fixed-income trading and sales revenue were up 39 percent compared with the period last year, propelled by strong results in currency trading and emerging markets. Equity trading was also strong, up 33 percent in a climbing stock market.

"We had a very strong client flows," said Mr. Sidwell. "Prime brokerage was also strong due to activity from hedge fund clients."

Advisory revenue, helped by a robust deal making environment, were up 99 percent compared with the period a year earlier.

Morgan Stanley's traders and investment bankers seem clearly to be responding to a mandate by the chief executive, John J. Mack, to take on more risk. The firm's value at risk, a key barometer that measures the firm's exposure to possible trading losses, was $87 million, up from $70 million in the period last year, although down a bit from the first quarter.

The firm's brokerage division showed a sharp increase; pretax income increased 67 percent compared with the period in the previous year. Under James P. Gorman, its new head, this area of the firm continues to show progress, with margins increasing to 16 percent, from 12 percent last year.

In asset management, where Mr. Mack has been making aggressive investments to compensate for past years of weakness, pretax income grew by 16 percent, although margins were down from last year.

For the quarter, net earnings were $2.6 billion, and diluted earnings were a record $2.45 a share, up from $1.74 a share a year ago. Morgan Stanley's stock rose 9 cents, to $87.89.

 

[John]

If you look at latest(maybe 1 month ago now) bloomberg magazine they discuss subprime cdo's etc.

Basically rating agencies provide a rating(get paid to do so) but only as information. An investor should not rely on that exclusively.

A prospectus will only have info at time of issuance but these deals are very fluid. Everything cant/wont be anticipated. You have to see in great detail how the deal works(btw not much info is available on these things).

agree, the performance of subprime RMBS backing these CDO of ABS depend, to a great extend, on fluid and fast-changing macroeconomic factors, i.e. available of credit and lending standard, which can determine how feasible it is for a subprime borrower to get out of of an expensive hybrid ARM and into a standard 30-yr fixed rate mortgage before the loan rate resets higher, or rate of home price appreciation, which would have allowed the borrower to sell the property enough to cover the balance of the loan had the real estate market continued its upward movement.

Rating agencies, at the time of RMBS and CDO origination, rely on a set of critieria (required credit enhancement, structural features, subordination), analysis of historical performance of similar collateral (loan to value ratio, borrower FICO score, weighted average coupon of mortgages), as well as simulations done on proprietary internal models, to render rating opinions, given the set of information available at the time.

Erica:
Attached is a report done by Moodys in March 2007 in response to the subprime crisis. It address many of your questions in regard to how the deterioration of subprime RMBS will affect the CDOs that invest in these assets.

 

[Bridgett]

Here you go. Morgan Stanley reported today, looks pretty good

I know!! I was really impressed by MS's performance, while reading the news this morning!!!