Monday, August 18, 2008

Explaining the brokers Part I

Don’t read this series if you expect clear tradeable answers. I don’t have them (yet?) and really this is just the beginning of another intellectual journey. It may be a dead-end.

For someone that might open a fund I am about to do something profoundly stupid. I am going to have a peek at the broker balance sheets in public without being entirely sure what I will find. This series might go nowhere – or it might wind up being very interesting. I am trying to get readers to help me pick apart the brokers.

I have to say that I got a lot of email on Fannie Mae when I did the series there – almost all expressing religious belief on whether Fannie is OK or not. Not much counted as analysis and less contained methods which are testable..

I hope my readers are better this time – but I am not counting on it.

Before I start my instinct on Wall Street Brokers is hyper-bearish. It is not that I think they have solvency problems (on that I have no opinion). It is just that I think that their stated business and their actual business differ substantially. When companies can’t explain clearly what they are doing then I get bearish – and nobody seems to explain brokers clearly.

With Fannie at least I could explain how the business was meant to work. With Goldman Sachs I don’t even start with that.

Part I is just going to leave everyone with a puzzle. Why are the broker balance sheets so big – and what business inflated their size to such grotesque levels? I think this is the key issue wit the brokers – but for the moment I will just give you some numbers.

The FED flow of funds data gives type of debt outstanding in the US at any time. At the last release (Q1 2008) there was 30.8 trillion of non-financial sector debt outstanding. [You don’t want to count financial sector debt because you are double counting though I have known a few reputable people who have done just that.]

Of this “only” 14.0 trillion was to households and “only” 10.6 trillion was mortgages. The mortgage growth rate had slowed to 3 percent. The fastest growing category was the Federal Government (up at over a 9% annual rate). That hardly bodes well for the US. 5.2 trillion of Federal Government debt outstanding. Private sector debt was 24 trillion. I want you to keep that number in head for the reason I am about to bold

  • 24 trillion – total private sector debt – is the maximum about of debt that it possibly makes sense in any way for financial institutions to intermediate. Brokers can’t make money intermediating government debt.

The second set of statistics is about the sheer size of broker balance sheets:

  • The Goldman Sachs balance sheet is 1.09 trillion in size at the last quarter (admittedly a slightly different date to the Fed Flow of Funds data).
  • Lehman is 0.639 trillion – and that was after some questionable moving of items off balance sheet.
  • Merrill Lynch is 1.04 trillion at the closest quarter
  • Morgan Stanley is 1.03 trillion.

On top of this there is probably almost a trillion of investment banking assets at Citigroup, over a trillion at JPM (including Bear Stearns) and another trillion at Barclays Global Capital.

Somewhere investment banks got on their balance sheet maybe 7 trillion in assets which is very large compared to the total assets that could theoretically be intermediated in the US.

Goldman Sachs has a balance sheet the same size as a smaller Japanese megabank.

One thing is for sure – you don’t hold all these assets because you are facilitating trades on behalf of your customers. I have seriously been told my investor relations at investment banks that the reason they hold so many assets is to facilitate client transactions.

I might be young and naïve – but I am not sure I was ever that naïve…

The investment banks are full of people considerably smarter than me. But the shareholder letters are not very explanatory. (These companies fail Warren Buffett’s test of clear shareholder letters.)

They don’t do what they say they do. So what are they? We all deal with them so we think we have some idea – but the places that I deal with don’t produce balance sheets that look anything like Wall Street. I have some answers – but I know before I start that they are not complete answers – moreover my answers are hard to test.

Some exploration (but probably few answers) coming in Parts II, III etc…

If people have suggestions I will include those (with some analysis) in later parts. Email me please.



Anonymous said...
One area that regulators might focus on, analysts said, is an investment bank's total assets -- including stocks, bonds and mortgages -- relative to shareholder equity, or the ownership interest of shareholders.

Regulators have so far evaluated the adequacy of an investment bank's capital mainly by focusing on the riskiness of its assets, which essentially has translated to allowing banks to hold less capital for lower-risk assets.

There is some validity to that approach. Dealers have large inventories of low-risk securities such as Treasuries, which inflate their balance sheets but do not necessarily need to be offset by much capital.

Anonymous said...

Have you allowed for the holding of non-US debt by the brokers, and the holding of US debt by non-US entities?

John Hempton said...

I am being asked - repeatedly - by email and in the comments - if I have thought about the non-US assets in the investment banks?

Well yes. And I have not added the non-US investment banks - try Deutsche, SocGen's investment bank, Calyon's investment bank, BNPs investment bank, Nomura and a few other investment banks not on the list.

If I do the study globally but include all the investment banks I still get an outrageous proportion of all financial assets sitting on investment bank balance sheets.

Its not obvious why. At least it is not obvious to me.


John Hempton said...

I could also add the off-balance sheet assets of investment banks in SIVs and the like. Trillions is the sum usually bandied about...


Anonymous said...

I think you are missing the point of the comments. No-one is disagreeing with your comments about IB balance sheets. They are just saying that you cannot look at a closed system of US debt/US IB's. The proportion of debt to GDP has escalated incredibly in all the developed economies.

John Hempton said...

I don't quite miss that. I live in one of the few countries that make the US look like sober savers. That country is Australia.

What is odd is that these companies that are not naturally intermediaries have become the biggest intermediaries of them all.

Traditionally banks make sensible intermediaries. They have DEPOSITS.

Brokers are not natural intermediaries - at least I never thought that...

And I am sorry if you think I missed the issue. This is a global issue - but brokers as intermediaries are most pronoucned in the US...


Anonymous said...

"I still get an outrageous proportion of all financial assets sitting on investment bank balance sheets. // Its not obvious why. At least it is not obvious to me."

See the UBS shareholder report for some insight? i.e. I get the impression brokers claim to be in the moving business but are in fact in the storage business.

pjfny said...

The IB's business model, outside of acting like pure brokers (trading as agents) and investment banking (advisory), was one big hedge fund......i.e, the mega carry trade. The did that carry trade, in their prop desks as well as in their other trading books. With carry trade...I mean any security or other assets, that were profitable carrying (holding) while funded with shorter term cheaper funding. With no regulatory oversight about the leverge in these firms, their balance sheets balloned and balloned as long as the assets they carried, went up....until they didnt'...The 30/40/60:1 leverage now hurts as much as they helped on the way up. Deleveraging is here, until it come down to much more reasonable levels.
Think about what happnens to your equity capital, when you have 50:1 leveerage,
and you assets (level 2/3 assets) goes down 10-50%. You cannot afford to m2m at proper mark.
Now it also looks like the equity raising window is shutting!

Anonymous said...

Not everything on their balance sheet is debt, they do have large holdings of equities, private equity portfolios. Also, do you think their short positions need to be taken into account? (They arguably reduce the risk.) Do you have any idea what has been the ratio of broker assets to private debt historically?

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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.