Loss Leaders

The costs of the credit crunch mount. There may be more pain to come.

“This time it’s different” are the four most expensive words in the English language, runs a saying among bankers. So it has proved at Merrill Lynch, an American investment bank which is ruing a stampede into collateralised-debt obligations (CDOs) and other subprime mortgage-linked nasties. Never mind that most of its CDOs were “super senior” and supposed to be relatively safe. On October 24th the Thundering Herd’s senior bulls sheepishly announced write-downs of $7.9 billion on Merrill’s mortgage holdings, $3.4 billion more than the bank had estimated only 19 days before. This tipped Merrill into loss. After a few days’ testy deliberation, the board tipped its chairman and chief executive, Stan O’Neal, through the nearest window.

The $161.5m that Mr O’Neal grabbed on his way out will no doubt encourage would-be successors to step forward. But the new boss will be taking over at an unenviable time. The mortgage crisis has done more than $27 billion-worth of damage to capital-markets businesses so far. With the value of subprime securities still falling, that number could rise dramatically when fourth-quarter results are unveiled. Hopes that banks would be able to put the worst behind them in a single bad quarter have been dashed. Several bosses, including Citigroup’s Chuck Prince, are under enormous pressure to steady the ship.

Big differences in the quality of risk management have become apparent. Merrill’s controls were left in the dust as it ramped up its trading bets. Mr O’Neal sacked a senior fixed-income executive who had rung alarm bells last year. The board ignored a warning in April. By contrast, Goldman Sachs and (to a lesser extent) Lehman Brothers appear to have minimised damage through tight oversight and shrewd hedging.

But analysts think Goldman must also have taken some huge gambles to raise third-quarter profits in a difficult market (and despite a $1.5 billion write-down). That happy result may have had as much to do with luck as skill, thinks Roy Smith, a finance professor and former Goldman partner. Remarkably, given the pummelling most banks have taken, Goldman’s share price is up by 24% this year. But it still trades at only around ten times earnings, little more than half the average for the S&P 500. “Investors will only pay so much for risk they can’t see,” says Mr Smith.

In Europe too, they are struggling to penetrate the murk. UBS, the biggest Swiss bank and long regarded as a leader in risk management, gave no better answers than any other institution for calculating the future impact of the subprime crisis when it reported its third-quarter results on October 30th. UBS’s investment-banking division lost SFr4.2 billion ($3.6 billion) in the third quarter. The bank’s value-at-risk, the amount it stands to lose on a really bad day, has shot up. On 16 days during the quarter its trading losses exceeded the worst forecast by its value-at-risk model on the preceding day. It had not experienced a single such day since the market turbulence of 1998.

In a conference call to discuss the results, Marcel Rohner, UBS’s chief executive, and Marco Suter, chief financial officer, struggled to explain the methodology behind their valuation of what seems to be a deteriorating portfolio of subprime securities. Reluctant to give a worst-case assessment of UBS’s exposures in future, the best they could do was predict that the investment-banking division would not make a profit in the fourth quarter. They also promised to de-emphasise proprietary trading and to make traders think harder about their bets by raising the proportion of pay they receive in UBS shares.


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