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January 30, 2008

Is this the Breaking of the Bear? Part 2
by Reggie Middleton

After Citigroup and Merrill Lynch, it's now Bear Stearns' turn to writedown more assets

Driven by the implosion of the US asset securitization market, the US housing industry saw writedowns and credit losses of $133 billiion, and still counting. Merill Lynch, leading the pack, has thus far written down assets worth $24.5 billion, followed by Citigroup, which has written down $22.1 billion worth of assets. J.P. Morgan Chase also written down $1.3 billion attributable to subprime losses. The meltdown in the US asset securitization market has its repercussion on the entire global financial systems with banks in Europe and across Asia reporting huge writedown of assets. European Banks such as UBS are anticipated to report huge writedowns in their fourth quarter results, totalling $14.4 billion, while HSBC has reported writedown and credit loss worth $10.7 billion. However, Bear Stearns which has so far written down $700 million and $1.9 billion in 3Q 07 and 4Q 07, respectively seems to have inadequately written down its assets taking into consideration the level of exposure it has toward the risky assets. Bear Stearns was the Street's, and the world's, fixed income mortgage derivative leader yet it actually came in close to last place in writing down the value of its mortgage derivative assets. Something just doesn't smell right... We are likely to see the company writing down more far more assets in the coming quarters.

Total writedown and credit losses

Source: Bloomberg

Deteriorating financial performance reflected by the last two quarter results

The turmoil in the credit markets and the Bear Stearns exposure towards subprime RMBS/CMBS and CDO investments negatively impacted the company's performance in the last two quarters. The company reportedly wrote down $1.9 billion of assets, $700 million more than announced in November 2007. The higher-than-anticipated write downs, poor investment banking results and weaker equity trading revenues saw Bear Stearns report a huge net loss of $6.90 per share significantly below the market expectations. Bear Stearns capital markets segments reported negative revenues primarily due to net inventory markdown in the fixed income business. Revenues from the fixed income business were a negative $1.55 billion, driven by the $1.9 billion of writedowns. Even after excluding the writedowns, Bear Stearns fixed income revenues were a dismal $355 million, significantly lower than 4Q 06.

In addition, the institutional equity and the investment banking businesses also witnessed decline in revenues. Institutional equity business witnessed a decline in revenues owing to weaker performance in the structured finance products. The investment banking revenues were also under pressure reporting a fall of 38% owing to lower high yield underwriting revenues resulting from difficulties in the fixed income and capital market environment. However, the growth in revenues in the Global Clearing Services and the Wealth Management segments helped offset the decline in revenues witnessed in the Capital markets segment.

Net income before tax (in US$ million) and y-o-y growth

Source: Company data

Wealth Management revenues to be under pressure

The failure of the two hedge funds of Bear Stearns have left the investors stranded, frustrated, and more importantly, losing money. More and more investors are suing Bear Stearns as they believe that the company misled them about the funds performance. The funds, the High Grade Structured Credit Strategies Fund and the High Grade Structured Credit Strategies Enhanced Leverage Fund, sought sanctuary from creditors by invoking jurisdiction defenses allowed by off shore domiciles after investing heavily in CDOs backed by subprime mortgages. Barclays PLC is suing Bear Stearns and two of its fund managers, as the collapse of the funds resulted in huge losses for Barclays. We believe all this legal actions will estrange Bear Stearns existing as well as potential clients putting undue pressure on the company assets under management (AUM) growth. In the asset management business, total AUM declined to $44.6 billion, compared to $57.8 billion in August 2007 and $52.5 billion at the end of the November 2006. The decline was primarily due to the $8.8 billion transfer of assets related to the spin out of O'Shaughnessy Asset Managemenint and poor performance. However, we believe the reputation hit taken by the company will put the company under pressure to generate higher revenues from this segment.

Bear Stearns lack of geographic diversification and overdependence on the US continues to be a disadvantage for the company. The significance of international diversification will become even more palpable in the near future as the US credit and economic conditions realize the hard landing that I called for last year, and continues to worsen. Bear Stearns derives 25% of its revenues from outside US compared to 40% to 50% of its peers. In addition, Bear Stearns derives a very large chunk of its net revenues from the fixed income business (almost 45%) business, which is at the forefront of the credit market turmoil. The deterioration in the mortgage market is more detrimental to Bear Stearns as compared to its peers as the company has a significantly higher interest in the mortgage market as compared to its peers.

Compensation expenses to be under pressure in the coming quarters

Bear Stearns compensation expenses is anticipated to be under pressure as the significant reduction in revenues of the company will not allow it to lower its employee cost significantly in the short term. The compensation expense as a percent of net revenues has increased to 57.1% in 2007 up from 47.1% in 2006. This was despite compensation expenses coming down to $326 million in 4Q 07 from $664 million in 3Q 07 and $1,052 million in 4Q 06. In addition, the executive committee has decided that they will receive no compensation this year (last year they made $156 million, or 3.6% of total compensation expense).The increase in the severance expense, legal and other expenses will drive the rise in the company's overall expenses.

Furthermore, if we compare the compensation expenses with its peers, the average increase has been in the range of 20-21% with Lehman brothers giving a rise of 10%, Goldman Sachs 23%, Morgan Stanley 19%. In this scenario, it is likely to be extremely difficult for Bear to attract and more importantly retain people who will make money (and in the past have made money) for them.

Compensation and benefits as a percentage of net revenues

Source: Company data

Pulling it all together - The Sensitivty Analysis and Valuation

Our Sensitivity analysis of its exposure towards riskier assets

Bear Stearns weighted average value per share, with forensic and economic adjustments to risky assets and book value

We have analyzed Bear Stearns exposure towards subprime MBS & ABS portfolio, the level 2 and 3 assets and its exposure towards counterparty credit risk in assigning our fair value. To value Bear Stearns in this report we have considered the Discounted Cash Flow (DCF), Price-to- adjusted book (P/ABV) and Price-to-Earnings (P/E) multiple methods. After a thorough review of the results, I decided to exclude the DCF analysis, primarily due to the theoretical nature of ascertaining risk premia, and the amount of guesswork involved in creating future cash flow streams. The DCF number would have raised the overall valuation by about 15%, depending on the weighting assigned (this is partially due to our generosity and conservatism in assigning quarterly revenue growth to BSC relative to its peers - again guesswork). It threw off a number that was singificantly disparate from that of the P/E and P/Adj. BV valuation models. Based on our final weighted average valuation, we arrive at a fair value price for the Bear Stearns of $36.42, which represent a downside of 58% from current level of $87.03.

The book value numbers are after our economic marking and adjustments, of course. The "E" portion of the P/E ration is quite conservative, since the we built model incorporated BSC doing much better during the next 4 fiscal quarters than their peers are reporting for this quarter, and in my opinion BSC will not only fail to match their peers, but underperform due to the loss of their primary value drivers - mortgage derivative and related fixed income products - not to mention their asset management, legal, and litigation distractions as well as client and talent retention issues.

Am I right about the Bear?

Despite the Bear Stearns negative developments, and my opinion of its value, Bear Stearns has managed to find investors as was mentioned earlier in the insider transaction section. These are accomplished and wealthy investors to boot. My concern is that so many astute, accomplished and economically powerful investors have failed to realize and fully appreciate the depth and breadth of the current real asset recession, burst bubble, and quite possibly asset depression we have recently entered. This has destroyed the value of many bottom fishing value investors, both intitutional and retail.

A brief perusal through my site reveals a fairly decent track record of recognizing the potential damage to be done by this "devaluation diaspora". Only time shall tell the tale of Bear Stearn's contribution to this list. Twelve months to date, BSC has lost over 50% of its share value and it near ground zero of the housing bubble burst. Observing the share price patterns of the companies who were actually at ground zero shows that a 50% is far from the midway mark when tracking from the peak of the bubble. I am certain their may be financial concerns such as well capitalized investment funds, foreign firms/funds, and/or stateside banks who have, and are considering a buyout. Yet, as I have stated with Ambac Financial, MBIA, Beazer Homes, and Countrywide during similar institutional forays into attempted vulture investing - Caveat Emptor: Seeking the bottom of a bottomless pit is a hazardous venture, indeed.

To date, I have been blessed with a modicum of accuracy in my research. As always, I am short any company that I am bearish on, and will be long any company that I am bullish on.

As with most firms on Wall Street today, financial leverage makes the good times, good - but makes the bad times nigh unbearable. BSC is not the most leveraged bank on the street, but it does employ more than enough leverage to get itself into trouble. Trouble is where it is at now. It was excessive leverage that exacerbated the problems at its hedge funds last summer.

Reggie Middleton
Reggie Middleton, LLC
Perpetual Interests, LLCTM
http://boombustblog.com/

Who am I?

Well, I fancy myself the personification of the free thinking maverick, the ultimate non-conformist as it applies to investment and analysis. I am definitively outside the box - not your typical or stereotypical Wall Street investor. I work out of my home, not a Manhattan office. I build my own technology and perform my own research - in lieu of buying it or following the crowd. I create and follow my own macro strategies and am by definition, a contrarian to the nth degree.

Since I use my research as a tool for my own investing to actually put food on my table, I can stand behind it as doing what it is supposed too - educate, illustrate and elucidate. I do not sell advice, I am not a reporter hence do not sell stories, and I do not sell research. I am an entrepreneur who exists just outside of mainstream corporate America and Wall Street. This allows me freedom to do things that many can not. For instance, I pride myself on developing some of the highest quality research available, regardless of price. No conflicts of interest, no corporate politics, no special favors. Just the hard truth as I have found it - and believe me, my team and I do find it! I welcome any and all to peruse my blog, use my custom hacked collaborative social tools, read the articles, download the files, and make a critical comparison of the opinion referencing the situation at hand and the time stamp on the blog post to the reality both at the time of the post and the present. Hopefully, you will be as impressed with the Boom Bust as I am and our constituency.

I pay for significant information and data, and am well aware of the value of quality research. I find most currently available research lacking, in both quality and quantity. The reason why I had to create my own research staff was due to my dissatisfaction with what was currently available - to both individuals and institutions.

So here I am, creating my own research for my own investment activity. What really sets my actions apart is that I offer much of what I produce to the public without charge - free to distribute and redistribute, as long as it is left unaltered and full attribution is given to the author and owner. Why would I do such a thing when others easily charge 5 and 6 digits annually for what some may consider a lesser product? It is akin to open source analysis! My ideas and implementations are actually improved and fine tuned when bounced off of the collective intellect of the many, in lieu of that of the few - no matter how smart those few may believe themselves to be.

Very recently, I have started charging for the forensics portion of my work, which has freed up the resources to develop the site to deliver even more research for free, particularly on the global macro and opinion front. This move has allowed me to serve an more diverse constituency, which now includes the institutional consumer (ie., investment turned consumer banks, hedge funds, pensions, etc,) as well as the newbie individual investor who is just getting started - basically the two polar opposites of the investing spectrum. I am proud to announce major banks as paying clients, and brand new investors who take my book recommendations and opinions on true wealth and success to heart.

So, this is how I use my background and knowledge in new media, distributed computing, risk management, insurance, financial engineering, real estate, corporate valuation and financial analysis to pursue, analyze and capitalize on global macroeconomic opportunities. I have included a more in depth bio at the bottom of the page for those who really, really need to know more about me.

Visit his blog Boom Bust Blog.

Copyright © 2007-2008 Reggie Middleton

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