Yesterday, I wondered
what the connection was between the weak subprime-mortgage market, on the one
hand, and some weakness in the second-quarter results from Bear Stearns and
Goldman Sachs, on the other.
Today, Kate
Kelly and Serena Ng of the WSJ try to answer some of those questions, although
their article is a bit confusing. It starts off by talking about a Bear Stearns
hedge fund, which has indeed taken a serious bath in subprime mortgages, but
which hasn’t had a significant effect on Bear’s bottom line. Later on, they
seem to continue to elide the difference between the performance of managed
funds and the banks’ operating results:
Both Goldman and Bear yesterday sounded one common chord: that continued
troubles in the mortgage market remain a big worry.
With the sort of weakness investors are seeing in the subprime market, "there’s
no hedging strategy you’re going to be able to employ that’s going to completely
immunize you," said Sam Molinaro, Bear’s chief financial officer, in
an interview. Investors have made big profits on subprime loans in recent
years, and losses on risky mortgage loans "are to be expected,"
he added. "While you don’t like to have them, it’s a fact of life in
the business."
In a call with reporters, Goldman finance chief David Viniar was even blunter.
"I don’t think we’ve seen the bottom" of the subprime problems,
he said.
Bear, which is known for its tough risk controls, has so far been unable to
navigate its way out of the turmoil. This raises the specter that other Wall
Street funds are sitting on big losses that could crop up in the days and
weeks ahead.
I do understand that banks generally make more money in bull markets than in
bear markets. But what exactly are the losses being talked about by Bear’s Molinaro,
here? Are they losses for the bank, or losses for investors? And the same question
can be asked of those hypothetical "Wall Street funds" which might
be sitting on large losses.
To the rescue comes my favorite informant on matters subprime, who sent me
an email yesterday explaining a lot of this. (He hasn’t given me permission
to use his name yet, so for the time being he’ll remain anonymous.) Firstly,
he explains why the subprime losses are showing up in the banks’ second-quarter
results, rather than their first-quarter results.
The reason is that the subprime meltdown didn’t really happen until the end
of the banks’ first quarter, which ended in February. So in a large part of
their first quarter they continued to make money by securitizing and trading
subprime mortgages, as well as by lending money to subprime originators. Then,
when the bottom fell out of the market in February, volatility spiked upwards,
and banks generally make money in times of high volatility. So what they lost
in terms of securitization and lending revenues they made up for on the trading
floor.
In the second quarter, however, volatility fell back down, but there was much
less activity on the lending and securitization fronts. Which means the banks
were hit on both fronts, and there was no way for them to make money in the
subprime sector. Unless and until subprime wakes up again, it’s unlikely to
be a source of much profit for banks. And of course if a sector was providing
large profits and now provides very little in the way of profits, then that
means the bank’s profits are falling. In journalists’ shorthand, this often
equates to "losses" in the sector: the important thing is not whether
profits are greater than zero or not, but rather whether they’re going up or
going down.
The sector is still alive: the same WSJ story reports that Merrill Lynch yesterday
launched a $1.6 billion bond issue backed by subprime mortgages, which "generated
significant investor interest". But such deals were certainly much more
common a year ago than they are now. And with long-term interest rates rising,
consumers’ appetite for new housing debt is sure to be constrained.
Banks such as Bear Stearns and Lehman Brothers have made a lot of money in
recent years from the mortgage sector in general and the subprime part of it
in particular. For the foreseeable future, they’re going to have to look elsewhere
for those profits.