Big banks face trouble as hedges come unglued

BY SUSANNE CRAIG

Just as they were emerging from their bunkers after a dismal first quarter, some of the big Wall Street investment banks got ambushed. That could lead to another round of losses when the second quarter closes next week.

The bad news comes from the hedges the banks have used to offset losses in real estate and other securities. These hedges, where the brokers bet against indexes that track markets such as real-estate securities and leveraged loans, have helped limit losses over the past year.

The profits the firms made by betting against the indexes offset some of the declines in value for other investments.

But since the market bottomed in mid-March following the collapse of Bear Stearns Cos. (in the process of being acquired by J.P. Morgan Chase&Co.), some of these hedges came unglued. In some cases, indexes such as the CMBX, which tracks the market for commercial-mortgage- backed securities or loans, rallied as much as 50%, while the securities the banks were hedging rose much less, or in some cases fell in value.

The biggest loser by far appears to be Lehman Brothers Holdings Inc., where losses from both writedowns on assets and ineffective hedges will likely range from $1.5 billion to $2 billion, according to some analysts.

Lehman Brothers had about $36.1 billion in commercial-real-estate loans and securities on its books at the end of the first quarter, and $17.8 billion in leveraged loans.

Last week at a conference hosted by UBS analyst Glenn Schorr, Lehman Brothers Chief Financial Officer Erin Callan said some of the firm's hedges have become "counter productive" or are actually losing money.

This is a far cry from a few months ago, when, she says, the firm's hedges were about 70% efficient, meaning that for $100 it lost on one side, it would recover $70 with the hedge.

Analysts say Morgan Stanley will be more affected than Goldman Sachs Group Inc. and Merrill Lynch &Co., but its losses related to ineffective hedges and writedowns will be less than half ofwhat Lehman is looking at.

Morgan Stanley was sitting on some $23.5 billion in commercialreal-estate securities at the end of the quarter and another $15.9 billion in leverage loans.

At last week's conference, Mor gan Stanley CFO Colm Kelleher declined to provide details on the firm's losses this quarter but played down the issue, noting the firm has been selling its holdings in many of the affected asset classes.

Goldman has substantially less commercial real estate on its books. However, it had $27 billion in leverage loans, more than any other rival, and analysts expect it will post some losses on its hedges on this portfolio.

To be sure, the hedges could start working again and some of the losses that are being booked now could turn into gains.

Even if that proves true, a new round of losses, albeit smaller than in quarters past, does little to help rebuild Wall Street's reputation for managming risks. Macquarie must st resell backers on its "model"

Macquarie Group's weak profit growth and grimmer earnings outlook account for some of the stock's 7% fall Tuesday. Investor concerns about lack of transparency certainly accounted for the rest.

What has become increasingly clear this year is that the Australian investment bank best known for its infrastructure funds is being judged differently from before by investors.

That explains why the once-invulnerable shares of Macquarie are down by a third in the past year.

What began as doubts raised by short-sellers have spread to more mainstream investors who have increasingly decided that the socalled Macquarie model is riskier than they thought.

To change this attitude, Macquarie needs to improve its transparency to the point that investors don't worry that demons lurk in one of the company's closets.

The first step could be to allay any questions about how its advisory division, which accounts for 44% of profit, benefits from services provided to the bank's range of funds.

The funds themselves also worry investors, who are concerned about high debt levels and assets that are valued (upwards usually) by Macquarie's own internal model.

In all, 20% of Macquarie Group operating income now comes from fees associated with these funds, so the concerns are material. And the company isn't doing enough to quiet them.

Macquarie's departing and incoming chief executives have been addressing all of these issues for months. Maybe investors are just jittery from the global credit crunch, but the message they're sending is that the executives haven't done enough to put the issue to rest.

If Macquarie Group's model is as solid as they say, their future success depends on getting people to believe them. -Andrew