Investors Want Transparency From Brokers

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Investors will be looking closely at how much investment banks disclose about their balance sheets next week, as the major brokerages begin to report second-quarter financial results in the wake of Lehman Brothers' (LEH) steep fall.

Though followers of financial services companies have long known that the industry's earnings statements are essentially unintelligible, the issue has increasingly come to the fore as investors seek explanations for the roughly $200 billion in writedowns that banks have announced over the last year, and they wonder how much worse things can get.

Lehman officially reports results Monday, while Goldman Sachs (GS) reports Tuesday; Morgan Stanley (MS) reports Wednesday.

Thursday's shocking removal of Erin Callan as Lehman's CFO is emblematic of the heightened scrutiny. Callan was ousted three days after the firm warned it would post a $2.8 billion loss, a vindication of sorts for critics like David Einhorn of Greenlight Capital, who have questioned how Lehman was accounting for various assets on its balance sheet.

While Einhorn criticized Callan, taking the view that she played fast and loose with Lehman's financials, she was hailed by others, notably Meredith Whitney, analyst at Oppenheimer & Co., as being unusually detailed in terms of disclosure. One investor at a multibillion dollar New York hedge fund says he thinks Callan was more forthcoming than most CFOs and that her fate will lead the other CFOs to be less so.

At the center of the storm between Callan and Einhorn were so-called level 3 assets -- assets whose value is highly subjective, because they trade rarely, if at all. The level 3 designation was created by the Financial Accounting Standards Board, the main organization that sets accounting standards for U.S. companies.

The term "level 3" refers to the assets on financial company balance sheets whose price is virtually impossible to discern because they don't trade. Einhorn and Callan dispute the amount of level 3 assets on Lehman's balance sheet, which rose from $38.9 billion at the end of the fourth quarter last year to $40.2 billion in the first quarter this year. What is extraordinary is that, even in the best-case scenario, nearly $40 billion worth of assets on Lehman's balance sheet are essentially impossible to value.

"What we have is an awful lot of uncertainty, not only in the inventory levels, but if we go a little further, the inventory levels convert into the book value of the brokerage firms, and so, for the first time in my relatively long career, you can't rely on the book value," says Brad Hintz, analyst at Sanford Bernstein.

In a research report that preceded Callan's removal, Whitney said she expects to see increased disclosure from the brokers. For example, she believes brokers will for the first time disclose what is known by banks as "tier I" capital ratios -- a measure of the amount of equity they have on their balance sheet. She has written that she believes Goldman will come out looking the best among the brokers by this measure.

One thing that will improve the amount of insight investors have into the investment banks is if some of the illiquid assets on their balance sheets begin trading. That will allow the banks to begin valuing the assets, thereby reducing the amount of level 3 assets they have.

Analysts polled by Thomson Reuters expect Goldman to earn $3.42 a share on revenue of $8.73 billion. The stock took a 2.9% hit on Wednesday, however, when rumors surfaced that the firm would have to write down the value of leveraged loans. The company declined to comment on the speculation.

Analysts expect Morgan Stanley to earn 92 cents on revenue of $7.05 billion.

"I'd like to see evidence that [the investment banks are] getting more and more price discovery within some of these pressured assets, and some evidence that they're going to be able to move it off their balance sheet," said David Killian, who oversees a $600 million equity portfolio at Stone Ridge Investment Partners, a Malvern, Pa.-based money manager that owns shares of both Morgan Stanley and Goldman but sold out of Lehman earlier in the week.


Killian says he is considering getting back into Lehman following its earnings call on Monday if he sees continued evidence that illiquid assets are beginning to trade.

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