Capital Markets

As Bad as it Gets?

Banks on both sides of the Atlantic announce poor results.
Economist StaffOctober 5, 2007

After the summer’s horrors, investors in banks needed something on which to hang their hopes. That something was the kitchen sink. On October 1st UBS, Credit Suisse and Citigroup all gave warning that earnings would be hit in their third-quarter results and all saw their share prices rally afterwards. Deutsche Bank got a similar response on October 3rd, after it said that it would take a charge of €2.2 billion ($3.1 billion) on its fixed-income activities. Investors appear to be betting that the banks have thrown everything bad into their assessments—a tactic known in the trade as “kitchen sinking”—paving the way for better times ahead. They may yet be disappointed.

UBS had the nastiest surprise to impart. The Swiss bank expects to report a loss of between $515 million and $690 million in the third quarter, thanks largely to a $3.4 billion write-down on its fixed-income assets, many of them securities backed by American subprime mortgages. UBS is the first heavyweight bank to go into the red as a result of the summer’s financial turmoil (although differences in earnings calendars play some part in that). Given its relatively small fixed-income business, the scale of UBS’s exposure to subprime mortgages indicates some serious flaws in what had once been thought of as a relatively conservative risk-management apparatus. The announcement by Credit Suisse, a perennial rival, that it still expected to make a profit this quarter compounded the embarrassment felt by UBS.

The response was swift. Marcel Rohner, UBS’s chief executive, announced 1,500 job losses, turfed out some senior managers and appointed himself head of the investment-banking division. The bank now intends to play to its strengths in areas such as equities and advisory work. That makes sense. The real value of an investment bank to UBS, and Credit Suisse too, lies in services that overlap with its thriving wealth-management arm, not in making big bets on American mortgages. Mr Rohner can also claim that the mess was not of his making: he was installed in the top job only in July after the failure of Dillon Read Capital Management, an in-house hedge fund.

Chuck Prince, the boss of Citigroup, has much more egg on his face after saying that the American bank’s profits for the quarter would plummet by 60% compared with the same period of 2006. Mr Prince’s ill-timed comment in July that Citigroup was still dancing to the music of the buy-out boom is being replayed endlessly now that things have ended in such discord. Citigroup announced write-downs of $1.4 billion on commitments to leveraged buy-outs, as well as further substantial losses on mortgage-backed securities and fixed-income trading. Unlike UBS, Citigroup expects to have remained easily in profit during its third quarter but Mr Prince, whose four-year tenure has been dogged by criticism, is under severe pressure.

Expectations are high of hefty write-downs at banks that have yet to report. On October 3rd Merrill Lynch sacked the head of fixed-income trading, which is also assumed to have done badly. The big question is whether a line is really being drawn under the turmoil. Banks have every incentive to be conservative when investors are braced for the worst: UBS is taking big losses on highly rated debt as well as its subprime securities. There are also signs of recovery in the credit markets. Mr Prince, tempting fate again, predicted a return to “a more normal earnings environment”.

But the assumptions behind some of the banks’ write-downs remain murky, and there are worrying indications of more economic weakness. A big part of Citigroup’s decline in earnings came from its consumer business, where rising defaults and higher loan-loss reserves, bumped up on signs that customers may be having more trouble keeping up with payments, chewed up a whopping $2.6 billion. These might not be the write-downs to end all write-downs.

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