Why I’m not Jumping at the Investment Banks at Present

Three reasons:

  • There are still significant areas of concern that have not unwound yet — residential housing exposure will increase as housing prices fall further, including lawsuits which will eventually prove not meritorious, and CDO exposure.
  • It is my firm belief that their hedges hold in minor moves, but not major moves.  VAR modeling is fine for when the winds are calm, but not when they are gale force.  At gale force the Extreme Value Theory models kick in, and they are untested at present.  Berkshire Hathaway’s experience in unwinding GenRe’s swap book was telling; few things were marked conservatively.  That is probably true industrywide, partly because auditors are incapable of audit the swap books in all of their complexity, or they’d be working for the investment banks themselves.
  • New accounting regulations make earnings quality more opaque, and less comparable across time periods and companies.  This should result in lower multiples, akin to big commercial insurers.

That’s all.  Personally I think the investment banks will be a buy sometime in 2008, but I am waiting to see how the current leverage unwind affects them.