Brokers Report Earnings This Week
September 10th, 2007 by John BrasherThe big brokers Morgan Stanley (MS), Lehman Brothers (LEH), Bear Stearns (BSC) and Goldman Sachs (GS) all report earnings next week for the quarter. Merrill Lynch (MER) reports in October. These are all important players on the world financial stage. Their financial results will be a good barometer of how bad the credit crunch in past months actually has been. Bear and Lehman have the most exposure to the credit crunch, since they rely more on fixed income sales, which means they heavily sold collateralized mortgage products, but all of them have substantial fixed income sales. The merger and buyout deals generate gigantic fees for these chaps, and the deals have slowed to a crawl as a result of the meltdown. Here’s where the brokers stood as of 9/7/07:
MS - 62.50, down from 90.00 (-30.5%)
MER - 73.20, down from 95.00 (-22.9%)
GS - 179.00, down from 233.00 (-23.1%)
BSC - 105.00, down from 172.00 (-39%)
LEH - 53.00, down from 86.00 (-38.3%)
Several hedge funds have collapsed, notably two run by Bear Stearns. Even Goldman had to pump $2 billion of its own money into one of its big hedge funds after losses in August. Brad Hintz of Bernstein Research (and former Lehman CFO) notes that the big brokers have substantial exposure to subprime because they securitize mortgage loans by cutting them up into tranches and selling the tranches. But the brokers wind up having to take the riskiest tranches that are exposed to the first losses (growing, and they will become gargantuan in 2008), known as residuals. BSC, LEH, GS, MS and MER have as much as $11 billion of these “residuals” on their balance sheets. They also get stuck with leveraged notes and other assets that no one wants now, because one of the ways they get underwriting deals is to take the paper and gamble on being able to resell it.
The market is waiting to see how much effect the crunch will have, how much their asset holdings (which are marked to market) will be devalued, how recent volatility has affected trading profits (they should be up) and how much the slowdown in M&A activity has hurt profits.
Many financial pundits are starting to say that the big brokers are so devalued that they are bargains. Maybe so, but they may be more of a bargain after next week… unless you think they have not been affected by the sheer immensity of the summer’s crunch and the fact that some of their most profitable activities have been virtually stopped dead in their tracks.
Trading and Call Writing
There will be lots of people shorting these stocks (many already have), though it may not be easy. When short interest gets large enough, where will you find stock to borrow? But even your Aunt Mabel can buy puts or place a bear put spread.
Anyone with a covered call on these stocks and who has not purchased a multi-month put to protect the position might consider doing so. Putting a covered call on these stocks requires such a put at this point. If the stock pulls back and catches support convincingly, the put (which will have increased in value with the stock’s drop) can be sold at a profit. Or the put can be exercised if necessary. Unprotected covered calls simply will have to ride it out, although the calls can be traded with the stock’s movement to produce trading profits.
These brokers are some of the most important financial companies in the world, so they are unlikely to vaporize. Bear Stearns is the greater risk and has been scaring people, Lehman is the next most likely to take a large hit. But the problems affecting the brokers are not resolved and not at a crescendo yet, either.
September 10th, 2007 at 6:47 pm
Well said John, good info. I know that none of those financials met my criteria, or the general critierea outlined on your great website, but I’m sure there have been folks that sold calls on them. I know many of them have made the lists because of the way the filters are set up, but they don’t pass many of your sites reccomended tests, or my own. A protective put would be great insurance at this point. Don’t wait until the stock goes below it’s support level though, or the put will no doubt cost more than the premium received for the call. I’ll buy a protective put if I am bearish at all on a position once it’s opened. Unless it’s a slow period with not many trades that meet my criteria I don’t do many trades as a buy/write and then immediately buy a protective put. I know some folks that do so on a regular basis, and it can work, though it obviously eats into the trades profit.
September 10th, 2007 at 6:50 pm
I forgot to mention that I really like the new lists, and appreciate the effort to launch them. Look at some of the MADI numbers on the Super Put list, whoa!
September 10th, 2007 at 7:36 pm
Glad you like the lists! I think they will be popular. For some reason right now, the MADI is wrong on a lot of stocks. The really high MADI numbers are almost all wrong. The long-term protective put placed on trade entry makes the best sense when 1) you are not really bullish on the stock, 2) it typically has great premium because of a backdrop of high volatility expectations, like GM, ATI and the brokerages, and 3) and the put is very cheap in relation to the current-month call. I would be OK writing the brokers as a CC now, but it would not be a first choice - except for BSC I think they are probably solid. However, I like them much better as superputs.
The thing about adding a protective put when insecure is that the stock may move too fast for that. I agree that a protective put is not a necessity to make consistent money, but it does free the writer up somewhat in terms of loosening trade selection criteria.
September 10th, 2007 at 9:04 pm
I’ve just spent some time checking out the super puts, very, very cool. Something wasn’t making sense to me with regard to the math of figuring the returns, I’m going to go back over it, and if I still can’t figure it out I’ll drop you a line. Callwriter continues to be the best cc site out there.
September 10th, 2007 at 9:21 pm
I think I have it figured out, but please straighten me out if my logic is off. I just looked at the first super put listed for September, for RMIX. It shows a 3.6% profit if called. Obviously if you have a net debit in the complete opening transaction of $8.30 and the stock is called away at the strike price of $7.50 in a couple of weeks, you have a loss of $0.80 at that point. I’m assuming that you arrived at the +3.6% by assuming an immediate sale of the put at the same price as you paid ($1.10), which would then net a 3.6% profit? I haven’t run the scenario through my ivolatility calculator to see what the likely price of the put would be in two weeks at close to the strike price, but assume that since it’s out so far that there is almost zero time decay and that the assumption of selling for close to the price paid is valid. I think it may have been Lee Lowell that touched on a strategy like this in one of his books, but you really have me taking a hard look at this now. I think that with using a volatility calculator to isolate trades with less likliehood of excercising, your point about collecting premium and continuing to write calls against the shares each month could be great. Obviously in the RMIX case, 3.6% for a two week play is nothing to sneeze at with the level of protection that is provided by the put.
Where I think this could be very powerful is on companies about to announce earnings. I’ve done well on some companies like GRMN by buying before earnings and then selling a call on the surge after announcement. Obviously, with the protective put you could do this with companies you feel less bullish about and have the comfort of the insurance put, I suppose if you’re pretty bulllish you could buy the stock and write the put as one transaction, and if the stock surges after the announcement, sell a call. If it doesn’t surge, you still have the protective put and can figure out which call, if any, makes sense to sell.
Darn John, I’m going to be up all night setting up some Excel spreadsheets and taking a hard look at this. In the past ten years I’ve subscribed to a lot of covered call sites, I think I’ve given most of them a test drive. You don’t find this kind of continual evolution and content anywhere else. Thank you most sincerely.