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Monday, July 23, 2007

Through The Fly's Eyes: Brokerage Firms


More Bad News To Come for Brokerage Firms

Our forecast predicting tough times ahead for the brokerage stocks is proving true, with most of the firms' stock prices declining nicely the past month. However, there is more to come and no need to do any bottom fishing yet.

The Bear Stearns (BSC) affiliated hedge fund whose book value was wiped out in three months, will not go away quickly as the lawsuits begin. Bear will claim all the transactions were arm's length, the claimants will say otherwise. From an investment perspective, it doesn't matter who is correct, it will simply take a long time.

While Bear was setting up conveniently structured hedge funds to invest in mortgages and other leveraged vehicles, other large brokerage firms began buying up mortgage origination businesses as the mortgage market was topping. These mortgage transactions were most likely done to conceal a rapidly slowing business in 2005 and 2006 or cover up losses that might have begun piling up. Look for this to lead to another leg down for brokerage stocks.

As the details come out, the Bear Stearns affiliated hedge fund had $925 million in capital at the end of March which was invested in $30 billion of debt instruments, not too much room for a mistake. If Bear was doing it, I will bet you other firms were also.

We have been blogging most of the year to be careful investing in brokerage stocks. From Merrill Lynch's (MER) top executives dumping huge amounts of stock earlier in the year to Goldman Sachs (GS) generating huge profit growth almost all coming from proprietary trading with not much growth in its transaction businesses, to Bear Stearns' strength in the mortgage market coming back to burn them. This is one sector to continue to avoid.


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