Wall Street profits short on details

(Fortune Magazine) -- Goldman Sachs, Lehman Brothers and Bear Stearns recently reported substantial gains from bets that certain bond prices would fall, helping each brokerage weather very difficult markets and making their investors very happy.

But given the big role that these negative bets played in salvaging what otherwise might have been a disastrous third quarter for Wall Street, investors might want to take a close look to see if the hedging was a sound source of profits for the investment banks - or ephemeral paper gains.

Goldman Sachs said its hedging bets paid off big in the third quarter. But investors know very little about the gains.

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For now, investors are cheering the news. Brokerage stocks rallied last week, helped by the Fed's decision to cut interest rates and also Wall Street's surprisingly rosy results for the quarter ended August 31. While Lehman (Charts, Fortune 500) and Bear Stearns (Charts, Fortune 500) both reported drops in profits, the declines weren't as bad as some analysts had expected. Goldman Sachs (Charts, Fortune 500), meanwhile, said net income surged to $2.8 billion.

All three banks, to varying degrees, credited hedging bets for their better-than-expected performance. All three appear to have gained from shorting mortgage bonds. (In Wall Street parlance, being "short" a stock or bond means that you will make money if it goes down in price.)

Now that the market has digested Wall Street's robust earnings, skeptics are asking hard questions.

How, for instance, can it be that the three firms were able to rack up large gains by betting in the same direction? Were these bets made in liquid markets where prices are dependable and positions can be sold quickly? Or were they made in illiquid markets where brokers have to make their own estimates about what the bets are worth - and where it may be difficult to exit?

Answers can be hard to find. Brokerage firms are tight-lipped about their hedging strategies and the precise gains they realized from them. But there's a chance that some of these gains won't ever translate into hard cash.

Last week, all three banks trumpeted their hedging strategies. Goldman was the most emphatic about the gains it made to offset losses in its fixed-income division, crowing about the fact that "significant losses" on certain securities were "more than offset by gains on short mortgage positions."

In its press release, Lehman stated that it too had made "large valuation gains on economic hedges and other liabilities." And on its conference call, Bear Stearns CFO Samuel Molinaro referred to "substantial gains from hedges" in the quarter.

Goldman declined to elaborate on last week's statements, saying that it doesn't discuss the details of its hedging. Lehman didn't comment. A Bear spokeswoman also declined further comment.

Using Bear as a test case, however, it's possible to get some idea of hedging's role. The company said it marked down financial assets and liabilities by $700 million in the third quarter, which includes gains from hedging. In other words, the $700 million is a net number that is lower than the gross loss number, which doesn't include hedging.

Speaking to analysts, Molinaro wouldn't say what the firm's losses were before hedging. If he had, we could easily subtract the $700 million from the before-hedges number to get the contribution from hedges.

One analyst asked if $1.5 billion was close to the right number for before-hedging losses. Molinaro would only say that the number was "probably too high." So let's pretend for a moment that before-hedging losses were somewhat lower, or about $1.2 billion.

Subtracting the after-hedging losses of $700 million from the hypothetical $1.2 billion gross number would mean hedging contributed $500 million of gains.

We don't know if that was the amount of hedging gains because Bear Stearns won't tell us. But if it was $500 million - or anywhere close to that - investors might want to find out how real those gains actually were.

A critical question for investors is whether markets were liquid enough for a large investment bank to place a large short bet on, say, mortgage-backed securities. And once in, can they exit the trades, pocketing the cash proceeds?

In the case of mortgages, hedge fund managers who have made profits from betting against home loans say they felt the market was liquid enough to place large bets against the ABX index, which charts the performance of instruments used to hedge against losses in mortgages to people with sketchy credit.

Andrew Lahde, of Lahde Capital Management, which has profited this year from declines in mortgages, says he has not had a problem placing bets and exiting trades he made on the ABX. He estimates daily trading volumes at between $5 billion and $15 billion, based on the underlying value of the mortgage-related instruments that make up the ABX as it trades.

Lahde's numbers would suggest a bank could, over a period of days and weeks, both place and exit trades made on the ABX.

In other words, if Goldman, Bear and Lehman did their hedging in the main ABX index, they may well have closed their trades, and if the trades are still open and on their books, there's a good chance the prices are sound and an exit is possible close to those prices.

However, several players in this market said that other mortgage-related hedging instruments were much less liquid. As a result, pricing is unreliable and it is extremely difficult to close out trades. A bank highly exposed to those instruments would not be in an enviable situation.

The other big question that no one seems able to answer is: What poor souls are on the other side of these trades - and will they be able to pay up if they're underwater? After all, it's no use being up on a trade with a counterparty that can't pay out.

Insurance companies and pension funds that took the other side of the short trade could almost certainly pay out. Hedge funds are another matter. They were huge players in the mortgage market, particularly in the subprime instruments that make up the ABX. Hedge funds are opaque and often highly leveraged, so they could be the flakiest counterparties.

"There is a tremendous amount of counterparty risk on hedge funds," says Janet Tavakoli, president of Tavakoli Structured Finance.

Because Goldman, Lehman and Bear were so keen to emphasize their hedging gains, investors will be extremely unforgiving if it turns out these profits can't be realized. The banks won't provide details, and none of the Wall Street analysts questioning the brokers on the conference calls thought to really press the brokers on this point.

It would seem an obvious question to ask. And it would seem an obvious data point for the brokers to offer up.