It is no secret that financial stocks have had more than their share of difficulty the past year. With liquidity drying up and capital becoming scarce, firms with leveraged balance sheets or inventories of marketable securities have taken write downs of epic magnitude. Headlines notate the multi-billion dollar losses posted by large firms such as Bear Stearns, Merrill and Bank of America, but the environment has been just as deadly for smaller companies operating in the same area.

KBW (formerly Keefe, Bruyette & Woods) is a small botique investment banking firms that caters to small and mid cap companies who need access to capital markets. The firm participated in 34 deals last year and started off very well in the first two quarters. However, the second half of 2007 was extremely difficult as the declining market and lack of liquidity brought investment banking activity to a screeching halt. At the same time, the company’s proprietary trading (essentially trading for their own account) took a major hit to the tune of a 4.4 million dollar loss in the fourth quarter. This compares to a gain of 10.5 million in the fourth quarter of last year. The only bright spot in the quarter was an increase in commissions received from the flurried amount of activity due to the market volatility. These gains were also impacted by an increase in accounts in Europe but it is difficult to project commission gains in the future due to their dependence on market trading activity.

While losses appear manageable on the surface, deeper concerns were raised on the conference call. Analysts asked management about the quality of assets held on the balance sheet and were likely disappointed to hear that little confidence could be placed in the asset levels stated in the quarterly release. Management claims to be taking a conservative approach to valuing the holdings, but in this market it is difficult to value anything that does not trade on a liquid exchange. The company holds positions it acquires through market making activities and typically securitizes these assets and sells them in a quarterly offering. They had to cut the deal size in November to be able to take any exposure off and will likely continue to find it hard to round up buyers for their issuance in the first quarter. The 10K filing will have more information on the particular securities held and the stock price will likely react to this release.

Investment banking is a cyclical business which can often exceed expectations both in the expansion phases as well as in the severity of declines. It would appear that we are in the early stages of a global contraction of credit. The excesses of the past several years will not likely be wrung out in a single quarter or even in a single calendar year. So I anticipate the environment for KBW to continue to be challenging and as the stock approaches the IPO price I would expect investors who held stock from the offering to become nervous. Human psychology plays a large role in market activity and with 70% of the stock being held by employees of the company, there could be a large amount of fear building. The ramifications could be as simple as a rangebound stock for the next several months. However, the more likely scenario would be a severe decline as investors and employees (and former employees) jump ship. I would use caution trading shares of this troubled name.

KBW Notes

FD: Author does not have a position in KBW

Additional Reading:

Marketbeat – No Sunlight for Brokerages