The meaningful energy distressed debt trading losses reported today by
Jefferies Group LLC (Jefferies) dragged down overall fiscal third 2015
(3Q'15) results. The trailing twelve month period was characterized, in
Fitch Ratings' opinion, by continued pressure on the company's
distressed debt trading business and elevated costs associated with the
company's nearly-complete divestiture of the Bache futures and
The latest results have no immediate rating impact on Jefferies'
'BBB-/F3' ratings or Stable Outlook, given the company's relatively
conservative leverage and liquidity profiles, the manageable size of the
losses relative to overall earnings capacity, relative stability in
Jefferies' investment banking and equity sales and trading businesses,
and the reduction in inventory positions that drove trading losses.
Market volatility exposure that characterizes the securities firm
business model is a key rating constraint that is incorporated in
Jefferies' current ratings. However, sustained underperformance in
business segments or further outsized trading losses would pressure
Jefferies' reported net income of $2.0 million for 3Q'15, compared with
$59.8 million and $83.6 million for 2Q'15 and 3Q'14, respectively. The
decline was primarily attributable to negative fixed income sales and
trading revenues of $18.2 million for the quarter, compared to revenue
of $153.4 million and $195.3 million in 2Q'15 and 3Q'14, respectively.
Poor results in this segment were driven by realized and unrealized
losses on distressed debt inventory positions related to the energy
sector, and in particular, oil and gas. The company attributed the
losses to declining oil prices and recent market volatility resulting
from news of China's slowing economic growth, although Jefferies' active
role on the distressed debt trading space likely further exacerbated the
The third quarter trading losses come on the back of significant
mark-to-market write-downs experienced by the firm's fixed income
segment during the broad high yield sell off in October 2014. The
reoccurrence underscores Fitch's belief that Jefferies' distressed debt
market making business creates inventory concentration issues and
exposes the firm to the risk of inventory write downs in times of market
disruptions. Jefferies indicated that it reduced its net distressed
energy position by approximately 50% during the quarter, down to $70
million at quarter-end. Although the reduction in the absolute level of
exposure is viewed positively, there remains the possibility for
additional losses emanating from the remaining positions.
Jefferies is rapidly approaching the completion of its announced
divestiture of the Bache futures and commodities business, contributing
to the overall balance sheet reduction in the quarter. Remaining costs
related to the wind down are expected to be less than $10 million on an
after tax basis. While the Bache business proved to be a strategic
misstep for Jefferies, Fitch views the wind-down of positively from the
perspectives of eliminating a persistent drag on earnings and allowing
Jefferies to focus on its core businesses going forward.
Strong results in the core equities trading business and investment
banking shed some positive light on the quarter. Investment banking,
which includes capital markets (equity and debt) and mergers &
acquisitions advisory (M&A) had solid revenues of $389.8 million, down a
modest 3.5% from the previous quarter but down 16.7% year-on-year.
Jefferies indicated that its investment banking backlog remains robust
which should bode well for future earnings from the segment, although in
Fitch's opinion, Jefferies' energy investment banking backlog may
experience pressure. Equities trading revenues for the period were
$203.1 million, up from $171.7 million in 3Q'14 despite a sell-off in
global markets in August.
Risk in Jefferies' trading book, as measured by value-at-risk (VaR),
increased slightly quarter-on-quarter with an increase in market
volatility partially offset by a 30% reduction in the firm's stake in
KCG through a June tender offer which yielded sale proceeds of $91
million. The number of trading loss days during the quarter increased
significantly to 21 in 3Q'15 compared with 10 in 2Q'15, largely
attributable to the firm's distressed debt positions and equity market
volatility. Total assets declined 3.2% to $42.8 billion from $44.1
billion in 2Q'15 with a reduction in Bache assets to $0.3 billion from
$3.0 billion in 2Q'15 partially offset by an increase in cash.
Jefferies-calculated adjusted leverage (defined as tangible assets minus
reverse repo and securities borrowed divided by tangible equity) was
flat at 10.3x at Aug. 31, 2015, consistent with 2Q'15.
Jefferies-calculated liquidity, which includes cash, cash equivalents,
high-quality government securities and reverse repurchase agreements
collateralized by high-quality government securities, of $5.2 billion
represented 12.0% of assets, while cash and equivalents comprised 8.0%
of assets, in line with prior quarters.
Jefferies, a Delaware-incorporated holding company, is a full-service
investment banking and institutional securities firm primarily serving
middle-market clients and investors. Its primary broker/dealer operating
subsidiary, Jefferies LLC, holds the vast majority of the firm's
consolidated assets and is regulated by the SEC. At Aug. 31, 2015,
Jefferies had U.S. GAAP total assets of $42.8 billion and members'
equity of $5.5 billion (including non-controlling interests and $1.9
billion of goodwill). Fitch considers Jefferies to be a core subsidiary
of Leucadia National Corp. (Leucadia, 'BBB-', Outlook Stable) based on
Jefferies' significance relative to Leucadia's equity and the role it is
expected to continue playing in the combined company's future strategic
Additional information is available on www.fitchratings.com.
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