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(Reuters) - Jefferies Group Inc's JEF.N profit dropped 23 percent during its fiscal fourth quarter as the investment bank took aggressive steps to reduce risk-taking after MF Global Holdings Ltd's MFGLQ.PK bankruptcy.
Jefferies management cut exposure to sovereign bonds of troubled European countries by $4.3 billion, or 82.5 percent, since early November and also took steps to reduce the bank's leverage and broader balance sheet.
While those decisions led to weaker profits and revenue, investors cheered Jefferies' report, sending its stock up 22.9 percent to $14.50, the highest close since before MF Global's bankruptcy filing on October 31.
"Jefferies did what firms across the Street are being encouraged to do by investors," said Jason Graybill, a senior managing director at Carret Asset Management, which owns Jefferies bonds. "Everybody is saying, 'Take less risk!' and that's what they did."
The investment bank sold all of its Greek debt holdings in November and reduced its gross exposure to bonds issued by Ireland, Italy, Portugal and Spain to $375 million worth of long positions and $534 million worth of short positions. That compares with $2.7 billion worth of long exposure and $2.5 billion worth of short exposure to all five countries on November 3.
Combined with other asset sales, Jefferies reduced its balance sheet by $10.2 billion, or 22.5 percent, during the quarter, with total assets of $35 billion at period-end.
The bank also cut its leverage ratio significantly, with common shareholder equity representing 10.8 percent of assets on November 30, down from 14.2 percent at the end of August.
The moves came in response to pressure from investors and clients following MF Global's collapse. That broker-dealer made a $6.3 billion bet on European sovereign debt that caused clients to flee and sent its share price tumbling to below $1.
After MF Global's issues came to light, ratings agency Egan Jones downgraded Jefferies' debt to a notch above "junk" and threatened to lower its rating further unless management took significant steps to reduce risk.
In a report on November 21, the ratings firm said Jefferies would have to reduce assets by $5 billion and raise $1 billion in equity capital to maintain its current "BBB-" rating.
Bank executives responded throughout November by making public statements and releasing financial data to challenge what they characterized as "misinformation" and "rumors" about Jefferies' financial position, even publicizing identification numbers for specific European bonds the bank held.
Still, Jefferies' shares fell as low as $9.77 on the day of Egan Jones' report, as the investors became increasingly concerned about its European exposure, leverage and funding.
Even though Jefferies disagreed with Egan Jones' analysis, Chief Executive Rich Handler said he shrank the balance sheet and reduced leverage to reflect the bank's ability to manage risk even in difficult market conditions, a pressure he suggested other Wall Street firms are also facing.
"Regardless of how clean a balance sheet one can say they have in this current climate, people are very nervous and I believe everyone's balance sheet is under pressure to come down," Handler said on a conference call Tuesday morning.
After reviewing Jefferies' report, Sean Egan, the president of Egan-Jones, backpedaled on the capital raising demand.
"They've overperformed in reducing assets, so I think we can back off that $1 billion in raising of equity," Egan said in an appearance on CNBC television.
After Egan's statement, Jefferies shares rose to a high of $14.88 in afternoon trading.
"These guys did the right thing," said David Smith, who follows Jefferies as chief investment officer at Rockland Trust, which has $1.6 billion in assets under management but does not own Jefferies stock. "They said, 'We don't feel overexposed but we're going to sell this stuff anyway,' and they shrank the balance sheet and took leverage down."
But while asset sales and risk reduction helped to ease investor fears, they also took a toll on Jefferies' bottom line.
The bank earned $48.4 million, or 21 cents per share, for the fiscal fourth quarter ended November 30, down from $63.7 million, or 31 cents per share, a year earlier.
Jefferies earned 17 cents per share when excluding special items. Analysts cut their estimates in recent weeks to as low as 11 cents per share to reflect expectations for a tough trading environment and lower investment banking revenue.
Jefferies' overall net revenue declined 18.5 percent, to $554 million from $680 million. Principal trading revenue fell more than 80 percent to $36.6 million and investment banking revenue declined 10 percent to $261.3 million.
Asked whether Jefferies plans to keep its balance sheet at the current size, given the impact on earnings, Handler said that while November had been a particularly difficult month for the bank, conditions have stabilized in December and business has picked up.
"People are back to business and the flows are reasonable and bid-ask spreads are capable of making money again," said Handler.
To protect its bottom line, Jefferies management also cut staff in the equities trading business and made sharp cuts to the bonus pool. Handler and a number of other senior executives have foregone bonuses for 2011, he said.
Compensation expenses declined 24 percent to $308.1 million from $405.4 million a year earlier. Adjusting for special items, compensation represented 59.4 percent of revenue.
MF Global's collapse also caused some clients to take money out of Jefferies, after an estimated $1.2 billion went missing from MF Global's segregated client accounts. Two months after its bankruptcy, regulators have not yet been able to deliver those client funds or explain where the money went. Some regulators have suggested the funds were used inappropriately for MF Global's own operations.
The Commodities Futures Trading Commission reviewed customer segregation practices at Jefferies Bache and "reported no issues," Chief Financial Officer Peregrine Broadbent said, but some clients took their business elsewhere.
Jefferies lost $2 billion of its $5.3 billion worth of segregated client funds from the third quarter to the fourth, Broadbent said.
Eight clients from its prime brokerage business left and 34 others transferred cash balances to another custodians, while 40 clients left its Bache commodities and derivatives trading operation. Broadbent said some of the clients have returned.
"I talked to a lot of clients who really believed MF Global and Jefferies were the same story a few weeks ago," said David Trone, an investment bank analyst with JMP Securities. "Now they don't think that anymore, because management really got into the nitty-gritty distinctions to prove otherwise. It's management's responsibility to do that."
Reporting by Lauren Tara LaCapra; Editing by Tim Dobbyn and John Wallace