Analysis-Jefferies faces scrutiny over lending to collapsed MFS and first brands

Jefferies Financial Group Faces Scrutiny Over Lending Practices After MFS and First Brands Collapses

Jefferies' Exposure and Investor Concerns

By Saeed Azhar and Tatiana Bautzer

NEW YORK, March 4 (Reuters) - Jefferies Financial Group is facing concerns about its lending standards and risk appetite after the collapses of British lender Market Financial Solutions and U.S. auto-parts supplier First Brands from alleged fraud.

Jefferies, an independent investment bank that competes with some of Wall Street's biggest names, saw 9% wiped off its stock price on Friday after news emerged that it had 100 million pounds ($134.02 million) of exposure to failed lender MFS.

The stock recovered on Monday, but fell another 2% on Tuesday.

The losses followed deep declines last year when a unit linked to Jefferies' asset management arm was embroiled in the bankruptcy of auto-parts supplier First Brands.

Despite Jefferies' finances remaining healthy, shares have underperformed against its mid-cap financial peers as investors and analysts question Jefferies' exposure to risky companies and its risk‑management discipline.

Analyst Perspectives on Jefferies' Risk Management

"My gut take is still that these are isolated issues, but management matters, and a hard-charging culture at Jefferies comes with a higher risk of adverse outcomes," said Sean Dunlop, a banking analyst at Morningstar. "This would mean that risk management issues - relaxing lending standards to drive growth, for example - are probably the bigger fundamental concern."

Jefferies declined to comment. The bank is in a quiet period ahead of its first-quarter earnings announcement later this month.

Investors Suing Jefferies

Investors are suing Jefferies, alleging the firm defrauded them into investing in a fund linked to First Brands, which owed Jefferies' asset management arm about $715 million of receivables. Jefferies has denied the allegations.

The lender is perceived as having a higher risk appetite relative to mid-market investment banking peers, which means it risks facing intermittent problems from borrowers, Dunlop said.

Jefferies' Role in Leveraged Lending

Jefferies is a large player in leveraged lending, underwriting and distribution of high-yield debt, and works extensively with specialized managers, credit funds and hedge funds, and other institutional investors, dabbling in riskier assets.

Still, its exposure was small in the $2 billion structured loan for MFS, which was linked to asset-backed securities, wrote UBS analyst Michael Brown. The strength of Jefferies' collateral would determine how much money it could set aside as a reserve for potential losses on the loan, he said.

"Anybody can be a victim of crime and fraud and I do not think having two losses due to fraud in two years is shocking, nor necessarily a sign of a bad credit portfolio," said Oppenheimer analyst Chris Kotowski.

While rising cases of fraud would increase banks' caution with collateral, Jefferies' potential losses are very small relative to its capital, he added.

The funds that Jefferies provided went straight to law firms to close specific, registered property transactions, which means the money can be traced directly to specific loans that have been registered in the UK, said Brown at UBS.

"While it's still early, and fraudulent issues are complex and take time to untangle, we believe a total loss scenario could be unlikely," the analyst's note said.

The exposure is small enough that if Jefferies needed to take a charge on its earnings for any losses, it would be limited, according to a source familiar with the situation.

Risk Management and Industry Implications

Jefferies' Financial Health and Performance

"The circumstances are not good, but they can absorb losses" given recent financial results, said Michael McTamney, senior vice president for North American Financial Institutions ratings at Morningstar DBRS.

Jefferies posted a fourth-quarter pre-tax loss of $30 million related to its investment in Point Bonita, the fund that has exposure to First Brands. Still, its earnings beat estimates, boosted by a rebound in dealmaking and strong underwriting.

While it did not rank among the top lenders for leveraged finance deals last year, Jefferies ranked sixth among primary underwriters for marketed leveraged finance loans in the U.S., according to Dealogic data. Jefferies was also advising First Brands on refinancing its debt last year before the company collapsed.

Broader Credit Market Considerations

It is too early to say if these cases represent bigger issues in wider credit markets and specifically in private credit. But McTamney said the agency is comfortable with the largest banks' risk management and potential losses in the credit cycle. The agency does not rate Jefferies directly, but analyzes the company as a competitor to the biggest U.S. banks. 

"There is growing exposure to non-bank lending entities and some opacity, but it does not seem to be worrying now," McTamney said, adding banks would probably increase disclosure to reassure investors.

Jefferies has ample capital and is in sound financial health, Morningstar's Dunlop said.

Jefferies as a Proxy for Alternative Asset Managers

The bank can be viewed as a proxy for the health and risk appetite of alternative asset managers, which have been shaken by turmoil at Blue Owl Capital, a major private lender, analysts said.

"With significant market concerns materializing regarding private credit businesses over the past couple of weeks, it's fair that Jefferies could also be assumed to be affected," Dunlop said.      

($1 = 0.7462 pounds)

(Reporting by Saeed Azhar and Tatiana Bautzer; Editing by Lananh Nguyen and Jamie Freed)