Most of Wall Street’s moneymaking machines have shut down. Mortgage-securitization activity has gone kaput, while IPO and M&A activities are sputtering. Even worse, Billions of dollars of future write-downs and losses are still buried inside Wall Street’s balance sheets.

Lehman Brothers (LEH: NYSE) appears to be among the most vulnerable of all the investment banks. The stock has rallied hard since the Bear Stearns rescue. Because its business model closely resembles that of Bear Stearns, Wall Street thought Lehman was next. And it might have been, if not for the Fed.

The Fed instituted a lending facility allowing the investment banks to temporarily swap the ugliest “alphabet soup” assets for Treasuries. These alphabet soup assets — mortgage-backed securities (MBS), asset-backed securities (ABS), collateralized loan obligations (CLO), and others — had been smothering the brokers to the point that Bear Stearns was hours from declaring bankruptcy.

In the hopeful words of Lehman Brothers CEO, Dick Fuld, the Federal Reserve’s lending facility “takes the liquidity issue for the entire industry off the table.” Sure, the Fed’s actions may have forestalled a modern-day “bank run” on Wall Street. But the Fed has not solved the bigger, longer-term crisis.

The Fed’s new facility allows Lehman to temporarily swap its garbage assets for Treasuries. What it doesn’t do is protect Lehman shareholders from losses on these securities. Lehman shareholders will be the first to absorb these losses. Shareholders are in the most junior position in every company’s capital structure. So the more leverage — or debt — a company employs, the quicker shareholders get wiped out when assets sour.

As the chart below shows, Lehman’s equity (in red) supports just a tiny sliver of Lehman’s towering liabilities. Lehman’s gross leverage ratio amounts to about 32 times equity. This means Lehman’s assets can fall only about 3% in value before equity is wiped out:

Lehman is scrambling to reduce leverage and raise capital by selling illiquid assets into a weak secondary market. Unfortunately, illiquid mortgage-backed securities aren’t a particularly hot item these days. There are few buyers for such assets — even at steep discounts.

According to Bernstein Research, Lehman’s “troubled” residential and commercial mortgage assets amount to nearly three times its tangible equity. That’s danger level for Lehman shareholders. And the danger is growing…

Lehman management has not been terribly forthcoming about reporting quarterly losses and write-downs. Brad Hintz from Bernstein Research hinted that fuzzy math produced Lehman’s “strong” March earnings report: “We believe the quality of these earnings was weak, as the firm benefited from a lower tax rate and enjoyed a $600 million mark-to-market gain on its liabilities.”

That’s a polite understatement. Believe it or not, accounting rules allow investment banks to book a profit when the value of the bonds they have issued FALL. Follow along with this crazy logic if you can: Because the holders of Lehman’s bonds became fearful that Lehman would declare bankruptcy, the bondholders dumped the bonds at very low prices. Therefore, because Lehman’s bond prices tumbled, Lehman could, theoretically, buy back the bonds at prices much lower than the stated value of those bonds on Lehman’s balance sheet. As a result, this bizarre accounting rule concludes, Lehman can book a “profit” on the difference between the issue price of its bonds and the depressed market prices. Taken to an extreme, Lehman could probably post one if its most profitable quarters ever, just by declaring bankruptcy!

Obviously, falling bond prices indicate financial stress, and certainly do not produce sustainable, high-quality earnings. Such “earnings” do not generate cash or create any value of shareholders whatsoever.

Net-net, Lehman is still facing the likelihood of losing tens of billions of dollars over the course of the next few years. As losses pile up, Lehman will have to raise capital. That means flooding the market with LEH shares. Lehman may have to issue hundreds of millions of new shares at a discount to rebuild its capital shortfall, severely diluting the existing shareholders.

David Einhorn, an accomplished hedge fund manager, recently explained why he’s still selling short Lehman shares. In a speech at the April 8 Grant’s conference, he said that Lehman may have to boost its capital by as much as $30 to $70 billion. If Einhorn’s guesstimate is anywhere close to the mark, Lehman’s shareholders are in for a very rough ride.

The worst might be over for the financial sector, just like so many investors seem to believe. But a lot of bad stuff is still rolling our way. For the rest of 2008, therefore, investors might want to take their cue from Credit Suisse CEO Brady Dougan when he said, “The number of times people have seen the light at the end of the tunnel, it turned out to be a train coming down the tracks.”

Regards,
Dan Amoss
May 28, 2008

Financial Bank Bear Market was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Better still, imagine they spell out the words “your savings” instead. Here’s goes…

“We need concerted action by governments, central banks and market participants to help stop this wave [of liquidations]…”

— Josef Ackerman, head of Deutsche Bank, speaking in Frankfurt on March 17

“The government is prepared to do what it takes to maintain the stability of our financial system…”

— U.S. Treasury Secretary Hank Paulson to Fox News, March 16

“In every country in 2008, every government has one aim — to maintain stability through the world economic slowdown. Britain with its central role in the world’s financial system is no exception…”

— U.K. Finance Minister Alistair Darling, in his Budget speech of March 12

Not quite with it yet? Check these examples, already done for you…

“The U.S. tax-payer last week agreed to help J.P.Morgan acquire Bear Stearns after a run on Bear, once the second-biggest underwriter of US mortgage bonds. In an effort to shore up Wall Street’s other firms, you also agreed to become lender of last resort to all 20 primary dealers in Treasury notes…” (Bloomberg)

“U.S. leveraged institutions, which include banks, brokers-dealers, hedge funds and tax-sponsored enterprises, will suffer roughly $460 billion in credit losses after loan loss provisions, Goldman Sachs economists wrote in a research note released late on Monday…” (Reuters)

“The [investment] banking system is facing the 21st-century equivalent of the wave of bank runs that swept America in the early 1930s. And your money is rushing in to help, with hundreds of billions from the tax payer, and hundreds of billions more from tax-sponsored institutions like Fannie Mae, Freddie Mac and the Federal Home Loan Banks…” (Paul Krugman in the NY Times)

With it now? Great fun, isn’t it! Just cut to the chase about bailouts and financial aid by remembering what the state’s big generous hand-outs are made from — your tax payments, both current and future, plus the spending power of your savings, ripe for inflating away by elected officials and their unelected agents and staff.

This game beats playing “Spoof” any day, we reckon…which is funny again when you come to think about it.

Because Spoof — played in pubs and bars across the world to decide who buys the next round of drinks — is a game without winners, only a loser. Exactly like this game, then.

Fancy another cocktail before playing (and paying) again?

“We need a continuing message from tax payers and cash savers around the world that they will do what it takes to support economic growth. That will not be easy. It may necessitate taking some risks with inflation. But the message has to be unambiguous…”

So said John Varley — or as near as damn it — in a long open letter to government, published by The Banker magazine at the start of this month.

Varley is group chief of Barclays bank here in London. According to the annual report released on Thursday, he took home £2.4 million last year ($4.8m), just down from his 2006 payout of £2.5m after annual group profits fell 1% to £7.08 billion “due to the global financial turmoil” as the BBC puts it.

Don’t get me wrong here; I have no problems — moral or otherwise — with the concept of multi-million-dollar salaries. Executive pay merely puts flesh on those inequities which life itself thrives upon. The profit motive in finance is precisely what created the joint-stock company, mortgage lending, the safety-net of insurance, credit cards, overdrafts and all the other monetary tools developed by Homo economicus in the last five hundred years.

But what sticks in the craw and makes us choke on our martini-olives, however, is the “privatization of profit [and] the socialization of loss” as Martin Wolf calls it in the Financial Times. Every time the bankers screw up, your money steps in to patch up the losses. Letting the crisis wear on is simply not possible, because no one has dared to try it before. “The authorities feel compelled to intervene,” writes Charles Kindleberger in his history of Manias, Panics & Crashes. “The dominant argument against the view that panics can be cured by being left alone is that they almost never are left alone.”

Hence the pleading from Wall Street and Washington alike.

“Tax-payers need to continue to supply liquidity,” Varley’s article in The Banker very nearly goes on, “and they can help the restarting of the residential mortgage-backed security and commercial mortgage-backed securities markets by being prepared to accept this paper as collateral.”

More than that, “it would have a significantly (and disproportionately) positive impact if your cash savings were to buy commercial paper.”

Ain’t you brave, gentle reader, stepping into the breach so gamely like this! And so modest, too. Thanks to you covering Wall Street’s losses with your tax-dollars, “we’re going to have maybe a mild recession, but we’re going to avoid anything worse,” reckons Jeremy Siegel, professor of economics at Wharton.

Yet the plaudits will go to somebody else, with nary a murmur from you, reckons Siegel. “[Ben] Bernanke may very well easily turn out to be a hero here,” he explains.

Which I guess was precisely your aim in putting money aside to provide for your future.

“Systemically important institutions must pay for any official protection they receive,” Martin Wolf continues for the Financial Times. “Their ability to enjoy the upside on the risks they run, while shifting parts of the downside on to society at large, must be restricted.

“This is not just a matter of simple justice (although it is that, too). It is also a matter of efficiency. An unregulated, but subsidized, casino will not allocate resources well.”

This quid pro quo — the “this for that” stated so bluntly by Varley at Barclays and Ackerman at Deutsche Bank — is fast-becoming the surest financial consensus in history. If we bail out the banks to stop their stupidity creating a second Great Depression, they must accept far tighter regulation by those governments and bureaucrats who step in to save the day. No redemption without legislation.

Thing is, of course, we’ve all been before. Across the world, hundreds of times. New regulations come in to stall the last crash…and a new complex system of finance sprouts up, thriving on excessive risk, which ends up needing your money — your tax receipts and your savings – to mop up the mess when it explodes in turn.

From Barnard’s Act of 1734 — which sought “to prevent the infamous practice of stock-jobbing” that had already peaked and exploded with the South Sea Bubble 14 years earlier — through to Sarbanes-Oxley in 2002, which tried to stop Enron and Worldcom once they had crashed, new standards come in after it matters. Financial risk-taking, meantime, simply moves on to find new ways to gear up, using the latest regulations to pin-point those loopholes that will, in due course, be closed up when it no longer counts.

“After the collapse of Equitable Life in 2000,” notes a letter to The Times of London today, “the Financial Services Authority [U.K. watchdog] set up a review team on the regulation of the assurance society. Among the important ‘lessons to be learnt,’ identified in 2001 were — and I quote verbatim — that ‘the FSA management take steps to ensure that the supervisory team is properly constituted with persons with the necessary expertise and knowledge’…

“[Yet] from the recent internal audit by the FSA on its regulation of Northern Rock [the top five mortgage lender which blew up in Sept. 2007] we learn that the bank ‘was monitored by supervisors with expertise in insurance, not banking’…”

More than that, the FSA failed to conduct a proper review of Northern Rock’s operations for the entire 18-month period leading up to its collapse. Even then, prior to that last full review of Feb. 2006 — and “contrary to standard practice” as this week’s official report into the scandal revealed — “formal records of key meetings were not prepared.”

Thus the quid pro quo of bailouts for new rules becomes, in the end, a straight swap of excessive risk for incompetence. Underpinning this long-run historical fact you’ll find the assumption that “if one cannot control expansion of credit in boom, one should at least try to halt contraction of credit in crisis,” as Charles Kindleberger concludes.

For you, the taxpayer and saver, all that means is you get to pay twice — first in higher deductions and then through inflation.

Bet you’re glad Ben Bernanke will get all the thanks.

Cheers!
Adrian Ash
BullionVault
April 4, 2008

Who Pays for the Bailout was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“Just like natural organisms, the financial system must have death to evolve into a better form…”

NOW THAT HE’S WEARING some sort of do-good government hat, even Hank Paulson is not thinking straight.

Regulate in New York and finance goes to Toronto. Regulate in London, it goes to Frankfurt or Paris — and since Toronto, Frankfurt and Paris are run by the same nervous bureaucrat-types, we can reckon soon enough that the entire financial markets will be hosted out of Singapore and Shanghai.

There they will accept the risks as well as the rewards, to their very considerable long-term benefit.

You simply cannot enjoy being the financial center of the world but start bleating for government bailout whenever asset prices dip a few percent. As Paulson is demonstrating, the regulatory price for being bailed out is far too high. We must all grow up and take a full measure of punishment. The banks must take theirs.

Let the shareholders and depositors take theirs too. Just like natural organisms, the financial system must have death to evolve into a better form. Of course, this sounds like a callous statement, but it may be the only way to avoid the moral hazard that Paulson is seemingly creating.

Paulson’s plan is a dressed-up confiscation of the profits of the cautious, and a transfer of those profits straight back to unreconstructed gamblers in the worst offending banks. This is very unwise. When will they learn their lesson? If reckless behavior is continually bailed out, when will we ever see a reversion to more risk-averse times? Sometimes a sound and safe bet is the correct one.

In these difficult times, profit (or more accurately the avoidance of loss) should be benefiting those who troubled to understand the risks in the system, and avoided them. But Paulson’s plan is currency creation, and a devaluation of the good quality assets owned by the cautious. He fails to understand that unless the system occasionally rewards caution there is no reason ever to be cautious again.

Where Goldman Sachs should be duly rewarded for its safer bets, Bear Stearns should be given its due punishment for its uncontrolled risk. If the stock needs to fall all the way to zero, that’s how Bear’s cookie should have crumbled. Instead, the company has been rescued and placed in the safe, strong arms of JP Morgan. Where is the justice?

The market works better without these rescues. Only by appropriate economic reward to the cautious, when they are right and everyone else is wrong, will caution sit well beside risk-taking in the financial system. The real threat to New York and London’s continued dominance of the world’s future financial system is government regulation itself.

Mr. Paulson should read F.A. Hayek’s classic The Road to Serfdom, and he would understand the inevitable failure of his rescue plans. He would see how these top-down rules remove society’s flexibility until one day we all wake up in a paralyzed “command” economy, where nothing can be done without official sanction.

Instead, he has forgotten what a command economy means. He should study the history of communism’s economic successes. It won’t take him long.

Regards,
Paul Tustain
BullionVault
April 1, 2008

The Problem with Bailouts was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The first difficulty is to establish who made the bear sales, and whether they did so in agreement with each other. The formula of creating and profiting from a bear raid is, of course, familiar from the history of stock markets, and can be traced back to eighteenth century stock jobbing, as described by authors such as Daniel Defoe. Before that, it could probably be identified in the highly sophisticated Dutch markets of the 1630s, when one could buy or sell puts in tulips.

In the nineteenth century, the authorities of the Stock Exchange had to deal with the criminal millionaires of the railway age, such as the partnership of Fish and Gould who manipulated the stock of the Erie Railroad. One of the dramas of the railroad age was recounted in an early twentieth century pamphlet on the capture of the Illinois Central Railroad by the Harriman interests, from those of the Fish family. The pamphlet has the striking title “The sandbagging of Stuyvesant Fish.” Somebody seems to have sandbagged Bear Stearns, and other people may have sandbagged HBOS.

It may be difficult to find them; it will certainly be difficult to prove their guilt. In the first place, it will be difficult to prove who had made the actual sales and purchases of stock — a difficulty which was often too much for early investigators. In the last three weeks there have been very large volumes of bear sales.

Even if it were possible to identify all the relevant bear sales, it would be extremely difficult to show which of them were intended to create a false market. In theory, it would be possible to reintroduce the post-1929 U.S. legislation which made bear selling illegal in most circumstances. Similar regulations were introduced in the United Kingdom. In the period after the Second World War, bear sales were impossible for most investors in most circumstances. These regulations were only gradually relaxed. However, it would now be impossible to outlaw all bear sales without simply transferring the business overseas to other markets.

The problem is most acute in the case of financial stocks. All banks are highly leveraged by comparison to other stocks, at least in ordinary circumstances. Recently, private equity deals have led to great increases in the leverage of some otherwise ordinary businesses. Bear Stearns and HBOS were both highly leveraged to maximize their profit opportunities, in a way that would be seen as perilous in any non-financial company. All banks, as a matter of routine, trade in debt, including their own debt. Whereas a manufacturer or retailer would be unlikely to be ruined by a few days of closure of credit markets, a bank can be perfectly safe on Friday and dead in the water on Monday. Like the unsinkable Titanic, banks can be holed below the water line if they cease to be able to borrow.

Some discipline needs to be found if the banking system is to be protected. The modern world economy depends on banks, more so than the business world of 1900. Yet our banks are still vulnerable to the deliberate creation of false markets in their shares or in their banking liabilities. What happened last week is a greater threat to world finance than Enron.

Regards,
Lord William Rees-Mogg
March 24, 2008

Bear Sales was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.