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.

As the quarter unfolded, it became clear that the world’s credit system was drifting aimlessly, like a ship sailing with no wind. A lot of business that should have gotten done just did not happen, for lack of funding. Funding went away because risk aversion kicked in with a vengeance, and for a very real reason.

The last 12 months or so have been a time of re-pricing risk — and this occurred on a global scale. But the re-pricing was not orderly. The U.S. dollar was steadily drifting downward in value, and prices for most things were readjusting just on this monetary basis alone. Add to this some severe industrial disruptions, from power shortages in South Africa to floods in Australia to economy-stopping winter weather in China.

Closer to home, the downward re-pricing of risk rapidly became a collapse as flaws in the U.S. rating agency process bobbed to the surface. With so much distressed commercial paper floating around, many people were paranoid about risk. It was like the old game of “hot potato,” except nobody could pass their potatoes onto the next guy down the line.

For example, in one major presentation, I heard General Electric CEO Jeff Immelt spend a large part of his discussion defending GE’s “triple-A credit rating.” Normally, Immelt would be up there slapping the pointer against the screen and bragging about all the great products that GE makes and sells. Instead, he was busy trying to “prove a negative,” that GE does not hold bad paper in its money operations. But Immelt believed he had to defend GE’s stock price by dispelling fears of a rating markdown.

And through it all, the resulting stock market gyrations were a reflection of investor confusion about the future. Are we at the end of something good? Are we at the beginning of something bad? Is this the beginning of the end? Or is it only the end of the beginning? Really, what comes next? Will credit markets liquefy? Or will they stay dried out? Can we do business? Or should we hold tight and sit on the cash?

New York Times columnist Paul Krugman recently told Fortune “Large parts of the financial system will have to be reinvented.” And there’s no argument from me on that one. But so much of the financial system is broken that the question is where to even start.

The Flipping Industry

It is apparent that much of the old way of doing business — particularly in the realm of lending money — was rotten to the core. In my view, it begins with the dollar itself. The dollar has been steadily deteriorating in value for decades, so inflationary expectations are part of the worldwide consciousness. That is, just because of the long-term decline in the value of the dollar, most people expect most things to go up in price most of the time.

So is it any wonder that people developed a “speculation expectation”? This fed into an entitlement mentality, as well, that tainted every rung of the credit ladder. A lot of people wanted to buy and flip, whether it was houses or stocks or commodities. So other people lent to people to enable buying and flipping. Flipping became a dominant, if not defining, element of the financial “industry,” of sorts.

The Money Was Just Too Good

But what an industry! For example, in the past five years, many people just plain lied through their teeth on everything from credit card applications to mortgage applications to the lending documents for multibillion-dollar takeovers. It was pure and brazen fraud in many instances, verging on burglary in plain sight. The next level up the food chain — the brokers and loan officers — often just looked the other way and rubber-stamped the papers. “Hey, not my problem.”

This kind of bad buck-passing went all the way to the top of some firms, many with familiar names. There in the ethereal reaches of the nice office buildings in Irvine, Calif., and Fort Lauderdale, Fla. — let alone Wall Street — the chief executives knew, or should have known, how risky the portfolios were becoming.

But these corporate worthies let it happen. The pressure to “make the numbers” was too much. The money was just too good. The bonuses were too sweet. And besides, there is always the old excuse that “Everybody does it this way.” Yet it was not for nothing that the ancients defined greed as a deadly sin. At each step of the ladder of financial deceit, people just let it slide. They should have known better, and maybe they did know better.

Now looking ahead, we have a hell of a rocky road before us. And can we as a society really “regulate” our way out of that situation? Or is there a systemic problem with deeper roots? Really, what do the Furies have in store for us?

Until we meet again…
Byron King
April 8, 2008

2008 First Quarter was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

In September at the Lehman Brothers’ Financial Services Conference, Citigroup’s CEO of North American consumer operations, Steven Freiberg, boasted, “Where you think there would be a fire — in our subprime portfolio — it actually looks pretty good.” He even provided a chart showing Citigroup’s industry-beating mortgage-delinquency stats.

Three weeks later, Citigroup announced that its third-quarter net income would fall roughly 60% from a year earlier, blaming “dislocations in the mortgage-backed securities and credit markets, and deterioration in the consumer credit environment.”

Apparently, “pretty good” in the current environment is “pretty dismal.”

Additionally, Citi disclosed that its securities and banking unit would be writing off $3.3 billion worth of losses — a large figure for even a megabank like Citi. This loss stems from its LBO-related leveraged loan commitments and the frozen CDO market.

The most troubling part of this preannouncement was the $2.6 billion increase in credit costs in Citi’s global consumer business. Of this figure, nearly $2 billion was an increase in Citi’s loan loss reserve. (The loan loss reserve account is a bank’s estimate of the losses it expects to take on its loan portfolio.) This large write-off was a clear message from Citi that the credit quality of its loans is deteriorating much faster than expected. To put Citi’s $2 billion allocation to loan losses in context, during the first and second quarters of 2007, Citi added just $646 million and $545 million, respectively, to its loan loss reserve account.

Many more dismal announcements from the banking industry were expected, and last week that’s exactly what we got. Merrill Lynch reported a $2.4 billion loss for the quarter following its massive write-downs. Merrill was the only one of the five largest investment banks to end the third quarter in the red. This was capped off by the retirement of CEO Stan O’Neal.

Once a major asset bubble pops — and the housing bubble was one of the largest asset bubbles of all time — the companies at the center of the mess usually try to take their lumps in a single quarter, often referred to as a “kitchen sink” quarter. By cramming losses and write-offs into a single quarter, they try to give Wall Street the impression that the bad news is out of the way and nothing but blue skies are ahead.

This game works very nicely sometimes…especially among gullible investors.

But “kitchen sink” quarters have an inconvenient way of recurring. It is improbable to believe, for example, that banks will be able to cram five years of reckless lending into a single quarter of write-offs. More likely, this quarter’s write-offs will begin a long-running trend.

“Kitchen sink” quarters will occur repeatedly in the financial sector, just like they did in the tech sector after the dot-com bust of 2000. Cisco, Intel and Corning reported a series of disappointing quarters.

The homebuilders are also playing the “kitchen sink” game, as Lennar and KB Home demonstrated in their most recent horrid results. Both of these homebuilders sliced large chunks off of their book values by writing off $848 million and $690 million worth of shareholder equity, respectively.

These massive write-offs illustrate how much raw land inflation and irrationally priced finished homes were hiding in the homebuilders’ inventory accounts. The most indebted homebuilders will likely experience some form of bankruptcy.

A little over a year ago, I wrote a Whiskey article entitled, “Are Homebuilder Stocks Actually Cheap ?” in which I warned that low price-to-earnings and price-to-book multiples were deceptive:

“After major declines, [homebuilder] stocks are trading for an average trailing P/E ratio of 4.7. This is incredibly cheap in the current market, but trailing earnings represent the very peak of the most speculative housing market in history (in other words, 2007 earnings are likely to decline significantly, making the forward P/E ratio potentially double or triple the trailing ratio). Your macro outlook for the housing market over the next couple of years will determine whether you think these stocks are bottoming or just pausing before another round of declines…

“The measure of book value for most homebuilders will be a moving target in the future, as further inventory charges and margin compression is very likely. So the argument that homebuilders are cheap rests on shaky accounting and extrapolation of the past into the future. That adds up to a ‘value trap,’ in my opinion.”

I see a similar value trap unfolding among the bank stocks. Most of the analysis I read doesn’t extend much beyond the parroted mantra: “Bank stocks are cheap on a price-to-earnings and price-to-book basis.” Citi’s earnings preannouncement reminds us that earnings and book values only reflect past results, not future results.

But for the moment, very few investors seem to fear the uncertainties of the future. So financial stocks have rallied on the garbage rationale that “bad economic news is cause for celebration because it will bring more interest rate cuts from the Fed.”

Unfortunately, negative surprises on bank balance sheets will far outweigh any benefits they receive from Fed rate cuts — benefits that tend to re-stimulate the credit creation process only after a very long time lag.

Finally, on the subject of recent Fed rate cuts, the financial markets are flashing many glaring signs that monetary inflation is spiraling out of control. And Fed Chairman Bernanke has received ample opportunities to establish his credentials as an inflation fighter. Despite gold and commodities soaring, and most global stock markets either approaching or blasting through July peaks, Bernanke has decided that federal rate cuts could not be put on hold any longer.

Last week the fed decided to cut interest rates by a quarter point in response to the credit and housing crises, and their potential to seep into other markets. The fed still has their eye on inflation, and has stated that further rate cuts should not be expected.

Indeed, if the dollar continues sinking — and commodities continue soaring — rate cuts may be on hold permanently…and that’s when the real carnage in the finance sector might begin.

Stay tuned!

Best regards,
Dan Amoss, CFA

November 5, 2007

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