BofA, Lehman, AIG: The New Financial Realities

Includes: AIG, BAC, LEH, MER
by: Roger Ehrenberg

So, B of A is buying Merrill. Lehman is toast. AIG, waiting in the wings? Today, there is only one word that matters - liquidity. Without this creator of option value, of the ability to ride out the storm, not even the largest institutions are immune to being dragged down in the tectonic flight to quality. So, just a few thoughts on this historic evening:

1. B of A (NYSE:BAC) is making a huge mistake. Merrill (MER) looks good, looks cheap. After all, its stock was more than 3x the acquisition price of $29 per share a mere 18 months ago. But how much of the less transparent, hard-to-price risk has Merrill really offloaded? The deal with Lone Star involved loads of seller financing, financing that merely gets credit enhanced (and more valuable) with B of A's assumption of the contingent liability. Do you know any of the bankers at B of A? I do. Do you know any of the bankers at Merrill? I do. We're talking oil and water. We're talking companies with different metrics of business success - ROA vs. ROE. Vastly different compensation payout ratios. I can't see this working out. The best of Merrill will leave, and the rest will stay. Adverse selection in action; the best hit the bid, the others, get overpaid through retention agreements issued by the acquirer. There is no happy ending here, except for the fact that the Fed has taken care of one big problem potentially burning a hole in its pocket: Merrill Lynch. I have only one thing to say to B of A: sucker!

2. Lehman (LEH) will go the way of good bank/bad bank. The only question is who will capture the option value. I think once the swap counterparties net off against each other and the remaining assets are marked to market, there will still be a big hole in Lehman's balance sheet. The Fed will step in to capitalize a bad bank, and capture the option value of buying time for the markets to normalize. It will be LTCM all over again. Sell the liquid, high-quality assets, finance the rest, and wait it out. The Fed will earn its money bank and then some in this scenario. They just need to get over the fact that they stupidly said they wouldn't do this again. Because they will. In the name of an orderly liquidation and wind-down of the portfolio.

3. AIG is scary. Such a massive balance sheet, coupled with a gross lack of transparency. $40 billion to fill a hole? Good luck. It's not coming. Selling their cash flowing crown jewels like IFC is all they can do at this point. Going to the Fed to ask for liquidity is another good move. They will probably bite. Question is how much they will tolerate being for the benefit of AIG shareholders. My guess is little to none at this point. Their sweet and charitable nature is clearly about to run out, leaving the regulators holding a baseball bat and not in a good mood. Sell the jewels they will, the question is if it is enough and if it buys them sufficient time. My guess is that it is not and that it won't. They will be banking on the Fed to do the "right thing," to save the firm. But not its equity holders. They're hosed.

Who's next? Who knows. My guess is that a bunch of regional banks topple under the weight of their MBS holdings. It is unreal that we've gotten to this point, but here we are. 1989 redux. Those were not pretty times. And I don't expect these to be any better.