BofA, Lehman, AIG: The New Financial Realities

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 (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.

Comments

[Philip Gvinter]

WM and WB with their massive Option ARM holdings should be the next two in line.

2008 Sep 15 01:09 AM

[Fish Gone Bad]

If anyone watched McCain's acceptance speech, you will find this funny.

McCain said that newly unemployed Americans will get training and get better jobs. Jobs that will stay. So I am thinking, aren't those the jobs that everyone at Lehman, just had?

Clark Jenkins
FishGoneBad.com

2008 Sep 15 01:43 AM

[dato2020]

America is in a self destruct mode. Our enemies...remember them?....remember what buildings were targeted?....they are stoking the fires to bring us to our knees...bankrupt the system...depression...... the revolution...violence.... play right into their hands.

Jerks making flippant remarks such as yours. You are talking about tens of thousands of families being shattered. So stop being so cute. You have not been around long enough to understand what really is going on and how it can effect our country. Probably never had to make a business result in the real world. Talk it but cannot walk it.

2008 Sep 15 01:47 AM

[jimmydazzle]

I would not be surprised if HSBC decides to top B of A's bid for Merrill before all this is over.

2008 Sep 15 01:48 AM

[Garya]

Lookingin, you are wrong. Bush financed the Iraq Oil War with liar loans. He allowed 9/11 as an excuse to go into Iraq. He wants to surround Russia and start another cold war or ww3. It is all at my blog. Learn, Lookingin. You are so deceived.

Bush is about Bush. To hades with the average American. You need to study about PNAC and the neocons and leo Strauss at Wikipedia. Then you will understand that lying to the masses is what neocons are all about. That is why Palin is already up to her eyeballs in lies.

2008 Sep 15 01:56 AM

[dato2020]

You seem to have lying on the brain. I am talking about contagion. Not conjuring up some half brain "He allowed 9/11 as an excuse to go into Iraq" theory!
When the fools get done allowing the Financial System to implode, you will not have to worry about McCain funding the next war! There will be no $ in the till and unemployment will be 20%!

2008 Sep 15 02:24 AM

[LennyLichtenstein]

Garya you have a future in crime because you just burglarized this guy's post. Roger all good points.

This happened in what seems like a different world
Disclosure: Short AIG 10, 15 puts for september

2008 Sep 15 04:53 AM

[guliamo]

I think BAC made a killing on the Merrill deal.. question is, was the price right?
Long term - this is a dynamite acquisition in my opinion

2008 Sep 15 07:07 AM

[1worldcurrency]

Try bad bank, bad bank. Your last article said Lehman was on the right track. Good call. The internet is forever.

2008 Sep 15 07:23 AM

[Jason Rines (iThinkBig)]

Politics - both parties responsible for the current mess we are in. This started in the early 1990's first under Bush I then accelerated with regulation removed to protect the system under Clinton, then Greenspan stoking the easy monetary policy after 911. By 2005 the housing bubble should have been popped. Economists did write in Bush II in 2006 in high pitch shrills sounding the alarm. Bush II got tired fighting a lame Congress of far left brats in 2006-2008 but that is part of the job description so he does not get a pass.

America will have it brief hyperinflation, economic collapse, and depression. But America will come back hard and fast afterwards. The bankers and politicians were beyond greedy and it is more then tens of thousands of families that are and will be effected. It will be 90% of the population, it's become a 'have' and 'have not' economy and the Middle Class will revolt at the polls in 2012. For now, lots of people with there hands out looking for help beyond banks. Next four years will be quite a struggle for many. Good luck to all.

2008 Sep 15 09:51 AM

[fxtrader07]

@paul&Shark: wtf? who cares how much you made or lost?
btw: people who need to brag about their trading success usually lose their money pretty fast. so better watch out

2008 Sep 15 10:24 AM

[fxtrader07]

@guilamo: it could be a self-killing, i.e. harakiri. time will tell.

2008 Sep 15 10:25 AM

[Roger Ehrenberg]

Squashnut, good bank/bad bank is the right structure. it was dependent upon them raising the capital necessary to capitalize the bad bank. They didn't. Fuld waited too long. I'm well aware that what I write is out there for all, forever. That is why I do it. I don't trade single stocks, I don't make money off of my blog. I do it because I enjoy sharing my thoughts. I never have claimed to be an oracle.

2008 Sep 15 10:40 AM

[buyitcheap]

Between the regionals MBS AND their FNM FRE holdings...that's a good possibility...

2008 Sep 15 12:24 PM

[TheEconomyKilledKenny]

Fellas, this is supposed to be a somewhat professional site where we can discuss various topics without yahoo-ite like comments. Keep it civil please.

@Lookingin: Depends which unemployment data reading you're referring to. The government always takes the lowest (U3 I think?) which is at about 6% right now... if you take the U6 say hypothetically today (hopefully I'm not getting my U's mixed up) I'd say after the coming weeks we'll be pretty darn close to your 20%.

2008 Sep 15 12:55 PM

[GreenestEgg]

None of this is a surprise. Compare the trend of 'net income' vs. 'cash flow from operations' on any of these banks' balance sheets and you'll see that this was coming since 2006.

More cash going out than coming in is almost never a healthy way to run a mature business, especially one that doesn't need to retool factories. It all seems kind of obvious in hindsight.

2008 Sep 15 01:40 PM

[1worldcurrency]

Yeah I take issue with the notion that Lehman Brothers could just spin away their problems into a bad bank, leaving either the taxpayer or some creditor to eat the losses while they avoid the "moral hazard". There must be accountability, including for bloggers who think they can spin nonsense. There is too little time and too much at stake.

2008 Sep 15 07:20 PM

[dato2020]

So there is no fall out from Lehman? See nothing happens when we allow these big financial institutions to fail! Next a run on uninsured MM's. AIG is a national corporate treasure...If they file tomorrow, it will destabilize the markets world wide....and as important, embarrass the USA world wide. I live and work over seas. If you could see the view from the outside looking in, it would sadden you.


Money market giant freezes redemptions
By Sam Mamudi
Last update: 5:19 p.m. EDT Sept. 16, 2008
Comments: 53
NEW YORK (MarketWatch) -- One of the first and largest money market funds has put a seven-day freeze on redemptions after the net asset value of its shares fell below $1. Primary Fund (RFIXX:
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2008 Sep 16 06:29 PM