Lehman Bankrupt, Merrill Swallowed, AIG Wilting: What It All Means

Well, just another ho-hum Monday on Wall Street. Not much to report, except another major banking institution, Lehman Brothers (LEH), filed for Chapter 11 protection, Merrill Lynch (MER) has been gobbled up by Bank of America (BAC), and the headlines are sure to continue to roll in on the future of insurance giant AIG (AIG). There is a lot of data to digest today, so in keeping with Ockham’s Razor, we will try to quickly get to the main points of each of these events and what they mean.

To begin, although it was expected by many, the bankruptcy filing of Lehman Brothers has shaken financials. Lehman has been on death watch for a few weeks (or months) because it was very heavily leveraged and deeply dependent on the troubled mortgage backed securities in its portfolio. Lehman claimed more than $600 billion worth of assets in its most recent filing, $20 billion in common stockholder’s equity and the rest in debt. Only the now defunct Bear Stearns had a higher gross leverage multiple than Lehman. That is simply too much debt to be supported by that little equity, and firms interested in purchasing LEH knew it. So, they (Bank of America and Barclay’s (BCS) were the most likely suitors) needed a government backstop before they could be inclined to add LEH “assets” to their balance sheets. The Fed rightly did not provide any backing for this deal which would have further exacerbated the moral hazard that was building in the wake of the Bear Stearns, Fannie (FNM) and Freddie (FRE) deals. Lehman will now try to sell-off its investment management unit and its broker dealer to the highest bidders. Now, Lehman will have to reap what it had already sown and, as always, it will be the equity holders and not the bond holders that will take the biggest hit.

The proud and venerable name of Merrill Lynch appears to be headed under the umbrella of Bank of America. BofA will in all likelihood become the world’s largest bank with this acquisition. Merrill’s stock traded at three times BofA’s acquisition price just a year and half ago. It is interesting to see BofA actively seeking to gain market share (see Countrywide deal) as other competitors are just trying to stay off of the front page. Time will tell if it made a good acquisition or is just creating more problems for itself, such as: (1) how much risk is left on Merrill’s balance sheet, (2) will the corporate cultures mesh, (3) will BofA retain the best Merrill talent, etc. This strategy could a major boon for BofA shareholders when the mortgage and credit crises begin to dissipate. Time will tell whether Ken Lewis and gang are remembered as geniuses or fools, but in the long run we think this deal will be beneficial to BofA shareholders.

Last, will AIG be next in the line following Bear and Lehman? The stock is off more than 50% today as it looks to fill a $40 billion hole. AIG is asking outside investors to come to the rescue and inject the $40 billion in capital to shore-up some of its toxic paper. AIG has even reportedly asked the Federal government for a $20 billion bridge loan, but this looks unlikely to be approved given Treasury Secretary Paulson’s new-found fear of moral hazard. The State of New York will allow AIG to transfer $20 billion of liquidity from its insurance subsidiary to the parent holding company, which will buy it some time. AIG plans to spin off some of its divisions including: auto insurance, annuity services, and, possibly, its aircraft leasing company, International Lease Finance. We hope that the Fed will again reject the inclination to bail out AIG and thus further the moral hazard risk, so that the markets can begin to recover on their own. As such, AIG needs to work through its problems on its own.

In conclusion, it is clear that there is a lot of fear in the market over the future of financials. We are not willing to say that we have reached a bottom in financials, but it is at times like these—when it appears that the sky is falling—that a contrarian investor should start to look for opportunities. If you need a few reasons why we remain bullish on the market for the long term: crude oil hit a seven month low of $94 per barrel this morning, the market’s price-to-peak earnings ratio is 14x—its lowest since 1991—and the dollar continues to rebound against most other currencies. So, the pressure from high oil and commodities prices is abating, stock valuations have moderated considerably from unsustainably high levels and the economy is still growing —at a 3.3% clip according to the most recent revision of the second quarter GDP. These improving factors are being overshadowed by overall glum market sentiment, and sentiment may stay low until housing begins to show signs of improvement.

Comments

[you_can_cal...:]

1) Yes, the sky appears to be falling at market bottoms, but that doesn't mean we're at the bottom because the sky appears to be falling. Things look terrible halfway to the bottom too.

2) Crude hit a low because the economy is tanking. Lowering a price from "totally unaffordable" does not make it cheap.

3) The current PE depends on the P AND the E. 14X is still high by historical standards, and if you don't believe the earnings will hold (and I don't), then it's really a higher ratio than you think.

4) The economy is not growing at a 3.3% clip. The number is complete, well, ...bullshit. They used a fictitious inflation number. If you really think the economy is growing that robustly, then maybe you should look out of a window.

5) The dollar is not rebounding against other currencies, they are falling to our level because their economies are also slowing (that's bad for us). Having everyone fall down after you doesn't mean you got back up.

A recovery will come (oh sorry, I forgot we're not in a recession), but that requires business expansion, which requires loans, which requires that most members of your financial sector not be fighting for their survival. The recovery will come, but it will be awhile.

Think about it. Fannie and Freddie have effectively been nationalized, 100+ year old firms are going belly up, housing continues to fall, the Fed is low on dry powder, we're still involved in two expensive wars, the global economy is slowing (not bottomed, SLOWING), consumers are in debt up to their eyeballs, and, most importantly, the financial firms that fuel recoveries DON'T HAVE ANY CASH.

We are not close to the bottom. Hate to sound negative here, but please. Just because everyone knows something is obvious doesn't mean they're wrong.

2008 Sep 15 04:23 PM

[JasonC:]

The only moral hazard going on right now is the hazard that regulators listening to barking ideological moonbats will burn the world to the ground trying to save the taxpayer 25 cents.

The Fed had to inject $95 billion in funds today and the funds rate still closed at twice its target. The Europeans added another $50 billion. Financial institutions sought $400 billion from them. So to date, not having a "bailout" has cost 10 times what a bailout would have cost. And counting.

People need to stop worrying about who gets stuck with a loss and start worrying about how big the loss is.

The size of the lost is not fixed. It can and will and is, ballooning with the destruction of institutions and of confidence in counterparties. It can destroy 10s of trillions or it can destroy 10s of billions in the end. It will be the former, not the latter, if men continue fighting over who gets stuck with what piece of it, instead of stepping up and allocating the damn thing and moving on.

The Treasury's decision over the weekend was a breathtaking error of world historical proportions, and every commentator applauding it today out of ideological drivel deserves to lose their shirt and go out on the soup lines.

2008 Sep 15 04:25 PM

[you_can_cal...:]

Jason, thank you. You are completely correct. When there is a run on the banking system, you don't stand by and let the invisible hand slap the shit out of you. Similarly, you don't let it pick up a weapon and shoot your family, your neighbors, and their dog. You get creative and do whatever you must to stop the contagion from spreading.

2008 Sep 15 04:35 PM

[spchampion:]

I've started calling the moral hazard of this whole thing the Meltdown Put.

It works like this: if you’re doing something risky, do it in such a way that a failure of your project results in complete financial Armageddon. While counter intuitive, you will actually protect shareholder value and backstop their losses by forcing the Federal Government to bail you out. On the other hand, a more conservative approach will give the government less reason to care, and your shareholders end up absorbing your losses.

If a bank risks ending the world, like Bear Stearns, they’ll get bailed out. If not, they’ll get ignored, like Lehman. It’s not completely like a real put, but close enough.

2008 Sep 15 04:59 PM

[icandoitdon:]

good grief.

it's utterly embarrassing to hear cries for federal help from overleveraged wall street firms and their polyanish shareholders who couldn't recognize a sell signal if it bit them in the a**. those who beg the loudest are usually the same ones who rail against government regulation of private enterprise.

i think the republic can withstand the loss of lehman. what it can't withstand is the coddling by our government of private enterprises that use excessive leverage to magnify returns during periods of boom while shoveling losses from excess leverage onto taxpayers during periods of bust.

2008 Sep 15 05:14 PM

[Jason Rines...:]

I am with you iCanDoIt. For Jason C, the global investor lost confidence in the financial system and began showing this in March.

Paulson told the world the GSE's were fine, more investors burned. CNBC touted that the banks are fine, more investors got burned. Confidence by the investment community is key to solving such a big crisis but the truth itself was not reported by the government nor the CEO's of the banking sector. America and Americans cannot solve problems when an obvious recession is going on and Washington is only focused on elections and has been for the last year. It was more important for this Congress to simply hate Bush to get ther savior elected then to do ANYTHING on energy or this financial crisis, so instead we get stewards of big business only, those stewards are the same who created many of these problems with Washington policy or lack thereof at front and center. Horrific, selfish human beings

Check my previous comments from March on, I strongly discouraged investment into the financials. My positions are a CEO of a Consumer Healthcare marketing company. I dropped Higher Ed in February of 2007 because going to college is often based on credit that appeared super-bubble to me, 25 years with 7 years very large acceleration. So shareholders had plenty of time, could conduct there own research into the exposure of investments in the financial industry. Also, countries pushing paper as 'innovation' has always been a historic benchmark of an imminent, massive crash. Now I will say this:

If the whole financial house of cards comes down and I must eat wheat pasta rations for a year, so be it. I would prefer a free market economy and a Republic of America instead of the corrupt leadership we have seen over the past decade of a couple of thousand people that decide my fiscal destiny no matter what I do, that fundamentals, hard work and brains don't matter, that only be part of the club matters. I hope those that caused this mess can afford plastic surgeons and like remote locations outside of the USA. It will be very messy by the time it's over.

The easy days are over and let's face it, it wasn't the taxpayer that created the problems that are bringing down the iBanks and nor will the current bailouts of the GSE's or all the combined toxins the American taxpayer will be paying off for a good long time be twenty five cents. Did the overleveraged American get to play with 30 to 1 ratios of equity and liquidity? How many discount windows can the avergae American consumer have access to?The blame lies at the feet of Washington for the past misery and the last few innings of this coming big misery which will play out over the next four years.

2008 Sep 15 05:57 PM

[MiningOilGa...:]

the financial system needed something like this to happen. Banks should know better than to gamble like they did. Not only will this correct the markets, but it will teach top management not to get so greedy like they did. I agree with the first poster, it is hard to predict that we are anywhere close to the bottom. At the rate the bad news is coming out now (basically hourly) the bottom feels far away.

2008 Sep 15 06:26 PM

[fatcat:]

AIG cannot be allowed to fail...I agree with all posters about the moral crap,but I also don't want to face anarchy at my age...even though I'm armed and dangerous..

2008 Sep 15 08:09 PM

[joe1:]

"you can call me al" GREAT comment but ya missed it on #2 "crude is low because the economy is tanking" Don't think so. Crude is low because every speculator finally realized that no asset in the world goes up in and endless fashion. That no matter what the mainstream media told you it was never about supply and demand.Well maybe a little... Funny were trying to fix something that was partly or largely due to speculators and we still cant figure out when they are a main factor in regards to a parabolic asset appreciation and when not.

2008 Sep 15 08:17 PM

[otbricki:]

How exactly is this teaching top management anything? The cream-skimmers got FAT bonuses when the Ponzi scheme was working, and they will get FAT golden parachutes on the way out. Their scam worked perfectly.

2008 Sep 15 08:25 PM

[ozcutty2:]

I think BAC could have waited another week and got MER for half the price.
LEH deserved to go under.
AIG is so very different, plenty of good assets, surely they won't let this one fail becasue of mark-to-market accounting

2008 Sep 15 08:38 PM

[icandoitdon:]

ozcutty2 you are correct on BAC why they bought merrill in the face of a bankruptcy proceeding by LEH i can't fathom. Ken Lewis stated that if they had waited to get it cheaper the opportunity might disappear. hello???? the firm was in meltdown!!

lewis also states that he wasn't "pressured" into buying MER. i wonder. how much due diligence could they have done in the 24 hours or so it took to put this deal together?

i think BAC will be a survivor and based on the premise that MER has been pretty aggressive in getting rid of lousy assets and raising capital, i sold some BAC puts late today at the 17 1/2 and 20 strikes but i'll be quick to exit the position or hedge it if BAC continues to sell off. trust nobody...least of all the CEO of a financial firm.

2008 Sep 15 08:55 PM

[Jason Rines...:]

I don't prefer anarchy either. But we are not in charge of the Central Banks, the Fed, Treasury of Congress. At least I am not. A collapse would be short lived if any occured but yes, anarchy would follow for a brief time. I am also prepared for that contingency.


On Sep 15 08:09 PM fatcat wrote:

> AIG cannot be allowed to fail...I agree with all posters about the
> moral crap,but I also don't want to face anarchy at my age...even
> though I'm armed and dangerous..

2008 Sep 16 12:06 AM