John Hussman: Fannie / Freddie Set the Stage for Lehman

Excerpt from the Hussman Funds' Weekly Market Comment (9/15/08).

It's important to recognize that the timing of the stress at Lehman (LEH) is not a coincidence independent of the Fannie (FNM) and Freddie (FRE) bailout. Rather, the U.S. government essentially sent an information signal that highly leveraged financial institutions were insolvent. Next to Bear Stearns (BSC), Lehman had the highest gross leverage multiple on the street (the continuing problem is that several others are quite close). Last week, Lehman reported $600 billion in assets, on less than $20 billion of common shareholder equity. Evidently, the markets (and potential acquirers) don't believe that the $20 billion is as tangible as Lehman reports. Put another way, a markdown in the value of Lehman's assets by just over 3% would wipe out that reported shareholder equity. One would need to have a great deal of faith in that asset valuation to have been willing to buy the company out at any price, since an outright buyer would have had to agree to pay off Lehman's bondholders (in excess of $100 billion).

A buyer might very well have been willing to pay nearly $100 billion for Lehman's assets, as well as its customer and counterparty liabilities, but the proceeds wouldn't have been quite enough to pay off Lehman's bondholders entirely. That's what everyone was trying to avoid. Not customer losses, but a bankruptcy that would leave Lehman's bondholders less than whole.

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Essentially what we've got here is an economy where the government provided a boatload of tax cuts, the benefit of which was invested directly and indirectly into mortgage securities, which helped to finance irresponsible lending, which produced a housing bubble, and now that the bubble has burst and the mortgage securities are losing money, those same bondholders are looking for the government to bail them out.

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As a sidenote, I should note that the main downside of a Lehman (or other) bankruptcy will not be for customers or counterparties, but to its debt holders, and by extension, institutions that are heavily exposed in the credit default swap market.

Comments

[AlexS:]

Why would you blame this on tax cuts? There have been other tax cuts before but I don't recall a subprime mortgage disaster. I blame it on the Community Reinvestment Act (CRA) of 1977 (Jimmy Carter and a Democratic Congress) followed by the 1995 action of Bill Clinton et. al. in "strengthening" the CRA and allowing institutions to sell derivatives, to hide the sales of subprimes in a basket of otherwise investment grade obligations. Part of the CRA was giving money to "community activist" groups to increase pressure on banks to make subprime loans, the same activity that gave Obama his start in community activist functions. Then of course this year the Congress in its housing bill mandated that a portion of all Fannie and Freddie mortgage loans include a percentage for those same activist groups. Nothing like a wheel to bring us back to where we were.

2008 Sep 16 01:55 PM