Liquidity or Solvency? Sometimes It's Hard to Tell

The current problems with Lehman Brothers (LEH), AIG (AIG), and Merrill Lynch (MER) are uncovering a number of issues that will no doubt change the way we look at the health, valuation and operations of businesses going forward. Of interest is how the current environment has resulted in Lehman Brothers being a company with liquidity that is not solvent, compared to AIG that may be solvent (for now), but has a liquidity issue.

Just last week the WSJ Deal Journal blog highlighted some of the various anomalies between Lehman's valuation and its apparent asset values as its stock price plummeted. As of last Friday, the closing price of Lehman put the market capitalization of the company at around $3 billion. Yet, many analysts highlighted that the current price reflected little about the true value of the company.

Analysts expected the company to receive about $3 billion for a 55% stake in Neuberger Berman -- as much, if not more, than the value of all of Lehman. The bonus pool for Lehman's 24,000 employees itself was estimated to be around $3 billion.

On the other hand, the company has $25-30 billion in toxic real estate assets to deal with, and therein lies the issue for Lehman. How much is the exposure, how much are they worth, and what are the potential losses? Even with the ability to spin off the real estate into another company, and further inject it with $5-7 billion in liquidity, solvency was still not guaranteed.

As Ken Lewis, the CEO of Bank of America (BAC) stated yesterday, the difference between the balance sheets of Merrill and Lehman was "night and day". Time will tell on BAC's move on Merrill. In the meantime AIG is scrambling to find capital to shore up its balance sheet and keep from getting a ratings downgrade, and subsequent higher cost of capital -- as if selling off assets was not a high enough cost. The Fed window may stay closed to AIG, but funds might travel out the back door before all is said and done (New York is already granting permission to access $20 billion in capital from subsidiaries, see WSJ article).

So, are the issues with Lehman, AIG, and even Merrill a result of bad risk management, lack of good regulation, poor accounting rules, circumstance, or some combination of each. The easy answer is some combination of each, but the situation is of course more complicated than that. Good risk management should help us to avoid failure, if not excessive loss when circumstances go against us, but there are no guarantees.

Regulation can force us to set aside risk capital, even when we don't want to, but again, it could be argued that a good risk management system that is actually both honest and honestly followed could serve a similar purpose (whether it does and would be followed, and whether that is why regulations exists in the first place is another issue and debate).

Of course, that leaves accounting, and I suspect this area in particular will receive a lot of attention in the coming months, especially with regard to mark-to-market. The questions of whether each of these companies would have the same liquidity issues if accounting rules were different will certainly get some play, which means it will be a busy fall, possibly followed by an equally busy winter, spring, and summer. All the regulators and agencies tasked with these problems may come to question the validity of the old proverb: "may you live in interesting times." Right now, something a little more boring would be nice.

Update: On another site a reader responded that leverage was the problem, and that any new regulations will probably overstep. I could not agree more. Just looking at things a little down stream, the mark-to-market issues may be nothing more than an identification / realization of the leverage problem. Nonetheless, I suspect the regulators will be busy trying to prevent a similar problem. Hopefully, any changes will be measured and focused with few unintended consequences.

Disclosure: None

Comments

[prescient11:]

This is exactly the question that needs to be asked.

2008 Sep 16 03:08 PM

[Jason Rines...:]

1) The source is Washington. Regulation existed that was repealed to facilitate this.
2) The source is Washington. Power brokers without term limits that regulate or de-regulate markets for money or political gain.
3) The source is Washington. This has happened before. After this is all over will it happen again someday? Yes, until mankind repairs the genetic code some crop of leadership somewhere will believe they should own all assets and not realize it's labor pool needs a measure of protection.
4) The source is Washington. Having appointments and agencies such as the Fed are answerable only to Congress, see point number 2.
5) How to fix it. www.ragingdebate.com/w... (excuse this early release of the site and sorry SA, no shameless free media plug intended) . Ask most people and Americans included about America: Love the country, hate this government. But don't think a massive power base that is now hunkered down in Washington are going to just happily go away. The American voter must do that and we as investors must educate the American people about the Constitution, the Founders what being free and having opportunity is about. The schools sure as hell don't teach much of history or what can be learned or profited from it!

2008 Sep 16 05:59 PM

[jrudnik:]

I am gonna hold of on BAC for a few days, if it has an upward trend we could have something. Especially with $70 billion liquidity fund as a backup for the major bank.

2008 Sep 16 08:47 PM