Beware The Financials

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Includes: C, GS, JPM, LEH, MS
by: Barry Ritholtz

As we noted yesterday, Lehman (LEH) was in the market buying shares as they fell 9%, according to the WSJ:

Following an 8.1% drop Monday, Lehman shares slid 9.5% Tuesday. The latest decline came even though Lehman was buying back large amounts of its own shares. Tuesday in New York Stock Exchange trading, Lehman shares were down $3.22 at $30.61, 22% below their book value -- the measure of a company's net worth based on assets minus liabilities -- at the end of February.

Why a company in need of additional capital is out buying shares requires a little explanation for the uninitiated: Any deal for a capital infusion will be based on share price. The firm is likely seeking to shore up that price -- and a bit of confidence in management -- through open market purchases. Although this strategy reduces the total shareholders dilution (what percentage the new buyers get) in the long, run, it has potential to be very problematic.

Indeed, this strategy proved to be disastrous in the 1929 crash:

"Perhaps the most intriguing parallel, though, is the crude attempt at self-preservation made by the investment trusts in 1929 and the banks now.

In the great crash, investment trusts with vast cross-holdings in each other tried to stem their collapse by buying up their own stock in what the economist JK Galbraith in his book, The Great Crash 1929, described as an act of "fiscal self-immolation". At the time, "support of the stock of one's own company seemed a bold, imaginative and effective course," Galbraith wrote, but ultimately the trusts were just "swindling themselves".

The 1929 situation had as a key factor the Trusts cornering stocks, implementing short squeezes, aggressively plying rumors, and engaging in other unsavory trading situations. These came on top of more than a decade of stock gains. In the present case, the situation is based on highly leveraged financial companies, complex derivatives, and collapsing housing market.

So while many of the elements are very different, the one consistent parallel between the two periods is the excessive usage of leverage by banks and brokers.

And what has this leverage done for Lehman Brothers this year? The FT looked into LEH's second quarter, and found huge losses:

Lehman Brothers lost $500m-$700m on certain hedging positions in the second quarter, contributing to what is expected to be a larger-than-anticipated loss that may lead the bank to raise more capital by selling a stake to an outside investor.

People close to the matter said Lehman had opened talks with potential investors including asset managers and Asian banks.

The NYT forecast an even bigger loss; $1billion in Q2. Regardless of actual size, these Q2 losses are the likely basis for the capital raise mentioned above.

The Times article also discusses David Einhorn's short position in Lehman:

Mr. Einhorn, who runs a $6 billion hedge fund called Greenlight Capital, has been profiting from the Lehman’s growing pain. Critics say he is needlessly fanning fears about the precarious health of the financial industry at the very moment executives are struggling to stabilize their ailing companies. Many on Wall Street still wonder if hedge funds like Greenlight helped bring down Bear Stearns and spread false rumors about the bank, a possibility the Securities and Exchange Commission is investigating.

In an interview on Monday in his Midtown offices, Mr. Einhorn, fresh from his latest round of television appearances, said he was not out to tell Lehman Brothers how to fix its problems. He questioned how the company valued the assets on its books, and whether it was disclosing all the risks it faces. Investors have good reason to question banks: Worldwide, financial companies have suffered more than $380 billion in write-downs and credit-related losses in the last year, laying bare their shoddy risk management. Lehman has been singled out because of the large role it played in the mortgage market and its reluctance to disclose information about its assets compared with other Wall Street banks.

“Lehman has been one of the deniers,” Mr. Einhorn, 39, said.

The bottom line: We remain wary of the Financial sector, for reasons I have enunciated over the past year. There are likely more write downs coming, more capital raises and dilution -- and lower financial share prices.

For those who believe the crisis is in its 9th inning, best of luck to you . . .

Previously
Financial Sector: Beware LEH, CIT
http://bigpicture.typepad.com/comments/2008/06/financial-secto.html

Sources:
Decision Time for Lehman
Balance-Sheet Woes Most Likely to Force Big Strategic Shift
PETER EAVIS and DAVID REILLY
WSJ, June 4, 2008
http://online.wsj.com/article/SB121255129479844233.html

Lehman hedges lose $500m to $700m
Ben White, Francesco Guerrera and Henny Sender in New York
FT: June 3 2008 23:37
http://www.ft.com/cms/s/0/f453e96c-31b0-11dd-b77c-0000779fd2ac.html

Banks' credit crisis solutions have echoes of 1929 Depression
Philip Aldrick
Telegraph, 1:30am BST 01/06/2008
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/06/01/cccrisis101.xml

Lehman Battles an Insurgent Investor
LOUISE STORY
NYT, June 4, 2008
http://www.nytimes.com/2008/06/04/business/04lehman.html