AIG, Lehman, Merrill – What it All Means to You

By Anthony M. Freed

AIG, Lehman Brothers, Merrill, WaMu - This weeks Four Horsemen of the Markets have had a tremendous, even historical effect on every aspect of business and finance this week, and the surprises keep coming.  Just as the Markets hit lows for the year, the Fed has now announced that they want Goldman Sachs and JP Morgan to fund a $70BB rescue fund for AIG. 

This announcement may have a saving effect here at the end of trading today.  AIG was somehow allowed to bend the rules and borrow $20BB from it’s own subsidiaries, effectively eating it’s own tail – and this maneuver does not get them out of liquidity hot water – they still have to hunt down more money, which seemed more likely last week than it does this, given the shakeups. 

The stock has been hammered today on the news.  Governor Patterson of NY seems willing to help in a regulatory manner, but there is no sign of the $40BB bridge loan life-line that AIG is looking for from the Feds.  Do them a favor folks, hold off on those hurricane claims.

Asia’s opening makes me nervous.  After being closed yesterday for holiday, they are basically going to have their Black Monday on Tuesday.  They are following two unanswered rounds of losses in both Europe and N. America, and they could get walloped. 

Then, what will European and N. American markets do?  There is no money to go buy up Asian deals – it is the Asian money that will dry up for any possible cheap deals for them, further leaving our Financials with no way out but the Government’s ever-ready printing presses.  There goes inflation driven by energy and food costs and weakening dollar.

After the bell, Neil Cavuto reported that the Feds are now strongly urging some kind of accident between AIG and Morgan Stanley intheir new role as financial Matchmaker.  Unfortunately, they are only 1 and1 so far, if Bear Stearns was a success and Lehman is a failure.

Richard Breeden, former SEC Chairman expressed support for the current Fed Chiefs, Bernanke, Paulson and the usual suspects, saying that they have basically got it all right on Fannie and Freddie, Bear, Merrill and Lehman. 

Why?  I don’t know.  It seems that Paulson has now pledged FDIC support for the stock market, and the funds are fast disappearing even without Paulson trying to spread them even thinner.

None the less, “The markets will survive Lehman’s failure” Breeden said.

Wow.  Glad he has the “ex” in front of that SEC Chairman moniker.

What is scary is that the moves by the Fed are having less and less of a positive impact on the struggling markets.  Up until now, one could expect at least a full day of rally when the Fed flexes it’s muscle.  Now, there seems to be little to no feeling of reassurance displayed by traders. 

I would even argue – especially if the Fed cuts rates tomorrow – that everything is quickly spinning out of their locus of control.  And judging from the Fed’s failure to force a Lehman deal combined with news that big 10 banks announced they will form a fund to back each other up, they may be more and more out of the loop, unless they are willing to pony up the cash.

Markets closed at record lows for the year, with the Dow down over 500 points, NASDAQ down more than 80 points, and the S&P down nearly a whopping 60 points.  See the article by Mr. Mortgage about How Meredith Whitney Scares the Crap Out of Everyone.

 

Lehman Brothers is under Chapter 11 Bankruptcy protection – this essentially will buy time for Lehman to sell off some of their still valuable assetsin an organized, not-so-firesale like manner.  There are still byuers (Vultures) hanging around looking to pick up Neuberger Berman, if given the chance.  Lehman has acknowledged today that they are still entertaining offers for Neuberger that were presented prior to the BK, which now looks to be nothing more than a tactic employed by Dick Fuld to keep his job longer, and take the media pressure off while he sells off what is best about Lehman.  It worked so far.

 

Merrill Lynch is now a division of Bank of America.  B of A’s Ken Lewis looks to have jumped the gun on Merrill, paying fully $10 more per share than the stock has been trading at today – and the stock is even trading up for the session.  I am of the opinion that Ken Lewis has one serious case of Jamie Dimon envy, and this is a major motivation in many of his decisions.  But Lewis, unlike Dimon, just does not seem to have the magic touch – his impatience and insecurity with his ability to close a good deal has had him jump the gun twice now with the CW and Merrill buyouts.  Lewis’ willingness to pay top dollar in a languishing marketfor what will prove to be even bigger problems down the road has been bringing shares of B of A down all year, and when B of A starts their writedowns in earnest, the stockholders will have some big questions for Lewis to answer. 

 

Maybe B of A just wants to be too big to fail.  Mission accomplished.

 

Washington Mutual- Hard to know what to say here.  Reminds me of a war movie where some poor grunt has to hold his buddy in his arms as he draws his last breath.  Very sad.  I am again hopeful that JP Morgan has their sights on WaMu and their $140BB deposit base, as well as their (rapidly shrinking) retail banking footprint.  Something should be happening this week or next, as I do not believe they really have the capital to make it much longer, especially in these damaged markets.  Wamu may become the new big-troublemaker after AIG because WaMu Failure Could Trigger Extension of Deposit Guarantees:

 

Many firms carry more than $100,000 in balances over the course of a month, particularly if they have a healthy payroll. And the requirements of payroll processing in particularly make it prohibitively expensive to operate multiple accounts. Although the Financial Times article does not address that issue, it does discuss that it may be necessary to increase the scope of FDIC insurance in this nervous environment.

All in all, as I write this post 20 minutes before closing today, the puts on financials are piling up, and the stage is being set for another raucous market Tuesday.  Henry Paulson has expressed his opinion that the regulatory system currently in effect is archaic, and is need of a complete overhaul. 

Say goodbye to the profits from over-leveraging in a fantasy market scenario where assets never lose any value.  We may see the pendulum swing back toward more regulation and away from the Gramm-Leach-Bliley Act  that was passed about 10 years ago, and that opened the door to the incestuous relationships between Consumer and Investment Banks.  Also watch for GE’s numerous mortgage-based money-pits start popping up in the headlines, and dragging down the giant. 

So, by years end we may see the end of the stand-alone investment bank, as Goldman and Morgan Stanley are the last holdouts.  We can probably expect them to find a distressed bank or two to pick up and diversify their capital base with the retail banking depositsthat have kept other financials out of any immediate liquidity problems.

The following is a fantastic reprint from Minyanville discussing some of the anticipated and surprise after-effects from the events this weekend and in today’s trading:

Roundtable: Why You Should Care That Lehman Went Bust

Even though Lehman Brothers was larger and older than Bear Stearns — its existence predates the Civil War — it was the first to get that dreaded dose of tough love. There was no Barclays or Bank of America deal, no “good bank”/”bad bank” arrangement — for the first time this year, the government allowed a large financial player to fail.

The implications of this failure are massive, and they’ll be absorbed over a period measured in months, not days. For one, Lehman’s 25,000 employees face an uncertain future. Its customers, many of them big financial institutions, will have to unwind what are bound to be extremely complicated transactions. And investors will have to figure out what to make of the largest U.S. investment bank failure since Drexel Burnham Lambert in 1990.

To get after that last issue, I asked a panel of Fool advisors and analysts to share their thoughts on these events. Here’s what they had to say.

1. As of Friday’s close, Lehman traded hands for $3 and change, down more than 90% from its 52-week high. Not many average Joe investors held this stock. So why is this failure so far-reaching?

Bill Mann, advisor: Lehman matters for its role in the financial markets far beyond its own capitalization. Lehman owned some $600 billion in assets, some more liquid than others, all of which are likely to be sold during bankruptcy. There should be no doubt, for example, that some of the extreme levels of volatility in emerging markets have come from Lehman Brothers selling heavily to raise cash in the face of this crisis.

Andy Cross, advisor: Lehman is the latest financial butterfly to flap its wings, and it’ll have ripple effects throughout the entire world of finance. What’s interesting in this case is that the Federal Reserve put its hand up to say “enough.” After bailing out Fannie Mae and Freddie Mac, and backing the JPMorgan Chase buyout of Bear Stearns earlier this year, the Fed apparently decided that Lehman did not qualify as “too big to fail.”

Tim Hanson, senior analyst: This isn’t just about Lehman. The company’s bankruptcy filing this morning is the latest symptom of a sick financial sector. In a way, this whole experience illustrates just how intertwined the global economy actually is. What started as the admirable goal of helping a few more people own their own home and jumpstart a slowing economy in the wake of crisis (Sept. 11, 2001) ended up inflating a massive housing bubble, encouraging financial institutions to take on unprecedented amounts of risk, taking down a number of venerable financial institutions, and decimating consumer confidence. This has essentially put us back to where we started: looking for ways to jumpstart a slowing economy in the wake of crisis. It will, however, take time. Lehman now must unwind its enormous trading positions, which will put greater downward pressure on asset values in the near-term.

2. Can U.S. taxpayers in any way rejoice that this marks a tide change in how the government handles large, failing financial institutions (or non-financial institutions)?

Mann: I think we can describe this past weekend’s events as an accidental victory for capitalism. Several big banks and several government entities sat in a room with the express purpose of figuring out how to rescue Lehman Brothers. The government stated that it would not guarantee Lehman’s liabilities, and one by one the banks dropped out of the bidding.

Now, recent activities in subprime securities notwithstanding, these big banks are run by fairly smart people, all of whom came to an obvious conclusion: If they did not step in and help rescue Lehman Brothers, their own stocks were going to be mauled. And yet they still decided that taking on the risk wasn’t worth it.

In the end, no one stepped in, and Lehman filed bankruptcy and will be wound down. While it probably feels a lot worse today around the globe as the financial system takes a massive shock, I believe that Lehman’s failure will help clean out the system faster than if billions of capital were being used to prop it up.

Of course, the cynic in me also says that Wall Street probably has learned two additional lessons. First, if you’re going to fail, be the first to do so. Bear Stearns got help. Lehman got bupkis. And second, if you’re going to take on risk, don’t just put your company at risk — make sure you rope in whole segments of the global economy.

Cross: The optimist in us all searches for the silver lining when we see a 158-year-old firm collapse under its own heavy leverage and poor risk management. I’m encouraged that the U.S. government apparently knows when to say “no.” Too bad so many once-stout investment and traditional banks didn’t have the same discipline when they were writing or selling risky loans and financial instruments.

Bill Barker, senior analyst: In any way? Well, rejoice is a little strong, but let me count the ways investors can be grateful:

Less taxpayer money used to largely reward undeserving executives.

There should be a renewed sense of urgency on the part of any financials with deeply flawed models and sketchily capitalized balance sheets to fix their problems now instead of waiting for help.

The market is all about getting rid of uncertainty.

In its own bizarre way, the government’s clear statement that it won’t bail out every company like Lehman makes these resolutions a bit more certain. Either these companies succeed or they fail — completely. It’s slightly easier to do the math and value companies when you get into binary outcomes, rather than having to calculate multiple scenarios and assign various probabilities to outcomes that you can’t even quite define. In the long run, I think this helps valuations of these companies, though obviously none of them are going to fetch better prices today.

Hanson: I’m not sure U.S. taxpayers (i.e., us) have much at all to rejoice about right about now. Our economy is fragile, we have a tremendous and growing deficit, and our obligations continue to pile up. The fact that the government did not step in here hopefully indicates that aside from the unwinding that has to take place, the Lehman fallout won’t be that bad. Going forward, the government may decide that it does not want to risk having to deal with large, failing financial institutions and decides to start breaking them up — which would be bad news for Bank of America and its growing collection of financial assets.

3. In 2008, there have been several high-profile failures or near-failures: Bear Stearns. IndyMac. Fannie Mae. Freddie Mac. Now Lehman Brothers. The FDIC increased its “problem bank” list by 30% last quarter; there are now 117 banks on that list, totaling $78 billion in assets. Given all of this, do you think we’re closer to the beginning of this mess, or the end?

Cross: My crystal ball is fuzzy on those details. And I think anyone giving you a straight answer has a bridge to sell you in Brooklyn. From what I can tell we still have a few chapters left in this story. But investors who are well-diversified across industries and market caps should be able to weather this storm, even if a few of your stocks are taking a beating today.

Barker: We’re far closer to the beginning of the number of companies that are ultimately going to fail. There will be far more than the handful we’ve seen so far. But I think that we’re much closer to end of general destruction of market capitalization of these companies, and the ultimate total of write-offs that we’ll see from them. We’ve already seen far more than $500 billion in mortgage-related write-offs, and I think that’s closer to the end than the beginning.

Hanson: Given that this mess is almost seven years old now, odds are we’re closer to the end. That’s not to say there won’t be an alarming climax, but the remaining big financial institutions (Bank of America, JPMorgan, Goldman Sachs, and Morgan Stanley (NYSE: MS)) look to be in better health than the companies mentioned.

4. For financial-related stocks, the bad news has been relentless. What would you tell investors about fishing for bargains in financials right now?

Mann: Don’t be fooled. Lots of financial companies are exhibiting enormous dividend yields and look extremely cheap on a price-to-earnings and price-to-book basis. But earnings and book value are historical measures, and many banks and financial institutions have fundamentally changed. One of the fundamental rules for dealing with a burning building is not to run into it if you’re already safely outside. Let others be heroes.

That said, in every sector there are good and bad companies, and the financials are no different. There are bank companies that have little to no exposure to the worst segments of the real estate market, and they’re gobbling up market share. These are among the financial companies that have dropped the least. Companies like PNC (NYSE: PNC), Wells Fargo (NYSE: WFC), and BB&T (NYSE: BBT) are quite cheap, even though they don’t look like it next to their scorched cousins.

Cross: I’m not ready to double down on financials yet, but for investors who are willing to take on a bit more risk you could look at a few banks. BB&T is one of the best out there. But again, make sure you’re diversified — in this environment, these bank stocks could continue moving south even if the companies’ fundamentals are relatively strong.

Barker: Don’t — please don’t.

All right, with more color: Invest in what you know. Invest in what you understand, or are capable of coming to understand. If you think that you can figure out the balance sheets of financials — great. But you’re in a very, very, very small group if you’re actually able to gauge what’s going on there. You might invest in Berkshire Hathaway, because if anybody’s going to make the right move scavenging from this mess, it’ll be Buffett and Munger. But doing it on your own? There are better opportunities out there.

Hanson: All stocks have been punished recently, not just financials. As a fellow investor pointed out to me on Friday, it’s either the end of the world or an incredible buying opportunity. Either way, as a modern day Pascal might wager, we should be buying, and the best opportunities are in the non-financial stocks that have been punished without even being tied to the current crisis. There is a caveat: It could get worse before it gets better. In other words, be absolutely certain that any money you put in the market today is not money you need to pay near-term bills. Be prepared to leave today’s investments alone for the next three, five, or forever years.