Tuesday, June 03, 2008

Lehman Brothers to the Market: Your destiny lies with me!

Our discussion of Bear Stearns' collapse (check out the comments, some really good stuff there) and what may or may not have prevented it is not entirely academic. Witness the trials and tribulations of Lehman Brothers, the new Dark Lord of the Credit Crisis. Today the Wall Street Journal is reporting that Lehman is looking to raise $3-4 billion in new capital, probably via straight common equity. Lehman has come out saying they don't "need" to raise capital, but they aren't ruling it out. If you read the Journal piece closely, you can see that Lehman isn't really contradicting the story. The Journal says...

"The amount of new capital under consideration suggests Lehman's quarterly loss could be larger than the $300 million or so that some analysts have been expecting."

So the possibility of Lehman's loss being exceptionally large is speculation on the Journal's part. Perfectly reasonable speculation, but speculation none-the-less. Lehman's non-denial denial, if it can be believed, only implies that they won't be forced to raise new capital because their losses are so large.

Getting back to Bear Stearns. The preponderance of evidence is that Bear Stearns would have been profitable in 1Q 2008. And yet they were about to be bankrupt mere days before reporting that profit. It is clear that Bear Stearns would have been able to continue operating had they been able to remain liquid.

According to the Wall Street Journal's excellent 3-part series on Bear's collapse, Bear Stearns CEO Alan Schwartz was confused and frustrated by the persistent rumors about his firm. He knew they had big mortgage exposure, but seemed to believe they were strong enough to get through it. But according to the Journal, as early as December, Bear's trading partners were growing uneasy. PIMCO told Bear to raise equity after nearly demanding an unwind of billions in trades, according to the story.

Its downright criminal that Schwartz continued to ignore these warnings. It may have been mere rumors that took Bear down, but Bear (and the Cayne/Schwartz team specifically) stuck their heads in the sand and refused to do anything to quell the rumors. Consider the apparent sequence of events:

  • Trading partners tell Bear they are uneasy and want to see more equity capital.
  • Bear does nothing.
  • It starts getting around the investment community that Bear is too leveraged, but won't raise capital.
  • The conclusion is that Bear's management is either deeply in denial about their condition or they are unable to raise capital.

That sequence is more or less known at this point. Note that even if one were to assume that Schwartz had been right, and Bear did have plenty of cash/hedges to offset mortgage losses, it wouldn't have mattered. Take the most positive possible spin on what seems to have happened next, and Bear is still toast.

  • Bear's lenders hear the concerns that PIMCO and others have. (Again, taking the most positive spin possible) Lenders don't necessarily think Bear is in immediate trouble, but still don't want to be caught as the last ones out if things turn south. Lenders like Rabobank decide not to renew short-term lending programs.
  • Prime brokerage clients, realizing that prime brokerage is a completely fungible service, have all risk and no reward by sticking with Bear. Note that they don't have to be panicking in order to reach this conclusion. If there is a 1 in a thousand chance of a disaster, with no reward for the 999/1000 outcome, why take that risk? These accounts start pulling out.
  • A classic bank run ensues.

But what would have happened if Bear Stearns had bolstered their capital base back in November or December? We'll never know, of course, but there certainly is a pretty good chance their major trading partners and lenders would have felt more comfortable. More confident. And more confidence is all it would have taken.

Back to Lehman. Some readers may remember that in 1998, during the Long-Term Capital Management collapse, Lehman was supposedly teetering. At the time, Lehman took the tact of simply denying the rumors. According to various reports I've read, ten and current Lehman CEO Richard Fuld wants to be more aggressive this time around. The firm has already raised $6 billion in new capital (vs. writedowns of $3.3 billion). Its sounding like whether or not they have big losses to report, they are looking to raise more.

I for one really hope they do. And I hope they do it via straight common equity. Because the more Wall Street accelerates their deleveraging, the sooner the financial system can regain solid footing. Lehman seems to understand that a stable financial system is better for their bottom line, and hence short-term pain of equity dilution will ultimately be in their long-run interests.

I also hope that Lehman and others move to write down what needs to be written down. Bear Stearns collapsed because no one understood what they owned and what risks they had courted. The more Wall Street's stuff gets written down, the less the public will worry about it, and the less chance we'll see another run on the bank.

16 comments:

Sivaram Velauthapillai said...

I'm just a newbie (don't work in the field or anything) and respect your opinion but I have to disagree with your regarding Bear Stearns.

You are speaking like a bondholder who ignores the business side of things. Just because customers ask you to raise more capital doens't mean you should. If companies did whatever the rumour mill was pressuring them to do, they never would go anywhere--not to mention diluting shareholders or just ignoring shareholder concerns. Consider countries like Japan where shareholders have very little say in their own firms, because, well, everyone else, including banks, public, government, etc, dictate the behaviour of the company.

Furthermore, consider the possibility that raising capital may weaken confidence further. Right now it is a fashionable thing to raise money but if Bear did that 6 months ago in any sizeable amount, it would have been one of the first ones to do so. It wouldn't surprise me if customers lost even more confidence had Bear Stearns done that (i.e. Bear actually has problems and why do business with them).

From what I gather about Bear Sterans--all of it in hindsight as well--raising a few billion would have done nothing! Unless your idea was to raise tens of billions (on top of this being difficult, even this may not have been enough), a run on the bank would still have brought it down.

Goldman Sachs, highly regarded by many and somehow avoided serious damage due to mortgage problems, can easily collapse tomorrow if there is a run on the firm.

In any case, I hate to say this but Bear Stearns probably couldn't have done anything. Let's say they had a few extra billion from a capital raise a few months ago. Customers would still be concerned given that its leverage was somethinge like 30x and Bear was a big player on mortgage products.

Bear Stearns simply was overleveraged with poor assets (questionable mortgage stuff) during a credit crunch. Hard to make a save in that situation. I think a run on Bear was still possible even if they had raised capital before.

I'm not implying that firms shouldn't shore up their balance sheet; however a run on the bank can easily collapse all these heavily-leveraged businesses, and I'm not sure if Bear Stearns' fate wasn't already written...

James I. Hymas said...

AI : Bear Stearns CEO Alan Schwartz was confused and frustrated by the persistent rumors about his firm. He knew they had big mortgage exposure, but seemed to believe they were strong enough to get through it.

The tragedy is, that if they had made it through, he would have gone down in the books as a steely-eyed executive with brass balls, who refused to dilute his shareholders and made them a fortune over the next few years as the mortgage holdings ran off the books.

The difference between hero and goat is razor-thin, and there ain't no textbook!

SV : Just because customers ask you to raise more capital doens't mean you should.

No, certainly not. But the people that needed to be impressed weren't customers, really: they were lenders. If I buy some Bear Stearns paper maturing next week for my clients ... I want the money back next week! I do not want to explain to MY customers why their assets are tied up in bankruptcy court for three years.

March was a wild time. CIT drew its lines; European speculators took a run at HBOS; there were rumours being passed on every day.

If BSC had taken dramatic action - diluting shareholders, paying up for 10-year bond money - you're quite right ... it wouldn't, all by itself, have made a huge difference to its leverage. But it would have given the Money-Market Nervous Nellies confidence that BSC was willing to do whatever it took to stay afloat.

And there would have still been plenty of second-guessers making Schwartz's life miserable.

Accrued Interest said...

Lehman story seems to be driving the markets lower at the moment. I think a contrarion play in brokerage stocks is intriguing, but Lehman looks like its going to close below its 3/17 low (closing not intra-day). The technicals look real bad and I wouldn't fight them no matter what your fundamental view.

psychodave said...

I think a contrarion play in brokerage stocks is intriguing
So might I, but I'd like to hear AI's latest on his JPM position first ... (pretty please)

Accrued Interest said...

Sold it. As some who e-mail me from time to time know, I trade the living shit out of my personal accounts, much to my compliance officer's chagrin. Most of it is in closed-end funds, playing some techincals there. I wind up doing a little in puts and calls on financials, since I'm closer to those stories than other stuff.

Anyway, I was long JPM and AGO about a month ago. Sold both. 20%+ gain on JPM, 5% loss on AGO.

Now I have a pair trade on, long WFC and short WM. I think if you want to own a bank, own the strongest one. And I think there is little WM is going to be able to do in the near term, and there will be a slow capitulation to this fact. Good sized gain on WM so far, small loss in WFC.

Anonymous said...

Super post.

Natixis in France is offering stock-holders stock instead of a dividend...if they want to. They have a choice.

The savings-prone French, I believe, are handling all this more creatively and more (a word I despise) pro-actively (ugh) that the US.

But equity is the name of the game, and dilution is its bedfellow.

Accrued Interest said...

*LEHMAN SAYS LAST TIME IT WENT TO FED FACILITY WAS APRIL 16

*LEHMAN DENIES SPECULATION IT ACCESSED FED BORROWING FACILITY

*LEHMAN SAYS ITS LIQUIDITY POSITION IMPROVED TO $40 BILLION IN 2Q

Lehman CDS is still off ~35bps but looks like 15 better than the lows.

ziggurat said...

Overall good comments. I would add that denying rumors is also a problem. Any comment just adds fuel to the fire.

There are a couple of big differences for Lehman. First, they can take less liquid assets to the Fed, unlike Bear. Secondly, heavy bets on CDS's won't occur since the Fed has drawn a line in the sand regarding defaults.

Anytime you borrow short and lend long you are at risk from a squeeze or run.

I am not a big fan of the prime brokerage business. This is a fault line where hedge funds meet the regulated economy and it seems to be the worst possible space to try to make money. It's just a bad game when your customers are the wise guys. It's not like everyone has their own turf and stays on it. The hedgies will do anything for a few basis points, including blowing up their suppliers.

From a meta perspective, the entire sector would have gone down without the Fed. Bear was just where they drew the line.

I was just watching parts of the movie, 'Rounders', and the line, 'short stacked and no outs' comes to mind.

Lehman should raise a lot of capital, just to show that can and will.

UrbanDigs said...

I guess the rumors I was hearing the week of May 19th turned out to be accurate regarding LEH!

You have any position in it?

Accrued Interest said...

Zig:

I'd say the Fed now views prime brokerage pretty much the same way it views bank deposits. By opening up the discount window, they're saying that prime broker withdrawals alone will not bring a primary dealer down.

Urban:

I had a small call on Lehman a few days ago, got stopped out yesterday. As I've said, I'm playing the stock market from the short side generally, but I do think there are contrarion long opportunities. But I'm keeping my stops tight.

Right now the technicals on brokers look terrible. Earnings are going to be a significant catalyst one way or the other, so I think if you want to play a contrarion, you should get long ahead of earnings. But beware coming in too early. Having a 10% pop on earnings doesn't help you if you are down 15% prior to earnings!

You also have to go into this with your eyes wide open. The only reason a broker long will work is because the shorts will have to cover if earnings are OK (as opposed to terrible).

I'm debating whether to play with Lehman (biggest short interest), Morgan Stanley (Lehman Lite), Goldman Sachs (scares me because there isn't as much bad news already priced in), or whimp out and just buy a broker ETF.

UrbanDigs said...

ahhh..you'll fight with me if you knew my positions for past 6-8 months.

Been playing SKF, SRS, EEV, DUG, FXP. So, really been focusing only on shorting. Tough to trade back and forth, because you dont know when that shock will come. Im 100% short. I must say I was quite confused 3 weeks ago as we hung around 13,000 for a while. Me and all my contacts were dumbfounded.

Think back to those that profited from shorting subprime. They put those positions on in mid-late 2005. They had to wait a long time to have it pay off. When I look at macro, you just know how the story will end. It will take time. Its an election year.

The game is over for brokers. I discussed on JAN 2nd:

http://www.urbandigs.com/2008/01/bonuses_its_2009_that_will_hur.html

Reminds me of when decimalization killed day trading for most of us who didnt evolve into position managers. Trading NASDAQ equities since 1998 with Tradescape (lightspeed platform, formed by DATEK traders)

Good times. Anyway, the IB's model today and what lies ahead is very suspect! As Gasparino is now saying ad nausem on air.

This credit cycle / deleveraging will come and go in waves. You have to have short exposure, and cover when vix spikes as market goes your way. I did lighten up my shorts though in past few sessions, damn it! I think another shock to system isnt too far away. I hope Im wrong.

urbandigs said...

sorry, here is link to discussion on today's Gasparino topic of 'how will IB's make money with no new product yet, and loss of major revenue generator':

Bonuses: Its 2009 That Will Hurt More

"Then came decimalization around 2002 I believe, can't remember. Stocks no longer traded in fractions, and instead started trading in dollars & cents. So, that same EBAY trade that I described above would now have a bid / ask more similar to say 99.98 x 99.99, giving us a penny spread. With spreads so tight, stocks just didn't move the way they used to; and a crash from the dot com bubble didnt help either. The game was over in my mind!

Back to the discussion so I can relate the analogy. The derivatives trade of securitizing loans and selling them off in pieces on the secondary mortgage markets generated billions in revenue for these banks & brokerages. Now that the housing bubble popped nationally, risk has been re-priced, secondary mortgage markets are not functioning properly, liquidity dried up for mortgage backed securities, and the announcement of billions in losses and potential insolvencies, THE GAME IS OVER! How will these banks and brokerages generate the kind of revenue that they got used to generating the past few years? "

Why did this concern take so long to become on air news?

Optionarmageddon said...

With all the 2nd liens lying over WFC,if and when they come clean the bank will be viewed differently. They were lending to 100% on a ton of loans out here in California for too long.

It's funny how everyone thinks the writedowns are coming to an end. This is sad because it's just the beginning and once this is realized watch out below...

Anonymous said...

AI

Great post again. Lehman is in tough shape and got a reprieve when BSC was bought by JPM becasuethey would have been gone by March 20th if BSC was not saved. Lehman has teh same issue as BSC in that they do not have a deposit base and runs entirely on teh cash from its PB business (which can be fleeting and awfully non profitable if your interest rate goes through teh roof) and from Repos (where counterparties can get out fairly quick). Remeber BSC was okay until Thursday morning when their counterparties did not want to reup their repos. Lehman needs to raise capital or it will need to hit its bank facility.

Anonymous said...

Most blogs, other than this one, seem to be questioning whether Lehman really had a profit 1st quarter. It seems it was actually a combination of legitimate one time gains but mostly implausible accounting gains. Even then it was a barely positive (for Lehman's size) ~150MM.

Was Bear profitable in the first quarter? A whole bunch of Monday morning armchair quarterbacks seem to think so.

Hymas likes to quote SEC chairman Cox in saying everything was OK. Are we to expect the SEC chairman to say a company his commission was supposed to be regulating was not OK?

Missing from AI's discussions is the background of what started Bears decline. It didn't happen overnight.

PIMCO started questioning Bears solvency (a little), but mostly its absurd leverage, starting in December. Pimco isn't some fly by night operation that any competent CEO should ignore.

If there was no problem, Cayne should have addressed their concerns. Either delever or issue an explanation why Pimco's analysis might be in error. Silence was basically saying Pimco was correct.

It was only after Bear got itself completely over levered in very illiquid mortgage securities that Pimco questioned them. And it was only after Bear ignored Pimco's concerns for over two months that there was "suddenly" a "run on the bank".

You may remember that Pimco questioned the leverage and financing of General Electric a few years back. GE was too reliant on short term CP to fund its operations Pimco said. GE addressed Pimco's concerns, partly by delevering and mostly by shifting to longer term financing.

Bear had at least two months to address Pimco's concerns one way or another.

Interestingly, Lehman isn't using Bear Stearn's ostrich approach to balance sheet management. They are publicly talking about their cash position, their lack of use of the Fed's special lending facilities, etc. Lehman has a lot more friends on Wall St, so arguably Morgan Stanley (and others) are helping them avoid the need to go to the Fed... but the point remains that Lehman management, unlike Bear, is trying to give hard numbers to support their solvency.


The big issue that even the folks at CNBC have pointed out is that the problems facing Bear and Lehman face every major sell side house on Wall Street. Bear and Lehman just happen to be overly concentrated in mortgage products, so they are "going down" first.

All these firms got themselves massively over levered-- meaning they had (past tense) very little real equity with which to withstand even a small decline in the mortgage market. 30-1 leverage means you only have "room" for a 4% loss (approx) -- and we all know non-conforming loans are off by way more than that. Even conforming loans are off by bit (and LOAS spreads are wider if they were hedged). This is a fancy way of saying that most of Wall Street has no equity -- and a few have negative equity.

Bear had negative equity, or at least it did before the Fed carved out the garbage from Bear's balance sheet. Cherry pick the best assets (and only half the staff) and its no wonder JPM was willing to pay $10 a share for the creme only.

Other firms are sitting on insufficient, or negative, equity. Its just a question of who.

Wall Street CEOs are belatedly raising capital to try to shore up their equity before anyone "proves" they are insolvent.

Ironically, the Fed's efforts to obfuscate true price discovery are making things even harder on the sell side. Since no one has real prices / real mark to market -- no one knows the truth. That makes rumors (founded or unfounded) a lot easier to start.

Chus said...

This is what I think: Lehman Brothers Bankruptcy