Lehman Brothers: Bounce too close to a supernova

I have nothing to say about Lehman itself, except to say that I really and truly believe they could have remained solvent in a more normal market. I'll also say I'm surprised no deal emerged as it seemed to me like there were enough parts worth buying. But deep down, I think Barclays in particular was scared that if they bought "Lehman" assets, the market would have seen it as nothing more than "Lehman" assets. In other words, Barclays might have gotten away with buying the same assets from someone else, but the very fact that they were Lehman's would create a special stain. What would then stop them from coming for Barclays? Ultimately, it was too risky.

On the market overall, it should be lower. Goldman and Morgan Stanley are going to have to merge with a bank. Period. Even if its a bank that's smaller (say a U.S. Bank), it will have to be done to diversify their funding sources.

This also pushes back any kind of recovery for the economy for a long time. I was thinking 3Q 2009, but now I'm thinking at least a year beyond that. I could be convinced to move off that either way by incoming delinquency figures, but for now I'm thinking year-end 2010 before any improvement in the economy.

So I've further reduced my credit underweight and increased Treasury exposure. The risk on Treasuries is the dollar. Most of the Treasury rally in September was dollar related up to today. For the moment we're getting a big rally on fear, which makes sense. But if the dollar starts to get pushed around, the Treasury market won't hold up.

Right now I'm willing to bet on Treasuries because I don't think Europe is any better off, and in fact I'd expect interest rate differentials to favor the U.S. on the margins (i.e., Europe will cut rates). But the situation is fluid enough to where I'm watching everything very closely.

This is truly uncharted territory.

Clumsy and Random Thoughts

• It is feeling very panicky right now, in that the market is moving suddenly and without proximate reasons. Unfortunately, the panic is legitimate. No one knows what a GSE bailout will look like.
• But you shouldn't conclude that a bailout would be difficult. Read this post. I stand by everything I said then.
• There are also rumors that PIMCO and SAC were not trading with Lehman. Both PIMCO and SAC have denied the rumor. Worth noting that PIMCO was one of the first to stop trading with Bear Stearns. Anyway, neither has reason to deny the rumor other than that the rumor isn't true.
• The more panicky things get, the more likely we get a relief rally after bank earnings are out. Odds are good that it will be a mixed bag, with some banks looking particularly ugly (Wachovia this morning warned of a huge loss) and others will be bad but not that bad. I mean, take a look at short interest on the NYSE...

• That being said, I don't think we can get a sustained rally (in credit or equities) until the market thinks it knows the outcome of both bank capital raising and home price declines. Now that will happen before housing has actually bottomed, because the market will look forward and conclude the worst is behind us.
• So I'm still vastly underweight credit generally and financials specifically. I've cut duration in an attempt to play a post-bank rally, but I'm just too chicken shit to buy a bunch of bank paper here.

LIBOR our only hope? No... there is another!

ICAP's, the largest broker of inter-lender transactions, has developed their own measure of U.S. inter-bank lending rates, ostensibly to supplant LIBOR. The first survey of New York banks was conducted today, and resulted in a 3-month rate 1.7bps lower than LIBOR.

Backing up a minute, LIBOR is supposed to be a measure of where very large and highly rated banks can borrow. Recently the accuracy of LIBOR has been called into question, some have gone to far as to say manipulated. U.S.-based banks in particular have complained that LIBOR, as currently constructed, is destined to fail as an accurate measure of U.S. lending rates.

This is because LIBOR is set by surveying 16 banks as to where they think they could borrow in U.S. dollars for various terms ranging from overnight to 1-year. Of the 16, only 3 are actually American: Citigroup, J.P. Morgan, and Bank of America.

Enter ICAP. Their survey will involve U.S. firms only, and will ask where the bank would lend to a un-named A1/P1 borrower for terms of one and three months. Called the New York Funding Rate (NYFR), it was set for the first time today at 2.4646% for one-month and 2.7715% for three-months. LIBOR reset today at 2.47688% and 2.78813%. Both are a little better by 1bps in the ICAP survey.

So what does this mean? LIBOR has been rising, from about 2.64% in late May to its current 2.79%. That 15bps does not reflect an increased probability of Fed hikes, at least not entirely. It reflects continued concern over the health of banks.

The fact that the NYFR was set lower would indicate that U.S. inter-bank liquidity is slightly better than in Europe. This is consistent with a widely held view that the risks in U.S. banks have been better disclosed when compared to their European counter-parts.

The swaps market reacted favorably, with 2-year swaps falling by 2bps and the rest of the stack falling by about 5bps.

In my opinion, fear about LIBOR is yesterday's news. The Fed has supplied access to tremendous liquidity to both banks and primary dealers. As a result, the jump-to-default risk has been greatly reduced. But that hardly leaves me bullish on banks or brokers. Today's market troubles are about a real lack of earnings power among financials. Take Merrill's downgrade of Lehman Brothers today. The analyst (Guy Moskowski) said...

"We expect LEH to survive because its liquidity profile is strong and the Fed discount window is open... but current business and asset mix are just not well positioned for the current environment."

I think you could insert dozens of bank/broker tickers into that sentence. He also discusses Lehman's book value (currently $33/share) but with little earnings growth in the near term, why would anyone pay close to book for the stock?

My point is that rising LIBOR was more about jump-to-default risk, which I think has abated substantially. So that's yesterday's problem. Today's problem is that banks have plenty of credit losses coming and so that will be tying up capital. They can't be turning in strong earnings if they are using capital on REOs. They also are facing weaker net-interest margin should the Fed start hiking rates.

Now I'd have to think that if I could look into a crystal ball and know for a fact that Lehman Brothers would survive as an independent entity one year from now, then I'd bet the stock would be a good bit higher. I'd say the same think about National City or Washington Mutual or CIT. But the odds are fair that each of those firms will seek a stronger partner sometime in the near future, and the merger price won't make the stock worth owning.

Lehman Brothers: Destructive power greater than half the starfleet

What to make of the fact that Lehman was apparently buying their own stock in the open market yesterday? Who knows. I think its supposed to send a signal that management remains confident, but no one is buying it. What seems more likely is that Lehman is close to a deal to sell shares to a private buyer (Korea?) and was trying to defend the price.

But here is a serious question that I honestly don't know the answer. Lehman reports earnings the week of June 16. Obviously the people directing purchase of Lehman shares have significant knowledge of what that earnings report looks like. We aren't talking about a run-of-the-mill earnings announcement here, where the question is whether EPS beats the street consensus by 2 cents or not. If Lehman has a significant writedown to announce, senior management already knows it. If they don't, management knows this too.

So given all that, why wouldn't this activity constitute insider trading?

Let's say, for the sake of argument, that Lehman actually has much better results coming that people think. Hey, anythings possible right? Maybe they indeed took losses on some CMBS hedges, as has been widely reported, but lucked into some gains on some other hedges. I'm not saying it happened, this is just for discussion.

So if indeed that's what happened, Lehman management is buying Lehman stock knowing it will rise in the near term. Management wouldn't be allowed to buy shares just before earnings for their personal accounts. But somehow the company can buy shares?

It smells fishy either way doesn't it? They are either just trying to prop up the price a little before a large equity sale. Or they are buying shares with insider knowledge.

Anyway, I know we have readers from the SEC and the Fed. And we have lots of other people more familiar with insider trading rules than I. Someone please explain how they are allowed to do this.

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.