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September 15, 2008

Lehman - Only the Stock and Bond Holders Should Expect Losses (Not Customers)

John P. Hussman, Ph.D.
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Well that was fast.

As I noted in last week's market comment, “by essentially capitulating that Fannie and Freddie have to be taken over, the government is also sending a signal that other financial institutions (particularly investment banks with high gross leverage multiples) may be vulnerable to failure.”

It's important to recognize that the timing of the stress at Lehman is not a coincidence independent of the Fannie and Freddie bailout. Rather, the U.S. government essentially sent an information signal that highly leveraged financial institutions were insolvent. Next to Bear Stearns, Lehman had the highest gross leverage multiple on the street (the continuing problem is that several others are quite close). Last week, Lehman reported $600 billion in assets, on less than $20 billion of common shareholder equity. Evidently, the markets (and potential acquirers) don't believe that the $20 billion is as tangible as Lehman reports. Put another way, a markdown in the value of Lehman's assets by just over 3% would wipe out that reported shareholder equity. One would need to have a great deal of faith in that asset valuation to be willing to buy the company out at any price, since an outright buyer would have to agree to pay off Lehman's bondholders (in excess of $100 billion).

A buyer might very well be willing to pay nearly $100 billion for Lehman's assets, as well as its customer and counterparty liabilities, but the proceeds wouldn't be quite enough to pay off Lehman's bondholders entirely. That's what everyone has been trying to avoid. Not customer losses, but a bankruptcy that would leave Lehman's bondholders less than whole.

Note the problem is not just one of “illiquidity.” Even if your assets are worth more than your liabilities, you can be illiquid without being insolvent, in the sense that your cash immediately on hand is not sufficient to meet demands for withdrawal or other payments. Insolvency goes further, to the point where the market value of your assets falls short of the market value of your liabilities.

As I write this Sunday evening, the outcome for Lehman is still not clear. But I'll repeat what I wrote about such issues in the April 7, 2008 comment:

“In any event, SEC Chairman Cox is right – Bear Stearns' customers and counterparties were never at risk of loss. Though counterparties don't have the SIPC protections, they did in the Bear Stearns instance have a substantial capital wall and legal safe harbors specifically designed to limit systemic problems. There was a willing buyer for Bear's entire book, so the book didn't need to be unwound, just sold in its entirety on day one. Major U.S. financial companies have enough capital (shareholder equity and bondholder debt) to provide a cushion in the event of substantial writeoffs, without customers or counterparties being at risk of loss in the event of outright bankruptcy. The only instance where there would be a question would be if the book value of the failing company was negative after entirely zeroing out all shareholder equity and bondholder debt, or if the only way to liquidate the book was to unwind it. That was not the case for Bear Stearns.

“As I said a couple of weeks ago, if we keep on believing that the default of Bear Stearns bonds ("bankruptcy") would have caused a global financial crash, then I expect that we are in for a global financial crash anyway. Not because there is any true risk to customers and counterparties, but because investors are misinformed about how the financial markets work, and they will panic as foreclosures and writedowns inevitably soar in the months ahead. A financial panic is fully avoidable if Wall Street and the media stop propagating the utterly false belief that a Bear Stearns bankruptcy would have led to a “chain reaction” of financial losses. While we might very well see some over-leveraged firms go bankrupt, with substantial losses to their own stockholders and bondholders, the customers and counterparties are generally not at risk if there is enough stockholders equity and bondholder capital to eat through without leaving the remaining book value negative. Bankruptcy or no bankruptcy, the underlying book of assets and liabilities can be transferred quickly. The only question is how much the bondholders come away with.”

In Lehman's case, $20 billion in shareholder equity is a very thin pool of funds to eat through when you're not confident in the true market value of the $600 billion in assets held by the company. But it's crucial to recognize that if you include both shareholder equity as well as Lehman's debt (bonds and subordinated debt), you've got a $143 billion cushion to eat through before any customer or counterparty would be at risk. With that kind of cushion, the issue is not, and probably will never be whether customers or counterparties are at risk. The only issue is whether you save the bondholders.

Essentially what we've got here is an economy where the government provided a boatload of tax cuts, the benefit of which was invested directly and indirectly into mortgage securities, which helped to finance irresponsible lending, which produced a housing bubble, and now that the bubble has burst and the mortgage securities are losing money, those same bondholders are looking for the government to bail them out.

That's messed up.

As a sidenote, I should note that the main downside of a Lehman (or other) bankruptcy will not be for customers or counterparties, but to its debt holders, and by extension, institutions that are heavily exposed in the credit default swap market. To reiterate a point in my 2003 piece, Freight Trains and Steep Curves:

“Aside from the risk that any particular link in this chain might be weak (know thy counterparty), the U.S. financial system has gone one step further. In order to hedge against the risk of defaults, banks frequently lay credit risk off by entering “credit default swaps” with other banks or insurance companies. These swaps essentially act as insurance policies for credit risk.

“Once again, however, the iron law of equilibrium is that every risk swapped away by someone is held by someone else. According to Bloomberg, over half of the world's trading in the credit swaps market is concentrated among five banks: J.P. Morgan (26%), Citigroup (10%), UBS Warburg (9%), Bank of America (7%) and Deutsche Bank (7%).”

It's not just credit

Though the drama of credit defaults, bankruptcy risk and government bailouts makes it seem that the current bear market is only about credit, it's important to recognize that there are other (equally expected) difficulties that the U.S. stock market faces.

Beyond concern about U.S. financials, I've consistently emphasized that the U.S. stock market has been very strenuously valued in recent years, primarily because investors were placing historically rich multiples on earnings that themselves were driven by profit margins about 50% above historical norms. It is those fundamental objects – valuation multiples and profit margins, that have placed an overhang on stock market returns, and will continue to do so until stock prices reflect relatively normal multiples on relatively normal profit margin expectations. That doesn't mean that stocks have to move to deeply below-average valuations or profit margins have to revert entirely to historical norms. But the extreme assumptions that have propped the market's valuation up in recent years are beginning to unwind. To some extent, the constant hope and excitement about credit bailouts simply draws out this process.

Market Climate

As of last week, the Market Climate in stocks was characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance. The best way to open the potential to increased risk exposure and more constructive investment positions would be for the market to move a good distance below the recent trading range. As I noted last week, that would create what I think is the best we can hope for at present, which would be an advance back to this area. While current levels do not provide the expectation for strong long-term returns (our current 10-year total return projection still being in the 4-6% range), normalized valuations are not so high as to be unsustainable, so substantial moves below this range create some prospect for appropriate risk taking from an investment (not simply speculative) standpoint.

In bonds, the Market Climate last week was characterized by unfavorable yield levels and relatively neutral yield pressures. Inflation pressures are likely to abate significantly in the months ahead, owing both to slowing global demand and to credit concerns (which lower monetary velocity – essentially increasing the demand for currency as a safe-haven, which slows its erosion of value). I continue to believe that the U.S. dollar is at substantial risk of a fresh depreciation. Though the economies of Europe and the rest of the world are slowing, the deterioration in the U.S. economy is also ongoing, and other countries have nowhere near the burden the U.S. does in terms of dependence on external capital. From my perspective, either U.S. domestic investment will weaken sufficiently that those capital needs will slow (which will tend to pressure the U.S. dollar via general economic weakness), or our continued reliance on external capital will pressure the dollar lower in order to create an incentive for foreign savings to finance us.

Though Treasury yields continue to be pressured on periodic credit concerns, the level of yields is low enough to create the risk of periodic yield spikes that can easily wipe out a year or two of interest differentials (compared with shorter-term Treasury yields). For that reason, the Strategic Total Return Fund continues to carry a relatively short duration of about 2.5 years. On the profound weakness in precious metals shares, especially on Tuesday (when the gold/XAU ratio spiked to about 6.7 and the XAU itself dropped close to the 100 level - at which point gold prices could have dropped by nearly half without the XAU being out of line), we moved just over 12% of the Strategic Total Return Fund's assets into precious metals shares, modestly reducing our foreign currency holdings to keep our overall allocation in precious metals shares, utilities and foreign currencies to 30% of assets (as of the time the positions are established).

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