Agora Financial’s Rude Awakening

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Baltimore, Maryland

• Will Lehman follow Bear’s market tracks?
• Financial institutions: The insane, the doubly insane and the triply insane,
• Trick question: When can a bank profit when the value of the bonds they have issued fall? The answer, and plenty more, just below…

Eric Fry, reporting from Laguna Beach, California…

“A few weeks ago the financial world was presented with the imminent failure of a publicly traded entity called Carlyle Capital Corporation,” recalled hedge fund manager, David Einhorn, as he launched into a fascinating presentation at the Grant’s Investment Conference on April 8th. “You see, it had leveraged itself more than thirty to one.”

“The press scoffed about what kind of insanity this was,” Einhorn continued, “Who in their right minds would take on such leverage?”

As the remainder of Einhorn’s eye-opening speech made indelibly clear, no one in his RIGHT mind would take on such leverage, but everyone on Wall Street would…and did. The big investment banks sport leverage ratios of 30 times or more…just like Carlyle Copr. “And I’ll tell you a little secret,” Einhorn smiled, “These levered balance sheets [at the Wall Street banks] hold some things that are dicier than government agency securities…They have various loans that they hope to securitize. They have pieces of structured finance transactions. They have derivative exposures of staggering notional amounts and related counter-party risk. They have real estate. They have private equity…And they hold this stuff on tremendously levered balance sheets.”

[To access the rest of Einhorn's fascinating insights about the troubled financial sector, click on the following link: http://www.tilsonfunds.com/Einhorn-4-08.pdf]

Somehow, insanely leveraged balance sheets, loaded down with doubly insane quantities of illiquid assets and triply insane levels of derivative exposure, became utterly “normal.” Everyone was doing it. And somehow, this insane modus operandi produced delicious, trouble-free profits for many, many years. But those Edenic days ended sometime last August. And there’s been hell to pay ever since.

It turns out that operating an insanely leveraged balance sheet wasn’t such a good idea after all. And it turns out that spending one dollar and borrowing twenty-nine to buy thirty dollars worth of exotic mortgage securities was just as stupid as it seemed to be.

At the same Grant’s conference where Einhorn presented his analysis, the billionaire hedge fund manager, John Paulson, remarked, “The maximum leverage that [my fund] has ever used…is around 2 1/2 to one. Could I ever run a portfolio that was 35-to-1 leveraged? No, even if I had shorts against it. I would never be able to match the shorts against the longs. It is just an excessive amount of leverage.”

Unfortunately, Wall Street’s whiz kids saw it differently. They loaded up the liability side of their balance sheets with lots of debt, then loaded up the asset side of their balance sheets with lots of toxic, illiquid assets. Guess what? It didn’t work. While the lightly leveraged John Paulson was busy making billions of dollars for his investors, the highly leveraged Wall Street banks were busy losing hundreds of billions of dollars for their shareholders.

In the column below, Dan Amoss, editor of the Strategic Short Report, handicaps the near-term prospects for the troubled financial sector, and offers a particularly grim prognosis for one particular member of the sector…

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What if the Worst is Not Over?
By Dan Amoss

Since the rescue of Bear Stearns on March 17, the Amex Securities Broker/Dealer Index has rallied 20%. The shares of Lehman Brothers have rocketed more than 30%. These dramatic rallies support the popular thesis that “the worst is over” for the financial sector.
But these dramatic rallies also provide attractive short-selling opportunities for every investor who believes that the “worst is yet to come.”

Most of Wall Street’s money-making machines have shut down. Mortgage-securitization activity has gone kaput, while IPO and M&A activities are sputtering. Even worse, Billions of dollars of future write-downs and losses are still buried inside Wall Street’s balance sheets.

Lehman Brothers (LEH) appears to be among the most vulnerable of all the investment banks. The stock has rallied hard since the Bear Stearns rescue. Because its business model closely resembles that of Bear Stearns, Wall Street thought Lehman was next. And it might have been, if not for the Fed.

The Fed instituted a lending facility allowing the investment banks to temporarily swap the ugliest “alphabet soup” assets for Treasuries. These alphabet soup assets - mortgage-backed securities (MBS), asset-backed securities (ABS), collateralized loan obligations (CLO), and others - had been smothering the brokers to the point that Bear Stearns was hours from declaring bankruptcy.

In the hopeful words of Lehman Brothers CEO, Dick Fuld, the Federal Reserve’s lending facility “takes the liquidity issue for the entire industry off the table.” Sure, the Fed’s actions may have forestalled a modern-day “bank run” on Wall Street. But the Fed has not solved the bigger, longer-term crisis.

The Fed’s new facility allows Lehman to temporarily swap its garbage assets for Treasuries. What it doesn’t do is protect Lehman shareholders from losses on these securities. Lehman shareholders will be the first to absorb these losses. Shareholders are in the most junior position in every company’s capital structure. So the more leverage - or debt - a company employs, the quicker shareholders get wiped out when assets sour.

As the chart below shows, Lehman’s equity (in red) supports just a tiny sliver of Lehman’s towering liabilities. Lehman’s gross leverage ratio amounts to about 32 times equity. This means Lehman’s assets can fall only about 3% in value before equity is wiped out.

Lehman is scrambling to reduce leverage and raise capital by selling illiquid assets into a weak secondary market. Unfortunately, illiquid mortgage-backed securities aren’t a particularly hot item these days. There are few buyers for such assets - even at steep discounts.

According to Bernstein Research, Lehman’s “troubled” residential and commercial mortgage assets amount to nearly three times its tangible equity. That’s danger level for Lehman shareholders. And the danger is growing…

Last year, the investment banks, including Lehman, adopted a new Financial Accounting Standards Board rule called “FAS 157.” This new accounting rule segregates balance sheet assets according to their liquidity and marketability. “Level I Assets” have readily available market prices. “Level II Assets” can be valued by comparing them to prices of similar assets. But “Level III Assets” lack any observable market price or price inputs. They are “marked to model” - not “marked to market.”

So how many Lehman assets are Level II and III? According to its latest 10-Q, Lehman categorized $60.5 billion and $23.8 billion of its mortgage securities as Level II and III assets, respectively. This adds up to $84.3 billion – or more than four times tangible equity per share! Therefore, if just 12% of Lehman’s $153 per share in Level II and III mortgage assets were written off - a reasonable assumption - such losses would eat through half of Lehman’s tangible equity.

The odd thing about Level III assets, also know as “mark-to-model” assets, is that the owner of them gets to decide how much they’re worth. I’m not kidding. Lehman management determines for itself the value of the Level III it owns. Therefore, no one can really know what the true value might be. There’s no way to know, for example, what models management uses to value its Level III assets. Hopefully, they are not using the same badly flawed models that predicted smooth sailing for subprime mortgage-backed
securities.

This lack of pricing transparency (or pricing reality) can be management’s strongest ally…for a while. But eventually, the truth will out. Eventually, the Level III assets will make their way from the dark recesses of Lehman’s balance sheet into the unforgiving light of real-world pricing. Eventually, living and breathing buyers will determine the value of these assets, not some mainframe computer in the Lehman back office. And as these real-world transactions occur, Lehman might face billions of dollars of additional write-downs and losses.

Lehman management has not been terribly forthcoming about reporting quarterly losses and write-downs. Brad Hintz from Bernstein Research hinted that fuzzy math produced Lehman’s “strong” March earnings report: “We believe the quality of these earnings was weak, as the firm benefited from a lower tax rate and enjoyed a $600 million mark-to-market gain on its liabilities.” That’s a polite understatement. Believe it or not, accounting rules allow investment banks to book a profit when the value of the bonds they have issued FALL. Follow along with this crazy logic if you can: Because the holders of Lehman’s bonds became fearful that Lehman would declare bankruptcy, the bondholders dumped the bonds at very low prices. Therefore, because Lehman’s bond prices tumbled, Lehman could, theoretically, buy back the bonds at prices much lower than the stated value of those bonds on Lehman’s balance sheet. As a result, this bizarre accounting rule concludes, Lehman can book a “profit” on the difference between the issue price of its bonds and the depressed market prices. Taken to an extreme, Lehman could probably post one if its most profitable quarters ever, just by declaring bankruptcy!

Obviously, falling bond prices indicate financial stress, and certainly do not produce sustainable, high-quality earnings. Such “earnings” do not generate cash or create any value of shareholders whatsoever.

Net-net, Lehman is still facing the likelihood of losing tens of billions of dollars over the course of the next few years. As losses pile up, Lehman will have to raise capital. That means flooding the market with LEH shares. Lehman may have to issue hundreds of millions of new shares at a discount to rebuild its capital shortfall, severely diluting the existing shareholders.

David Einhorn, an accomplished hedge fund manager, recently explained why he’s still selling short Lehman shares. In a speech at the April 8 Grant’s conference, he said that Lehman may have to boost its capital by as much as $30 to $70 billion. If Einhorn’s guesstimate is anywhere close to the mark, Lehman’s shareholders are in for a very rough ride.

The worst might be over for the financial sector, just like so many investors seem to believe. But a lot of bad stuff is still rolling our way. For the rest of 2008, therefore, investors might want to take their cue from Credit Suisse CEO Brady Dougan when he said, “The number of times people have seen the light at the end of the tunnel, it turned out to be a train coming down the tracks.”

Joel’s Note: As we’ve often said in these pages, “trains are for riding, not for getting run over by.” Actually, we’ve never said that…but you get the drift. Lehman might be on shaky footing, in other words, but you don’t have to tie yourself to the tracks. In fact, why not grab a ticket and ride the trend of collapsing financials all the way to the…er, bank?

Dan’s Strategic Short Report offers one of the best bear market strategies we know of and, given the case he makes above, we reckon it might be worth a look. You can read his Ultimate Bear Market Strategy report Right Here.

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Rude Endnote: Bad day for the markets yesterday. Good day for commodities. So, were you on the train as gold rose to $920 and oil nipped at $130 a barrel?

Send your thoughts on all things Rude related to the address below. Until tomorrow…

Cheers,

Joel Bowman
aussiejoel@the-rude-awakening.com