The Worst Is Not Over
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Dan Amoss thinks he’s found the next culprit. And this isn’t just a gut feeling, there’s real evidence here. Is the worst behind us? Dan doesn’t thinks so.
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 moneymaking 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.
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Lehman Brothers (LEH: NYSE) 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.
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Tags: Amex, Bank Of America, Bear Stearns, Dealer Index, fed, Financial Sector, Investment Banks, LEH, Lehman Brothers, Merrill Lynch, Mortgage Securitization, Nyse, Securities BrokerAbout the Author
Dan Amoss, CFA, is managing editor for Strategic Investment and a contributing editor for Whiskey and Gunpowder. He is a Chartered Financial Analyst and joined Agora Financial from Investment Counselors of Maryland, investment advisor's for one of the top small-cap value mutual funds. Dan combines his institutional background with a drive to seek out the most attractive investments within big picture trends.
Whiskey & Gunpowder is free e-letter that explores the government’s intrusions into every day life. Whiskey & Gunpowder offers biting analysis of hot-button housing issues, gold news, and commodities and resource investing strategies so you can protect yourself as the Constitution is slowly erased. Featuring insightful articles that explore a range of topics including commodities, politics, technology, nature, history and anything else our writers could possibly dream up, Whiskey & Gunpowder offers the kind of analysis that the mainstream media will never give you.