After the US government put out a forest fire with the takeover of Freddie Mac and Fannie Mae last week, Wall Street’s troubles were far from over. As they say, when you see a rat in the house, you can bet there are hundred more rats lurking in the dark corners. Slowly but surely, they are being flushed out now.
This week, we saw Lehman Brothers, the fourth largest investment bank, filing for bankruptcy protection, which sent massive shock waves through the global financial markets. Merrill Lynch merged with Bank of America as its shares went into a free fall.
Standard & Poor’s frowned on the deal as Merrill Lynch was snapped up for a 70% premium. BOA shares tumbled by 14 per cent as S&P cut its credit rating and warned that the deal would put further strain on the bank’s capital after its purchase of Countrywide (mortgage lender) in July.
Stock markets were pummeled and investors were especially concerned about Washington Mutual and AIG’s ability to meet short term obligations. Both could follow in Lehman Brothers footsteps if they failed to secure billions of dollars in capital and the ramifications of a melt-down are overwhelming.
Already, a Lehman Brothers bankruptcy implies a fire sales of its assets (stock, bonds, property and mortgage securities), depressing prices and forcing more write-downs by other banks and investment banks. In the coming months, we can expect tsunamis to test the foundations of the financial sector again.
Why was Lehman, a 158-year old financial institution, which survived world wars, scandals, in-fighting, loss of its independence, finally shuttered? Let’s recount the events. Over the weekend, bankers huddled in Liberty Street to discuss an emergency rescue plan for Lehman Brothers, in anticipation of a bank run and frenzied sell-off of its shares on Monday.
Barclays Bank which was in advanced talk to purchase the Lehman Brothers pulled out because no guarantor was in sight. Bank of America which was deemed to have the financial resources to absorb Lehman Brothers into its fold, also gave up when government support was not forthcoming.
To be frank, I will do so in their position too, for Merrill has a competitive advantage in retail banking and the atmosphere in Lehman Brothers is poisoned with internal politics and they have a history of being dogged by financial scandals.
As minutes ticked away, nobody knows who will bear the risk of an insolvent institution, without the backing of American taxpayers. Fact is, no one wants to be the “white knight” unless Lehman Brothers’s most toxic assets are taken out of the picture, that is, fed to the poor Americans.
Disaster loomed closer as Bloomberg arranged a session for netting derivatives transactions with Lehman, or canceling trades that offset each other, in case the investment bank goes under. Lehman Brothers did not disappoint with an abrupt bankruptcy announcement hours later.
When Chapter 11 was filed, Lehman Brothers cited bank debts of $613 billion, $155 billion in bond debt, and assets worth $639 billion. Very clearly, Lehman’s stocks are almost worthless. When all assets are sold (cheaply) to pay banks/creditors, bond owners, there is little left for for shareholders.
The sad fate of Lehman Brothers symbolizes the ills of Wall Street but they never seem to learn. Lehman played a dangerous game involving huge borrowings and high returns.
Explosion in leverage ballooned balance sheets to astronomical level – at the end of 2003, Lehman had $13 billion in shareholder equity and $312 billion in assets, which translates to $24 in assets for every dollar of equity.
By the end of 2007, Lehman’s shareholder equity rose 73% to $22.5 billion but assets soared by 121% to $691 billion – a whopping leverage of nearly $31for every dollar of equity.
Where were the board of directors, regulators and US government when the investment banks were up to their eyeballs in debts? Aren’t those responsible for overseeing these investment banks supposed to crack the whip when the fat cats stepped out of line? Fact is, every party is a partner-in-crime in the world’s best business which we call investment banking.
In a perfectly competitive environment, investors should be able to force market participants to provide higher quality products at reduced pricing, else the business goes elsewhere. Unfortunately, the “invisible hand” of free economy cannot function in this game as investment banks and their employees continue to make excessive profits at the expense of their clients.
Investors play the sucker’s role without a whimper of protest and pay for recommendations which often went awry. The recent housing boom saw investment banks posting record profits and growth. A substantial component came from fuelling investors’ desire for high returns by promoting mortgage-backed securities with Treasury-like safety and better yields.
However, these debts were actually cleverly disguised time bombs designed to blow up clients while fattening the coffers of investment banks. Thousands of such securities have been downgraded since the U.S. subprime crisis rear its ugly head a year ago.
In the corporate world, CEOs heeded the “trusted” advice of investment bankers that led to mergers and acquisitions in the hopes of creating value for shareholders. That usually ended in tears and massive write-downs. Nobody cared that the investment bankers were self motivated.
Investment banks also promoted exotic derivatives aggressively to corporate treasurers, pension funds and insurance companies, under the guise of reducing risk and boosting earnings report. Nothing could be further from the truth. Warren Buffett rightly described derivatives as financial “weapons of mass destruction.” Again, nobody cared to think why Warren Buffett made such a remark.
Lehman Brothers doesn’t deserve my sympathy. They participated in this housing boom wholeheartedly. Though they nearly collapsed under the weight of the Enron scandal in the 90s, they survived without any refinement in their risk management. The September 11 terrorist attack destroyed their office but not their spirit as trading resumed without much mishap.
Such turbulence must have bred a superiority complex that the organization can survive any crisis. Unfortunately, when you play Russian Roulette, you put your life on the line and this time round, Lehman could not escape the bullet.
AIG is currently suffering an unprecedented ordeal from credit swaps, which is a form of derivatives. I will discuss more about AIG as well the greed and narcissism of investment banks later. These rants cannot be covered in the space of one post.