For the past year, we have been advising investors to steer clear of the Finance sector. As we noted yesterday, Lehman was in the market buying shares as they fell 9%, according to the WSJ:
"Following an 8.1% drop Monday, Lehman shares slid 9.5% Tuesday. The latest decline came even though Lehman was buying back large amounts of its own shares. Tuesday in New York Stock Exchange trading, Lehman shares were down $3.22 at $30.61, 22% below their book value — the measure of a company’s net worth based on assets minus liabilities — at the end of February."
Why a company in need of additional capital is out buying shares requires a little explanation for the uninitiated: Any deal for a capital infusion will be based on share price. The firm is likely seeking to shore up that price — and a bit of confidence in management — through open market purchases. Although this strategy reduces the total shareholders dilution (what % the new buyers get) in the long, run, it has potential to be very problematic.
Indeed, this strategy proved to be disastrous in the 1929 crash:
"Perhaps the most intriguing parallel, though, is the crude attempt at self-preservation made by the investment trusts in 1929 and the banks now.
In the great crash, investment trusts with vast cross-holdings in each other tried to stem their collapse by buying up their own stock in what the economist JK Galbraith in his book, The Great Crash 1929, described as an act of "fiscal self-immolation". At the time, "support of the stock of one’s own company seemed a bold, imaginative and effective course," Galbraith wrote, but ultimately the trusts were just "swindling themselves".
The 1929 situation had as a key factor the Trusts cornering stocks, implementing short squeezes, aggressively plying rumors, and engaging in other unsavory trading situations. These came on top of more than a decade of stock gains. In the present case, the situation is based on highly leveraged financial companies, complex derivatives, and collapsing housing market.
So while many of the elements are very different, the one consistent parallel between the two periods is the excessive usage of leverage by banks and brokers.
And what has this leverage done for Lehman Brothers (LEH) this year? The FT looked into LEH’s second quarter, and found huge losses:
Lehman Brothers lost $500m-$700m on certain hedging positions in the second quarter, contributing to what is expected to be a larger-than-anticipated loss that may lead the bank to raise more capital by selling a stake to an outside investor.
People close to the matter said Lehman had opened talks with potential investors including asset managers and Asian banks.
The NYT forecast an even bigger loss; $1billion in Q2. Regardless of actual size, these Q2 losses are the likely basis for the capital raise mentioned above.
The Times article also discusses David Einhorn’s short position in Lehman:
"Mr. Einhorn, who runs a $6 billion hedge fund called Greenlight Capital, has been profiting from the Lehman’s growing pain. Critics say he is needlessly fanning fears about the precarious health of the financial industry at the very moment executives are struggling to stabilize their ailing companies. Many on Wall Street still wonder if hedge funds like Greenlight helped bring down Bear Stearns and spread false rumors about the bank, a possibility the Securities and Exchange Commission is investigating.
In an interview on Monday in his Midtown offices, Mr. Einhorn, fresh from his latest round of television appearances, said he was not out to tell Lehman Brothers how to fix its problems. He questioned how the company valued the assets on its books, and whether it was disclosing all the risks it faces. Investors have good reason to question banks: Worldwide, financial companies have suffered more than $380 billion in write-downs and credit-related losses in the last year, laying bare their shoddy risk management. Lehman has been singled out because of the large role it played in the mortgage market and its reluctance to disclose information about its assets compared with other Wall Street banks.
“Lehman has been one of the deniers,” Mr. Einhorn, 39, said.
The bottom line: We remain wary of the Financial sector, for reasons I have enunciated over the past year. There are likely more write downs coming, more capital raises and dilution — and lower finacial share prices.
For those who believe the crisis is in its 9th inning, best of luck to you . . .
>
Previously
Financial Sector: Beware LEH, CIT (June 2008)
http://bigpicture.typepad.com/comments/2008/06/financial-secto.html
Sources:
Decision Time for Lehman
Balance-Sheet Woes Most Likely to Force Big Strategic Shift
PETER EAVIS and DAVID REILLY
WSJ, June 4, 2008
http://online.wsj.com/article/SB121255129479844233.html
Lehman hedges lose $500m to $700m
Ben White, Francesco Guerrera and Henny Sender in New York
FT: June 3 2008 23:37
http://www.ft.com/cms/s/0/f453e96c-31b0-11dd-b77c-0000779fd2ac.html
Banks’ credit crisis solutions have echoes of 1929 Depression
Philip Aldrick
Telegraph, 1:30am BST 01/06/2008
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/06/01/cccrisis101.xml
Lehman Battles an Insurgent Investor
LOUISE STORY
NYT, June 4, 2008
http://www.nytimes.com/2008/06/04/business/04lehman.html
Related:
The Panglossian World of Finance
Daniel Cohen
VOX EU, 3 June 2008
http://www.voxeu.org/index.php?q=node/1197
Assume we’re in the 9th inning – or choose your sports analogy – how are these banks, whose fee-based business on the real estate, PE, etc… going to get their prior earnings back? Write-ups? Aren’t they already priced in? Ask the SWFs about write ups.
If write-ups aren’t priced in how do you justify current PE’s? XLF is not a Ben Graham type of asset. It’s more like the current Laker’s / Celtic’s series, same team names, but the makeups are different, the players are different, the outfits are re-constructed, and the drama – and upside – is all media hype.
Nice post BR.
From NBC Nightly News yesterday, a gas-electric hybrid with 300 mpg to retail for $27k-$30k. Made of lightweight composites, one has to wonder how it would come out of a collision with a traditional car or truck…
http://www.msnbc.msn.com/id/3032619/#24951985
Anyone who thinks we’re in the 9th inning doesn’t yet realize they’re at a football game.
the crisis may well be in the 9th inning, but of which game in the series?
as for buying back shares, did the fed have no conditions attached to the lending facilities they opened to investment banks? isn’t lehman brothers effectively recycling taxpayer money into a share buyback? and are lehman or other i-bank execs allowed to sell shares or awarded bonuses in the fiscal years in which they are sucking at the teet of the Fed?
bear had to be saved, but couldn’t the Fed have attached some conditions to the banks and their management to at least try to contain moral hazard?
I think Harvard would have done better listening to Borat again.
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=af8P5EVP1q_4
with just about 90% of it’s ahem……”assets” in securities is it no wonder the express elevator down is gaining steam??
Morgan Stanley did the same thing last year (pump it’s shares for placement) and it was just about the most obvious thing I’ve ever seen…how that is legal still remains a question (free market BS aside). Best thing about it was that they gave the deal a choice….buy now (before we announce our $6b loss) or after we do…….they went for the after the announcement option. What was that quote in the last Indiana Jones movie when the guy chose the wrong grail to drink from…..
“he chose ….poorly”
After the $6b loss the stock got pumped over 16 points and 6 days later the deal closed on that price…
How smart was JPM to go to the Fed first??
Very.
Ciao
MS
The failed hedges news has been swirling for weeks and I posted a comment about it on May 12 on your site.
http://bigpicture.typepad.com/comments/2008/05/baltic-dry-inde.html
I shorted some LEH the next day
The key to these names is not liquidity and the chance of failing like BSC.
The key is that the outlook for earnings for the next 3 years sucks. Even if the market recovers they have hedged themselves into a box and the earnings still suck. There is nothing there for a growth investor and the value boyz are all in already or they think it will come down more..
What’s an ibank worth with no earnings and no earnings growth? Not much. I think the market is trying to find that valuation here.
>>What’s an ibank worth with no earnings and no earnings growth? >>
In all of the “analysis” no one ever asks that question….just where is it supposedly to come from? They get wrapped up in the fact that they are “raising capital” but never mention that they destroy it faster than they can even attempt to get it.
When a hedge fund slaps down it’s own money to buy some piece of one of these banks I “might” believe that we are close to a bottom. Loaning out money to make a purchase, ala Citi, doesn’t count.
For those who still believe in the I-banks or any other “great value”….please do about 15 minutes of research and you will find out how great a value they are.
Ciao
MS
LEH is scheduled to announce earnings in a couple of weeks on June 17th. How is it that they are able to purchase shares so close to their announcement date? As an employee of a competing investment firm, I am precluded from trading in my company’s shares during the “blackout period” leading up to announcement date. How is it that a Firm is permitted to buy shares during the blackout period but an individual is not? What am I missing here?
Regards, MjF
rules get relaxed when a “crisis” erupts….
Just another non-enforcement for the “greater good”. AS I recall the blackout is 3 weeks prior and 3 days post…..may be different for the “special ones” and no I’m not talking about Mourinho…..
Ans they want more regulations to not enforce…….
Ciao
MS
looks like LEH found a sucker….
Ciao
MS
MS, expirience shows that banking industry as a whole is not profitable to shareholders long term. It is very profitable for those who work in it, but not for the shareholders.
During last 30 years there were several crisis wiping out sometimes up to a decade of earnings.
It wuld be best for everyone if they remained partnerships.
Leh was just raised to buy at Merrils.
So they decided to play a cooperative game after all, which is logical.
flipper i agree with you on the partnerships and i think that going private will be the end game for LEH.
The only reason to be public is stock options but they can always IPO again someday.
MikeF,
I have a call in to the CFO of my former company asking that very question. My former company and employees were precluded from transacting in company shares for 15 days prior to the close of a quarter until 3 days subsequent to earnings for that quarter being released to the public. I don’t get it either.
TheGuru
MS has several points here and yesterday’s vidclip of Saut discussing the terrible outlook for the financials is more than a big canary in the mine; it’s a major indicator that the deep re-thinking of broken business models is starting to get traction. And even reflected in the CNBC chattering heads though most of their guests don’t get it. The industry is going to go thru an enormous re-reg and de-leverage as risk is more properly priced and, hopefully, we’ll see some return to good business practice ala this post and others. FWIW I did a survey of these structural factors in a series of three posts collecting a bunch of readings: http://tinyurl.com/5drt77 http://tinyurl.com/4jhcrl and http://tinyurl.com/4he2wv The last of which looks at the PE business, especially the mid-market. Another post took a pretty deep dive on Citi to see if they were finally going to do the things they should have done ten years ago and reached a favorable conclusion: http://tinyurl.com/5zy8tb
The question now is execution ! Try looking at JPM’s last investor presentation for how to turn a framework like Pandit’s into some realities. Excellent IMHO.
The only reason to be public is stock options but they can always IPO again someday.
GS was still private during the 90s and the stock options fest. Did they ever come up with some funky item to pay out to employees, or did they just go with cash?
Great stuff, particularly parallels to 1929. The present circumstantial similarities to the 1928-1929 period are uncanny. Not that history necessarily is set to repeat itself. However, I am betting it will rhyme a great deal.
Firm share repurchases during the blackout period between the close of the books (in Lehman’s case 5/31) and the earnings call (6/17) are perfectly legal.
dblwyo – Interesting posts and links. Thanks.