Financial Freak Show

Financial freak show

September 15, 2008 – The S&P/TSX Capped Financials Index has not retested its mid- July low of 154. In fact, the index, which tracks Canada’s major financial services companies, closed last Friday at 184, up 19.5% from July’s low. It’s a sign that investors believe that the worst could well be over for the big Canadian banks, most of which have taken sizable writedowns of US subprime mortgage-related debt.

A price floor seems to have developed for the financials, and compared with the financial freak show unfolding south of the border, Canadian banks now appear as bastions of financial probity. But that’s no reason to gloat.

Most Canadian banks’ balance sheets were fouled with the same sort of junk that’s bedevilling much of the US financial sector just now, but not to the same degree. They cleaned it up in a hurry, but let’s not forget that with one or two exceptions – Scotiabank and Toronto-Dominion Bank leap to mind – Canadian banks fell into the same trap that their US counterparts did. So no kudos for these guys – at least not until they restore shareholder value and demonstrate a return to the principles of solid bank management.

On the other hand, the financial drama that continues to unfold in the south 49 has taken on the epic proportions of high Shakespearean tragedy. With much rending of garments and falling on swords the fourth-largest US investment bank, Lehman Brothers Holdings, descended into the banker’s hell of non-confidence last week, as the Korea Development Bank abandoned a possible deal that would have kept Lehman afloat. By Friday’s close, Lehman shares had lost 70% of their value.

With one white knight gone, Lehman put itself up for sale and opened the bidding to all comers. As of Friday evening, reports had a Bank of America-led consortium potentially interested, as well as the UK banking giant Barclays. An announcement of some kind was expected over the weekend. But you can be sure that whoever steps up to the plate will be looking for some sort of a backstop from the US government. It’s not clear that will happen…see the postscript below.

And sure enough, we’re back to the moral hazard quandary we’ve been writing about in these comments ever since the Fed stepped in to save Bear Stearns by guaranteeing its worst debt. When that little drama played itself out back in March, we even asked, not wholly rhetorically either, “Who’s next? Lehman Brothers?”

Since then, the US government has completely taken over mortgage companies Fannie Mae and Freddie Mac and their trillion-dollar mortgage holdings. Granted, Fan and Fred are much more critical to the financial system than Bear Stearns was, though Bear was important enough. And Lehman in turn is well down on the list in terms of being a threat to the functioning of the global financial system, despite the fact it is a much larger player than Bear Stearns. In the bailout game, timing is everything! Which leads to the question of whether the feds will in fact step up with the big wads of cash that they brought to the Bear bailout. At some point or other, they’re bound to let one of the biggies fail.

Turns out it was Lehman. Next could be Seattle-based thrift giant Washington Mutual Inc. (WaMu) if takeover talks with JP Morgan come to nothing. Or American International Group (AIG), until recently the world’s largest insurance company. All are facing serious capital concerns, debt downgrades, and loss of confidence. All appear ready to go on the block as well. We’ll know in the very near future whether that block belongs to the auctioneer or the butcher.

It’s no wonder, then, with all this “deleveraging” going on, that Wall Street remains gun shy about US financial stocks, with investors selling just about everything in the sector – the shares of even relatively unsullied companies like Goldman Sachs Group posted steep losses last week.

The financial storms blowing up and down Wall Street have actually eclipsed the real storm blowing into the Texas Gulf coast over the weekend. Hurricane Ike effectively shut down Gulf coast oil drilling and refinery operations last week, propelling the price of gasoline in Canada to record highs, with one-day jumps of 13 to 15 cents per litre. Of course, what was missing from the inevitably breathless news reports and political tub- thumping about “price gouging” (besides any vestige of thought and analysis, of course) is even a mention that the price of crude oil itself briefly fell below US$100 per barrel last week.

But investors didn’t miss that little bit of commodity news and pushed the S&P/TSX Capped Energy Index to a small loss on the week, contributing to the continuing commodity malaise currently afflicting the resource-heavy TSX. However, much of the sale proceeds apparently went into the financials, because the S&P/TSX Composite Index posted only a razor-thin loss on the week after staging a strong rally from about mid- week onwards.

Though US investors pushed indexes mostly lower on Friday following a drop in retail sales and some anxiety about the fate of Lehman, the big US equity benchmarks stayed in positive territory week over week. The Dow Jones Industrial Average gained 1.6% on the week, while the S&P 500 Composite Index advanced just 0.6%.

The US credit mess has yet to come to a head. But have you noticed how the inflation story, so prevalent over the past few months, has disappeared from the radar? Declining commodity prices – particularly in the energy complex – have considerably eased the pressure on prices. That in turn will provide central banks some breathing room and

© 2008 by R.N. Croft Financial Group Inc. Page 2 possibly pave the way for an easing of interest rates in early 2009. If the drums start beating more strongly for rate cuts over coming weeks, watch for growing signs of a tightening of credit spreads and an easing of the credit crunch. That is also likely to coincide with a bottoming of housing prices in the US, which will be a major indicator that the worst is over. If our thesis holds, stock markets will begin their bottoming process in anticipation of a recovery in 2009.

Postscript Analyzing the Lehman bankruptcy

Lehman Brothers was not able to count on the federal government for any help in its hour of need, and that has all of Wall Street shaking. Shares of Lehman sunk deeper into penny stock territory on Friday, as the beleaguered firm raced to find another bank to buy it in a bid to stave-off an imminent collapse of the historic 158-year-old firm.

In early Friday trading, Lehman’s stock fell 10% to $3.80, continuing a downward death spiral that began Sept. 8. After Wall Street has concluded Lehman CEO Dick Fuld wouldn’t be able to pull off his previously announced plan for shoring up the investment firm’s balance sheet, it pretty much became a race against time for Fuld to find a buyer – at any price – for the firm. By Friday afternoon, speculation on Wall Street was that Bank of America, Barclays, and consortium of private equity firms were the most interested suitors.

But it wasn’t clear that any of those potential buyers would want to do a deal with Fuld, as long as the acquirer would also take on some US$30 billion in rotting commercial real estate assets that Fuld was planning to unload. Treasury Secretary Hank Paulson, according to wire service reports, said the federal government was unwilling provide any additional help to Lehman beyond allowing it continue borrowing short-term money from the Federal Reserve – something the firm has been able to do since the spring.

When JPMorgan Chase agreed in March to a shotgun marriage with Bear Stearns, to similarly save that investment firm from collapse, the Fed guaranteed up to $29 billion of Bear’s bad mortgage-related assets. The Fed backstop gave JPMorgan CEO Jamie Dimon enough security to take on the risk of rescuing Bear from a certain bankruptcy filing. This time, however, it didn’t appear that either the Fed or Treasury were willing to provide a similar guarantee to Lehman’s would-be savior.

And without that kind of government-backed guarantee it was by no means certain that any bank would be willing to take on the risk of adding Lehman’s questionable commercial real estate assets to its balance sheet. “There’s very little chance anyone will do a deal for Lehman without the government stepping in,’’ says Janet Tavakoli, a derivatives and structured finance consultant in Chicago.

The apparent reluctance of either Treasury or the Fed to go the distance and insure that a deal got done is why on Friday, some on Wall Street were already beginning to whisper

the unthinkable: a Lehman bankruptcy filing. And that’s precisely what occurred over the weekend.

Lehman’s bankruptcy filing, of course, could turn out to be a real mess for Wall Street given all the tens of billions in short-term loans other banks have extended to Lehman, which are backed by collateral. And of course, there are numerous other trades and transactions Lehman has done with hedge funds and other trading partners that also are backed by collateral – in some cases potentially backed by pieces of the same assets.

Andrew Rahl, a bankruptcy lawyer with Reed Smith, says the Lehman bankruptcy filing would be an unprecedented event, given that some of Lehman’s divisions, such as it brokerage arm, are regulated entities. “Clearly this would be a filing without any real precedent. There could be unintended consequences; there could even be some favorable consequences.’’ One favorable outcome might be the freezing of some of Lehman’s ailing commercial real estate assets by the bankruptcy court – meaning those assets wouldn’t find their way into the market anytime soon.

Concurrent with Lehman’s failure was Bank of America’s takeover of Merrill Lynch & Co., another financial giant with mountains of troubled-assets on its balance sheet. This move propels Bank of America firmly into the biggest of the big leagues, changing the face of Wall Street investment banking in the blink of an eye.

Also on death watch, though, are several other large financial institutions, including insurance giant American International Group. Wall Street is coming to grips with the reality that if the federal government can’t bail out all these institutions, there may be no buyers out there to save them.

In the government’s bailout of Fannie Mae and Freddie Mac, it wasn’t just shareholders who got creamed – holders of Fannie and Freddie’s higher-yielding preferred shares also took a beating. To date, most Wall Street banks have been able to raise capital by selling preferred stock to deep-pocketed sovereign wealth funds and private equity firms. But Wall Street won’t be able to do those deals if there’s uncertainty about whether those preferred shares will have any value down the road.

It’s not a pretty picture. But it’s another reason why this year-long subprime mortgage- inspired credit crunch is shaping up as one of the worst financial disasters in decades.