The current problems with Lehman Brothers, AIG, and Merrill Lynch are uncovering a number of issues that will no doubt change the way we look at the health, valuation, of operations of businesses going forward. Of interest is how the current environment has resulted in Lehman Brothers being a company with liquidity that is not solvent, compared to AIG that may be solvent (for now), but has a liquidity issue. Just last week the WSJ Deal Journal blog highlighted some of the various anomalies between Lehman's valuation and its apparent asset values as its stock price plummeted. As of Friday, the closing price of Lehman put the market capitalization of the company at around $3 billion. Yet, many analysts highlighted that the current price reflected little on the true value of the company. Analysts expected the company to receive about $3 billion for a 55% stake in Neuberger Berman - as much, if not more than the value of all of Lehman. The bonus pool for Lehman's 24,000 employees itself was estimated to be around $3 billion. On the other hand, the company has $25-30 billion in toxic real estate assets to deal with, and there-in lies the issue for Lehman. How much is the exposure, how much are they worth, and what are the potential losses? Even with the ability to spin off the real estate into another company, and further inject it with $5-7 billion in liquidity, solvency was still not guaranteed. As Ken Lewis, the CEO of Bank of America stated today, the difference between the balance sheets of Merrill and Lehman was "night and day". Time will tell on BAC's move on Merrill. In the mean time AIG is scrambling to find capital to sure up its balance sheet and keep from getting a ratings downgrade, and subsequent higher cost of capital - as if selling off assets was not a high enough cost. The Fed window may stay closed to AIG, but funds might travel out the back door before all is said and done (New York is already granting permission to access $20 billion in capital from subsidiaries, see WSJ article).

So, are the issues with Lehman, AIG, and even Merrill a result of bad risk management, lack of good regulation, poor accounting rules, circumstance, or some combination of each. The easy answer is some combination of each, but the situation is of course more complicated than that. Good risk management should help us to avoid failure, if not excessive loss when circumstances go against us, but there are no guarantees. Regulation can force us to set aside risk capital, even when we don't want to, but again, it could be argued that a good risk management system that is actually both honest and honestly followed could serve a similar purpose (whether it does and would be followed, and whether that is why regulations exist in the first place is another issue and debate). That leaves of course accounting, and I suspect this area in particular will receive a lot of attention in the coming months, especially with regard to mark-to-market. The questions of whether each of these companies would have the same liquidity issues if accounting rules were different will certainly get some play, causing it to be a busy fall, possibly followed by an busy winter, spring, and summer. For all the regulators and agencies tasked with these problems, they may come to question the validity of the old proverb: "may you live in interesting times." Right now, something a little more boring would be nice.

Update: On another site a reader responded that leverage was the problem, and any new regulations will probably overstep. I could not agree more. Just looking at things a little down stream. In fact, the mark-to-market issues may be nothing more than an identification / realization of the leverage problem. Nonetheless, I suspect the regulators will be busy trying to prevent a similar problem. Hopefully, any changes will be measured and focused with few unintended consequences.

Lehman Brothers (LEH) is considering shifting approximately $32 billion of commercial mortgages and real estate to a new company, nicknamed Spinco, using a good-bank, bad-bank model of the 1980s (see a recent SeekingAlpha article on the good bank, bad bank debate). Lehman would fund the bank with $8 billion of equity coming from Lehman (Korea Development Bank is in discussions to purchase 25 percent of Lehman for $6 billion), with the remaining $24 billion borrowed from Lehman or outside investors (see Bloomberg article). The Spinco option would allow Lehman to off-load 80 percent of its commercial mortgages, establishing a company capitalized and managed by outside investors. One benefit of spinning off the mortgages to its own shareholders is that Lehman can allow existing shareholders to benefit from any recovery in asset prices, thereby eliminating the need to sell at fire sale prices. If the plan fails, Lehman may be forced to seek out private equity funds and sell parts of the company, such as their asset management business Neuberger Berman (see previous post here and here).

While Lehman brothers certainly seems to be getting hit from every direction (see comments on Opsraie's problems here, of which Lehman has a 25 percent stake), they are certainly trying to be creative in how they pull the company out of potential failure. While taking the Merrill Lynch route of selling assets for 22 cents on the dollar (and financing much of the sale themselves) may have not even been a possibility for Lehman, current actions do indicate the they seem to think the worst is behind them, at least as far as the credit crisis is concerned. Maybe they have no other alternatives. Liquidity and confidence issues remain, but if they can get the needed capital, and keep from selling the entire company and its assets on the cheap, Lehman may in fact come out stronger, or at least be able to survive. Of course, this really depends first on staying afloat and not becoming the next Bear Stearns. Fortunately for Lehman, so far they have appeared to have a little less panic from their nervous investors (not much), a few more options available to them, and a little more time than a weekend to get something done. But as they say, paraphrasing, "act now - while 'capital' supplies last."

A recent Financial Times article highlights some research it has done on the impact of the housing and credit crisis on Merrill Lynch. We all know of the problems and losses with Merrill and others, but when you add up the numbers the FT finds that in the past 18 months the losses have amounted to roughly one-fourth of the profits the company has made over its 36 years as a public company. The recent credit problems have caused Merrill to report after-tax losses of more than $14 billion during a time when the company took nearly $52 billion in write-down on its balance sheet. Looking at historical data, the FT calculates that the company's total inflation-adjusted profits between 1971 and 2006 were close to $56 billion. More near-term, the $14 billion in losses also amounts to half of Merrill's profits since 2000. Amazing. If this is not an advertisement for better risk management, I am not sure what is. Securitization and leveraged loans have certainly seen better days. To add insult to injury, it also turns out that Merrill Lynch had the highest ratio of credit related losses to historical profits when compared against ten large U.S. and European financial institutions. UBS had the dubious honor of having the second highest ratio.

The WSJ has a nice article summarizing the auction-rate security mess, along with a short primer on what auction rate securities are, as well as how they are bought and sold through auction. Definitely worth the read for those interested in what has recently become a larger Wall Street focus. Auction-rate securities are essentially a form of debt issued by municipalities, student-loan organizations, and others interested in borrowing for the long-term, but doing so at short-term interest rates. How is this achieved? By auction, of course. Every 7, 28, or 35 days, depending on the product, banks will hold auctions in what amounts to a resetting of the interest rates as the securities are passed on to the new security holders (or reset for existing holders that want to stay long).

As reported, UBS, Merrill Lynch, and Citigroup alone have committed to buying back more than $36 billion of the securities. The problem that each of these companies find themselves in, among others, is that at times the auction-rate securities may have been promoted as being similar to short-term CDs, but with higher returns. Unfortunately, as credit problems increased, the auction-rate security market also began to freeze up, making it difficult for these securities to be re-priced. Many investors were left with bank statements that simply listed a "null" placeholder where their security prices were once quoted, implying that liquidity was poor enough that a reliable price could not be provided. To complicate matters, apparently the liquidity issue has persisted for a while, even as more securities were being marketed and sold, causing many banks to prop-up the market by issuing their own bids. The WSJ reports that UBS alone may have submitted bids in just under 70% of its auctions between January 2006 to February 2008. Allegations against Merrill Lynch imply that they gave the false impression that demand was high, driven in part by dark pools of liquidity in the auction market (see previous posts here, here, here, and here on dark pools of liquidity).

As recourse, and a way for UBS to hopefully reduced the intensity of this recent black eye (how many eyes does UBS even have?), the company has agreed to buy back from investors nearly $19 billion of auction-rate securities, starting with individuals and charities this October, all the way to institutional clients in mid-2010. It is worth noting that while UBS plans to start buying back securities in October, the actual purchase could take longer. As reported in a Barron's article back in May, and discussed in a previous post, how much money investors get back from auction-rate securities depends on who originally issued the securities. The investors of auction-rate securities sold by a municipality or a closed-end taxable mutual fund have already received their money or will be receiving it soon. Investors in closed-end tax-free municipal-bond funds will probably have to wait a little longer. If you or one of you investment funds purchased auction-rate securities sold by a CDO or student-loan trust, well, you may be waiting a while to get your money back, possibly many years.

The auction-rate security issues once again highlight the need for better due diligence and a better understanding of risk. As we often forget, higher reward is almost always accompanied by higher risk - I dare say 100% of the time, but someone will always find exceptions in an inefficient market. If you look for more return, you need to understand the risk. Auction-rate securities based on CDOs should have raised red flags for some. Deception is one thing, but offering a blind-eye is another. Furthermore, the way we talk about risk also probably needs to change. For instance, have you ever noticed that we seem to be having "100 year floods" every other year, or how the metaphorical "perfect storm", whether in finance, insurance, or other fields seems to occur with more regularity? Anecdotal? Sure. But eventually simply stating that the recent event was the prefect storm or a once-in-a-lifetime event will not cut it. There are only so many times that you can cry wolf before no one cares about the real danger lurking in the woods. Maybe auction-rate securities and their current issues provide another one of those warning calls we need to listen to, regardless of its eventual magnitude and implications in the current market.

Since 2007, sovereign wealth funds have spent almost $80 billion to buy stakes in U.S. companies, in particular banks that were desperately in need of a capital infusion. Now, the International Herald Tribune is reporting that the lender of last resort may be having second thoughts. Even though most SWF don't have to report mark-to-market losses in public, they still want to make a return, and some high profile investments, such as those in Merrill Lynch (MER), are not turning out as expected. Many SWF are now entering "south-south" trades, or in other words, simply investing in other emerging economies. While the moves are being made to not only look for higher return, south-south trades also prevent emerging economies (many of which got their start-up capital from the West) from simply recycling their funds back into these same economies. Oil-exporting countries for one are looking to hedge against oil price fluctuations by becoming underweight assets correlated with oil prices, i.e., just about everything U.S. based. If this trend persist, then many small, medium, and even large companies may start depending more on alternative forms of capital, such as the hedge fund lending discussed in a recent post.

As discussed in a recent Bloomberg article, the spread between the 3-month Libor and the overnight index swap (OIS) rate, traded forward 3 months, is greater than similar expiring spreads. This recent movement in the spread is signaling that traders are concerned that banks will have difficulties obtaining cash to fund existing assets, as well as putting into question their ability to shore-up their balance sheets. In general, an increasing spread signals that funds are becoming less available. The recent activity appears to be driven more by traders leaving the short-term, closer to expire positions early over worries about Libor and its reliability.

The spread has averaged about 11 basis points over the last 10 years, but has ranged between 24 bps to 90 bps this year, and has gotten as high as 106 bps last December. The activity in the swaps market is worrisome, indicating that derivative traders do not feel that the sell-off of financial companies in March was the low, and that the worst is not behind us. Recent problems/concerns with Lehman Brothers, Wachovia, and UBS, as well as the recent sell-offs in Goldman Sachs, Merrill Lynch, JP Morgan, and Citigroup are also highlighting concerns with the financial companies. As usual, this is not good news for the economy and the market as a whole as it needs a strong financial system to keep greasing the gears of expansion. It may be a long summer until the credit markets start showing a little more confidence.

The WSJ has an interesting article that describes a situation of how even the best intentions for hedging risk do not always work out exactly how you had hoped. In an effort to stem the tide of losses resulting from bad real estate and leveraged loans, many firms on Wall Street began shorting vehicles that would allow them to profit as these markets collapsed. Unfortunately, tracking error raised its ugly head, and now many are finding that not only were they not getting close to 1-1 back ($1 loss in assets followed by a $1 gain in the hedge - often unrealistic, but a high goal nonetheless), many are getting much less, with a 70% efficiency being a relatively good recovery. To add insult to injury, some are finding that their assets are continuing to fall in price, even as the tracking index they shorted against has been rallying - causing a double loss on both the falling long asset and the rising short index.

It looks like the company with the worst hedges in place is Lehman Brothers, which is expected have write-downs on BOTH assets and ineffective hedges somewhere in the range of $1.5-2 billion. Morgan Stanley will have about half this amount of losses, with both Goldman Sachs and Merrill Lynch being less effected, so far - Goldman in particular has less real estate, but more leveraged loans than its competitors, and may eventually post some losses from these hedges.

As highlighted in the article, it looks like Wall Street has a long way to go in the area of risk management.

Merrill Lynch is apparently now going to require stock analysts at their firm to issue underperform ratings on at least 20% of the companies they cover. Right now, Wall Street analysts on average only give about 5% of companies an underperform rating. Merrill will also limit buy ratings to 70% of the companies covered, as well as limit neutral ratings to 30%. Analysts at Merrill now recommend sells on about 12% of the stocks followed.

Beyond making few sell recommendations, understanding exactly what underperform means has also be inconsistent between brokerage houses. As a result, Merrill Lynch has also further defined its ratings. Now, underperform will be the lowest rating and will apply to stocks that are expected to have a negative total return over 12 months, or gain the least among stocks in the same industry. Neutral stocks are projected to return up to 10% (doesn't sound neutral to me), while a buy rating will apply to companies that are expected to return more than 10%.

What does this mean? Essentially, 1 in 5 companies that Merrill covers will be a dog. A full 20% of the analysts covering stocks will be looking for the companies that don't quiet make the grade. So why is Merrill Lynch making these changes? Are they bowing to the pressure put in motion by Eliot Spitzer back in 2003? Is John Thain being influenced from his experience at the NYSE? Maybe, but more than likely it is about money, and not just lawsuits. During any volatile market, especially one that has the overhang of housing, credit, and inflation issues, not to mention the potential recession talk, investors and traders are interested in what to sell. Buying is easy, selling is harder. Sell guidance is valuable, especially in our current environment.

But can Merrill make money letting clients know what to sell, especially if those same clients were already advised by the company as to what to buy? Certainly valuable to the client, but probably not as value adding to Merrill. Yet, recent data from Bespoke Investment Group showed that over 10% of the shares available for trading are sold short. Given that over 1/3 of all stocks fall each year on average, providing sell data could be profitable for those willing to paying up for it - i.e., hedge funds. Of course, providing sell data is not without its own cost. Investment banks in the past have been opposed to providing too many sell recommendations, worried that they may offend potential or current clients that they hope to do business with. As such, while being potentially profitable for sale to hedge funds, expect the sell recommendations to also be filtered somewhat, avoiding upsetting the investment banking apple cart.

Merrill Lynch posted a quarterly loss of $1.96 billion, due to $6.6 billion in write-downs related to mortgages, CDOs, and junk loans. There were also an additional $3.1 billion in mortgage-related securities that were held at its U.S. banks. Astonishingly, the losses over the past three quarters have been $14 billion, more than the bank earned in 2005 and 2006. Merrill will also let go of 4,000 employees in the capital market and trading groups, passing over the large network of financial advisers and staff. This news, while not good for Merrill employees, should temper the market's response to its recent losses.

Given the losses and on-going struggles, Moody's is warning that it could downgrade the bank's credit rating, in part because they may be forced to take another $6 billion in future write-downs. Looking at the last nine months, CDO write-downs alone have totaled over $18 billion, with $1.5 billion coming in the last quarter. While it looks like the level of CDO write-downs is decreasing, exposure isn't. In the last quarter, CDO exposure rose from $5.1 billion at the end of last year, to $6.7 billion at the end of this quarter. This of course, begs the question: "What previous risk is left on the books, and is the new risk exposure being properly managed?" As we have seen too often, it is not always the size of exposure (see Goldman), but the type and level of counter-party risk you are taking, and more importantly, the risk measures you have in place to manage such risk. Until we get more clarity, further write-downs and ratings downgrades should not really come as a surprise, and the market will certainly continue to price in this uncertainty.

Tickers: MER