Page 1 - These comments written on September 10, 2008
LEHMAN BROTHERS AND MARKET COMMENTARY
THIS AIN’T MY FIRST RODEO. IN RECENT WEEKS IT FEELS
AS IF IT COULD BE.
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This morning, September 10, 2008, Lehman
Brothers made a call to once again reassure us that all is well. Well,
maybe not well but OK enough to keep them going for awhile at least. The
stock fell below 8 yesterday to a 10-year low – a drop of 45% for the
day. (Today, September 17th, Lehman is 17 cents per share.)
Today Lehman has announced a $3.9 billion loss for the quarter and has
cut the dividend from 68 cents annually to five cents. We wonder why five cents instead
of zero cents.
We think this is the end of Lehman
Brothers as we have known it. Lehman Brothers was
founded in 1844 in Montgomery, Alabama by Henry Lehman, an immigrant
from Germany. Six years later his brothers, Emanuel and Mayer, joined
him and they named the business Lehman Brothers. They were brokers who
traded cotton, the cash crop of the time, and opened an office in New
York in 1858. All of this occurred before and during the Civil War.
After the War the brothers moved to New York and helped establish the
Cotton Exchange.
Lehman was the firm I joined when I first
came to Wall Street in 1960. Headquarters were on One William Street,
and Lehman’s sales force for the world was eighteen of us at that time.
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Last night OPEC agreed to a 520,000
barrel per day cut in output below the official July
output target of 28.8 million barrels per day. This meeting was in
Vienna, the usual location, and the next is scheduled for December 17th
in Algeria. With all their money we do not understand why they would
change the venue from the luxury of Vienna to the sands of Algeria.
The Financial Crisis is far from over as
on Monday, September 8th, the Government announced the bail-out of Freddie Mac and Fannie Mae, the largest in
world history.
It is estimated that these two
“companies” own or control between 60% to 70% of all U. S. mortgages.
They had to be bailed out because of the enormity of the implications of
their failure. Because their approximately $6 trillion of debt, no one
is sure how much this will cost the American taxpayer. Low estimates
seem to be around $300 billion, but we will have to wait and see.
At this time when the stock markets are
impacted by enormous and irrational selling caused by forced liquidation of hedge fund positions and of other very
highly leveraged investors, the thing to do is to have patience, hold on
to shares of excellent companies and wait for the dust to settle. We
will not be buying aggressively even with stocks at these levels until
we can see stabilization and some clarification of the extraordinary
issues with which we and the rest of the world are dealing.
John W. Hamilton
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THE GREAT UNRAVELING
September 17, 2008 |
After we wrote the above, Lehman
Brothers declared bankruptcy on September
15th, the same morning the headlines across
the front page of the Wall Street Journal
were: Crisis on Wall Street as Lehman
Totters, Merrill Seeks Buyer, AIG Hunts for
Cash.
• As
mentioned, Lehman did declare bankruptcy on the 15th. Its
stock traded as high as 86 in February 2007 and now sells
for 16 cents.
• Merrill Lynch was bought for stock on the same day by Bank
of America. Merrill’s stock sold as high as 98 in January
2007 and as low as 16.25 on September 16th.
• AIG (American International Group – reportedly the world’s
largest insurance company dealing in 130 countries) was
bailed out by the Federal Reserve (our money) to the
tune of an $85 billion loan last night. AIG sold for 103 in
January 2001 and now trades under 2. This was the third
bail-out by the Federal Reserve after Bear Stearns and
Fannie Mae and Freddie Mac – mentioned above. Hank
Greenburg, AIG’s founder and chairman until his being ousted
3 ½ years ago, reportedly lost over $6 Billion in his AIG
holdings last week alone.
We understand that in order to protect the interests of the US
government and taxpayers the “AIG facility has a 24 month term.
Interest will accrue on the outstanding
balance at a rate of the month LIBOR plus
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850 basis points.” Further the Fed said: “the
interests of taxpayers are protected by key
terms of the loan. The loan is collateralized
by all the assets of AIG and of its primary
non-regulated subsidiaries…. The loan is
expected to be repaid from the proceeds of
the sale of the firm’s assets. The US
government will receive a 79.9% equity
interest in AIG and has the right to veto the
payment of dividends to common and
preferred shareholders.We do not exactly understand the
79.9%
stock ownership instead of 80%, but
apparently it has something to do with the
Federal Reserve’s not wanting its AIG
holdings to show on its balance sheet.
In this morning’s “Gartman Letter” the
following is stated: “There are times when
‘pragmatism must trump philosophy,” and
the confusion and liquidation of the past week
or so is one of those times.” These comments
were directed to those who “find this
expansion of the Fed’s powers bothersome at
best and inordinately disconcerting at
worse…”
The problem with AIG’s insolvency, whose
insurance operations are reportedly
functioning very well, is that the company
had issued over the last years some $400
Billion of what we call toxic waste –
derivatives, SIVs, other exotic financial
instruments of virtually every type
imaginable, and they did not have the
liquidity to support their counter-party
responsibilities in the event of problems with
these instruments. Please accept this as a gross over
simplification, but it essentially is
what all the “players” have been doing over
the last number of years.
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By rough count the Fed is backing J P
Morgan Chase’s buyout of Bear Stearns by
$29 Billion. The exposure to the Federal
Reserve (the American Taxpayer) as a result
of its buyout of Fannie Mae and Freddie Mac
could be in the area of $300 Billion – nobody
really has any idea. China alone has close to
$400 Billion of their bonds. And now the Fed
has spent $85 Billion rescuing AIG, the
American International Group of insurance
companies.
Sometimes we wonder how much money the
U. S. Federal Reserve has or can come up
with for the next emergency.
A few of the others playing in the
same sandbox along with their all-time highs
and approximate present prices are listed
below. Please note these companies are not
listed in order of importance and do not have
identical problems. By no means is this a
complete list of entities that own financial
instruments of questionable or
unascertainable value.
AIG
103 2
CITIGROUP
57 15
FANNIE MAE
89 0.45
FREDDIE MAC
74 0.26
GE
60 23
GOLDMAN SACHS
250 118
LEHMAN BROS
86 0.16
MERRILL LYNCH
98 20
MORGAN STANLEY
91 23
UBS 66 14
WACHOVIA 66 10
WASHINGTON MUTUAL 46
2
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At this time we would again invite you
to visit our Web site: www.HamiltonAdvisors.com and would like
to share with you the Commentary we wrote
just over a year ago on August 28, 2007 titled
“The Chickens are Coming!” After all, Past is
Prologue, and we think that a look back to
what was happening a year ago and well
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before that along with our rather outspoken
thoughts could be of interest in these times of
Crisis in the Financial Markets.
Our hindsight was foresight, and we
made our investment decisions accordingly.
We have not, to the best of my recollection,
taken any significant positions in companies
primarily involved in the financial markets
well before or since then.
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THE CHICKENS ARE COMING! THE
CHICKENS ARE COMING!
August 28, 2007
“The world, one had to remember, was
analog, not digital, in the way it operated. And
‘analog’ actually meant ‘sloppy.’” The Teeth
of the Tiger, by Tom Clancy.
We wrote that last month (please visit
our Web site www.HamiltonAdvisors.com)
and will include it again this month as
“sloppy” cannot begin to describe what we
have seen lately in the stock and bond
markets.
Remember the old adage that the only
three things you had to know about real
estate were Location, Location, Location!
Now you have to add Credit, Credit, Credit
and more Credit! And Leverage in many
cases involving billions of dollars.
The markets have been
extraordinarily sloppy, and frightening,
because of U.S. and Global credit policies
over the last five years and because the
Financial Geniuses have been able to spread
the risk from this country to the entire world.
And the entire world has bought into it hook,
line and sinker!
The banks and Wall Street have
developed, and more importantly sold, to the
buyer and the seller, mortgages that have at
times equaled 100% of properties’ market
values at the time they were issued. Often
those mortgages did not even require the
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buyer to include more than his or her name,
presumably their real name, although in the
end that really wouldn’t make much
difference. These were called “Nodocumentation”
or “no-doc” loans. Billions of
dollars worth of these mortgages were also
sold, where one could not only buy the
property at 100% of stated or sometimes
overstated value, but also with interest-only
payments.
Or, one could buy a 30-year mortgage
and pay interest only for two years and then
enter into a more conventional financing
arrangement at a very high interest rate for
the remaining 28 years. These were known as
2/28s and were the rage in 2005 and 2006,
particularly at a time when house prices were
skyrocketing and interest rates on mortgages
were at there lowest in memory if not in
history. Subprime loans rose to more than
$600 Billion in 2005 and 2006 versus $160
Billion in 2001 when they were primarily
used for home-equity loans. Later homes
were used as ATMs and offered many of the
biggest and “best” bets imaginable.
It was a Win-Win situation for
everyone --- the house buyer and seller, the
real estate agent, the insurance broker, the
mortgage broker, the lawyers and the first time
lender, usually a bank. As the business
grew, the loans were “packaged” or
“securitized” and sliced into tranches where
the poorest credits (“junk”) were at the
bottom of the pyramid while the highest
quality credits (AAA) were at the peak. The
ratings agencies often assigned their highest
ratings to the entire pyramid.
It is important to understand that this
process effectively transferred the risk of
owning a mortgage, or a package of
mortgages, from the first lender – the bank –
to the ultimate mortgage holder – the
investor. The investor often does not have a
second-party against whom he could make a
claim in the event of a default. The investor,
as mentioned above, could be anywhere in the
world during these halcyon days and could be
a hedge-fund, an endowment, a retirement
system or pension fund, et cetera, et cetera. |
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Nobody really knows who or where
all the investors are, let alone how much
money has been invested in subprime
mortgages. What is known is that the amount
of money involved is beyond a mere mortal’s
comprehension. Further, the investor did not
and still does not, in the overwhelming
number of cases, know or is able to find out
the “real value” of his “asset.” Furthermore,
the investor in the subprime mortgages no
longer had the Fed or deposit insurance to
fall back on as before.
Who could have been so naive as to
think of a world where house prices would
plummet and mortgage and interest rates in
general would rise? It was supposed to
continue to be just the opposite.
But contrary to conventional wisdom
the worm turned, and housing prices have
been plummeting while interest rates have
been rising. For example: If one bought a
home for $100,000 and paid nothing down
and “interest only,” what would one expect to
happen when that buyer can or will no longer
pay the interest only, or pay the higher
interest due when the mortgage resets
(meaning a higher interest must be paid by
the home owner on his interest only, 2/28
mortgage or ARM – Adjustable Rate
Mortgage)? The lender paid $100,000 in the
beginning, but the house is now worth, say,
$70,000 more or less.
The homeowner decides he cannot or
will not pay the mortgage or interest on his
home where he owes $100,000 on a property that is
worth only 70% of that. What happens
when that owner sticks his key in the front door
and walks away? The bank or lender takes over a loan
investment that now carries a $30,000 realized loss.
Multiply this situation by an estimated 7,000,000
times in the coming months, and you can see how some
people can become upset – like right now! What is
happening today is that the lenders, in many
cases, are trying to “unwind” or sell their
securitized mortgage packages where they have in
many cases leveraged themselves by borrowing
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their cash investment in order to purchase
those high interest bearing mortgages.
The most dreaded words in the
investment business are NO BID, and that is
what is happening now. Potential buyers have
either said NO BID, having no interest in
buying the mortgages or other assets, or they
are offering very low prices that if a
transaction occurred at that level would in
turn necessitate the hedge-fund’s or other
investors’ possibly having to mark down –
devalue –their entire investment portfolio.
These investments in many cases had
previously been marked to the investor’s
“model” – often their cost - rather than
marked to the “market.” But that is a
different subject for a different day as it
brings up the extraordinarily important
question of how valid the previous
performance records of many “investors”
have been since the “real value” of the
investors’ assets could have been worth far
less than the value stated in their “models.”
The validity of performance results in recent
years is brought into question. And the
conflict is that the money managers, for the
most part and to a very large degree, get paid
on their performance. We will soon get more
evidence as to how much recent years’
performance results have been overstated.
The degree of accuracy of reported
performance results will be the subject of the
SEC’s and other federal and state agencies’
investigations as the story unfolds, and the
truth becomes clear.
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LOW RATES, A WORLD AWASH IN
MONEY AND MORE CREDIT
The U.S. Federal Reserve bank
lowered the federal-funds rate to just 1% in
June 2003 and kept it there for more than a
year. The idea, as told to the public, was to
avoid deflation.
Mr. Greenspan said in August 2005,
six months before retiring: “History has not
dealt kindly with the aftermath of protracted |
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periods of low risk premiums.” But what the
Fed, i.e. Mr. Greenspan and Mr. Bernanke,
did not foresee was the deluge of capital
pouring into the U.S. from oversees. The
effect was to keep our banking system awash
with capital. Interest rates remained low, at
least lower than they should have been, in our
opinion. Mr. Bernanke has referred to
foreigners putting their reserves into U.S.
Treasury obligations a “global savings glut.”
The Drudge Report as recently as July 20th
stated: “Foreigners put more money into
American stocks and bonds in May than in
any previous month in history.”
WE WROTE TO OUR CLIENTS ON JUNE
1Oth WHEN THE MARKETS WERE
HITTING NEW HIGHS:
“Risk still exists although it is not
mentioned in polite company and certainly not
on TV.
“In other words, it has taken seven
years and two months for many of the averages
to get back to where they were in the halcyon
“dotcom” days --- the craze that exploded in
March 2000. Not surprisingly, there are now a
number of other excesses that are sources for
legitimate concern.
“The U. S. economy seems to be
coming in for the much desired “soft landing”
and global money supply is at a level never
seen before. However, continuing problems in
housing and with the extraordinary financial
leverage used globally by Hedge Funds and
Private Equity groups could scuttle today’s
market euphoria.”
And we have not even mentioned the
Leveraged Buy-Out Crowd and Private
Equity folks out there who may have to be
funding up to $500 billion under these
conditions to complete their previously
announced deals. There are many on that
very large hook for $500 billion.
Again we would like you to note the
following relevant comments from the
Financial Times. |
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On November 7, 2006, the Financial
Times carried an article titled “Big buy-out
collapse ‘inevitable.’ “The collapse of a large
buy-out is ‘inevitable’ and could ultimately
pose a threat to the stability of the UK
economy, Britain’s main financial watchdog
warned yesterday as it became the latest
national regulator to turn its attention to the
private equity industry.” “The US justice
department also recently launched an inquiry
into potential anti-competitive behaviour
among US buy-out houses.” There is currently
a short-term approach and speculation in the
financial sector in general that is bad for the
economy. It must become more sensible. When
you see groups buying one company after
another and then another, you start to ask
questions….” “The default of a large private
equity-backed company is increasingly
inevitable….” “Such defaults would have
negative implications for lenders, purchases of
the debt, orderly markets and conceivably, in
extreme circumstances, financial stability and
elements of the UK economy.”
The results of a financial blow-up – or
melt-down - will affect the US markets and
ultimately the economy, just the same as in
the UK and elsewhere in today’s Global
Economy. In other words, each of us would
be negatively and seriously affected.
Also note from the Financial Times on
May 3, 2007 an article titled “NY Fed warns
on hedge fund risk.” The first sentence began:
“The risk hedge funds pose to the global
financial system has reached levels by some
measures comparable to those just before the
Long Term Capital Management fund
imploded in 1998, the Federal Reserve Bank of
New York said yesterday.” “The bank’s study is
the latest contribution to a debate that has seen
regulators and analysts express concern over
the risks and leverage taken on by hedge funds,
the private investment vehicles that are
increasingly influential in financial markets.
The hedge fund industry has mushroomed in
recent years and now accounts for an estimated
$1,500bn ($1.5 trillion to us Americans) of
investments.” |
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The following is a quotation from “Et
Tu, Paribas? (Review & Outlook) on the
Opinion page of the August 10th Wall Street
Journal: “What’s becoming clearer by the day is
that we’re watching the unraveling of a global
real estate financing bubble. The U.S. subprime market is the heart of the problem,
but financial innovation has spread the risk
around the world in a way that wasn’t possible
a generation ago. Long-term assets – real
estate – have been financed by hedge funds
with short-term debt instruments, and the
amount of the debt now exceeds the value of
the collateral in these subprime investments.
Somebody is going to have to swallow the
difference….”
We will be the first to admit that we
are unable to call market highs or bottoms.
Imagine the markets to be like a pendulum
that when at rest its “real” or “true” fixed
point (or value in this case) is at 6 o’clock.
Bull markets always overshoot to the upside,
for example to 9 or 10 o’clock and bear
markets to the downside, for example to 3 or
2 o’clock.
We repeat we are not in the “gloom
and doom” business --- just the opposite.
Nevertheless, the above articles and
comments are from eminently respectable
sources that we take very seriously in view of
our experiences having spent careers in the
investment business in excess of 110 years. It
is part of the struggle to Preserve Capital as
well as to make money, and we have learned
over those years that one of the best ways to
“make money” is to keep from loosing it.
The tip of the Iceberg: If what has
happened to Bear Stearns (two hedge-funds
holding more than $20 billion of assets just
several weeks ago requiring $1.6 billion – the
numbers are still vague), Goldman Sachs (its
Global Equity Opportunities Fund needing a
$3 billion cash infusion after a 30 percent loss
of its value last week and its flagship formerly
$10 billion Global Alpha fund down 27% for
the year as of last Friday, June 10th) and KKR, can such problems crop up anywhere |
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else or with different forms of financial
instruments? Take a guess. And keep in
mind, while these players are not exactly
warm and cuddly, they probably have had
the most experience working with many of
the “smartest” people inhabiting these non-eleemosynary
intuitions.
The problem is years of unwise credit
expansion and unwise use of leverage with the
result that the Chickens are now Coming
Home to Roost. The Trillion dollar question is
how many Chickens are coming home and
how long they will be staying!
John W. Hamilton
August 28, 2007 |
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John W. Hamilton
jwh@hamiltonadvisors.com
Deborah J. Hamilton
djh@hamiltonadvisors.com
J. Brock Hamilton
jbh@hamiltonadvisors.com
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PRIVATE WEALTH MANAGEMENT SINCE 1980 |
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No part of this publication may be
reproduced in any form, or referred to in any other publication, without
express written permission. This article contains the current opinions
of Hamilton Advisors and does not represent a recommendation of any
particular security, strategy or investment product. Such opinions are
subject to change without notice. Information contained herein has been
obtained from sources believed to be reliable, but is not guaranteed.
This article is distributed for educational purposes and should not be
considered as investment advice or an offer of any security for sale. ©
2007 Hamilton Advisors, Inc. All rights reserved. Tel: 203 629 1112.
Fax: 203 629 1469
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