What was the Proximate Cause of the Market Meltdown in the Fall?

Conventional wisdom suggests that the collapse of Lehman Brothers precipitated the meltdown that followed, but Kim Thomas, in a letter to the editor of the Financial Times yesterday ("Not All Observers Agree on effect of Lehman Collapse"), offers a different take, drawing on research by Stanford University economics professor John Taylor (the gentleman on the right in the photo above). The text of Mr. Thomas's letter is below.

Sir, Contrary to the assertion by Edward Luce (“Obama signals overhaul of economy”, January 9), it is not a truth universally acknowledged that the failure of the authorities to save Lehman Brothers triggered the financial meltdown.

An event study by John Taylor of Stanford University (in The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong, available at www.stanford.edu/~johntayl/ ) using the three-month Libor-OIS spread as a measure found a small increase in financial market turmoil, within the normal range of fluctuations, occurring on September 15, the Monday after the weekend decisions not to bail out Lehman Brothers.

That was followed by a slight decrease in turmoil around the time of the American International Group intervention of September 16 and then a moderate rise, still within the normal range of fluctuations, for the rest of that week. It was only after the announcement of the troubled asset relief programme on September 19 and particularly after the testimony of Treasury secretary Hank Paulson and Fed chairman Ben Bernanke of September 23 before the Senate banking committee - in which they presented a two-and-a-half page proposal for legislation with no plans for oversight and few restrictions on use of the funds - that the measure of turmoil began what Prof Taylor describes as a "relentless upward movement" that lasted three weeks until it "went through the roof".

Prof Taylor argues that the failure to bail out Lehman Brothers was only one element in a sequence of government policy decisions that had exhibited a lack of consistency and clarity of purpose since at least the Bear Stearns intervention the previous March. He suggests the lack of coherent policy was first laid bare for all to see on September 23.

After that the public seemed to conclude that conditions must be much worse than they had been led to believe previously, and firms suddenly faced considerably more uncertainty in making business and investment decisions.

Kim C. Thomas,
San Jose, CA, US

The photo above is from Professor Taylor's Stanford website.

A Difference Between the Dot-Com Bust and the Real Estate Bust

During the dot-com bust, the bag holders were, for the most part, individual retail investors -- average Americans, who bid up the price of Internet stock IPOs. Investment banks collected huge fees on those IPOs, regardless of how the companies they brought public performed. In the wake of the real estate bust and the related credit crunch, the biggest bag holders have been on Wall Street: Lehman and Bear Stearns -- two firms that survived the Great Depression intact -- gone, nearly all of their respective CEOs equity stakes wiped out; the country's largest broker/dealer, Merrill Lynch, forced into a sale to Bank of America; etc.

That's something I've thought about as I watched Congressman after Congressman rail against Wall Street in yesterday's hearings while lamenting the plight of his average American constituents.

USEG Expands Share Buyback; More of Mark Cuban on Buybacks

U.S. Energy Corp (Nasdaq: USEG) expands its share buyback. It had already bought back about $3.1 million worth of its shares under its previous $5 million authorization, and now USEG's board has expanded that authorization to $8 million.

Separately, on his blog last week, Mark Cuban reiterated his opposition to buybacks ("The AIG-Lehman-Merrill Link"),

3 Companies facing cash crunch oblivion. A bankruptcy, an desperation sale and pure desperation. What do all 3 companies have in common ? Share buybacks. Billions and Billions and Billions in share buybacks over the last 18 months.

[...]

Can anyone say “financial engineering” ? think all 3 companies could have used that cash they spent trying to pump up their stock prices ? All that cash going to people who sold the stocks, huge losses going to those who held the stock. Thats why dividends are far better than share buybacks. At least in this case all shareholders could have gotten something back other than “the bag” remaining shareholders continue to hold.

In the cases of AIG, Merrill, and Lehman, I doubt the shareholders would have been much better off if they had received dividends in lieu of buybacks over the last 18 months, and I doubt the money used in the buybacks would have been enough to materially affect the outcomes there. It certainly didn't help though.

I wonder what Cuban would think of USEG's share buybacks. USEG has plenty of cash, so it's not facing a cash crunch; it doesn't have current earnings, so it's not engaging in 'financial engineering' to boost earnings per share; and it's buying back its shares at well below book value.

The Atlantic's Megan McCardle on the Politics of the Financial Crisis

Excerpted from Megan McCardle's Atlantic column, "The Blame Game":

Naturally, the two presidential candidates are moving quickly to deal with this crisis -- that is, to blame it on everyone except themselves. John McCain and his surrogates are pushing the dubious notion that the primary problem is a lack of transparency and accountability. He might send someone down to Lehman's trading floor to ask the people packing up their desks whether they feel they've gotten away with something.

Meanwhile, Barack Obama is pointing the finger at John McCain, or at least Senator McCain's ideas:

The challenges facing our financial system today are more evidence that too many folks in Washington and on Wall Street weren't minding the store. Eight years of policies that have shredded consumer protections, loosened oversight and regulation, and encouraged outsized bonuses to CEOs while ignoring middle-class Americans have brought us to the most serious financial crisis since the Great Depression.

I certainly don't fault Senator McCain for these problems, but I do fault the economic philosophy he subscribes to.

This may play well on television, but it is rather disappointing coming from the man who promised us a new kind of politics. There have been no significant changes to the financial regulations in the last eight years that might credibly have created this crisis (the one major alteration, Sarbanes-Oxley, moved things in the other direction). And it's hard to blame loosened oversight when the entire market systematically overvalued the now-toxic securities. Lehman Brothers was not, after all, trying to put itself into receivership for the sheer joy of molesting taxpayers.

Worth reading the rest of it.

It's a little disconcerting to have both major party candidates running as populists. Of the primary candidates in both parties this year, I think the one who might have been best-qualified to deal with the financial crisis was Mitt Romney. He didn't have the sorts of qualifications the American public seems to prefer this year though: he wasn't raised by a single mother, didn't spend any time in a POW camp, didn't live until age ten in Scranton, PA, didn't seem like he actually liked hunting, etc.

Privately-held versus Publicly-traded Investment Banks

In the course of work for a client, I've had some discussions with senior executives at a decent-sized, privately-held investment bank. Since the company is privately-held, of course I don't know exactly how well it is doing, but judging by how it has expanded and made a lot of new hires over the last couple of years, I'm inclined to believe the company's executives when they say their investment bank has been doing well and has avoided the problems that have plagued larger, publicly-traded firms such as Lehman Brothers. I wonder whether this is true more broadly of privately-held investment banks, and whether there has been any research conducted comparing privately-held investment banks to their publicly-traded counterparts with respect to their stability, ability to manage risk, etc. Perhaps it's simply the case that firms with less capital available are forced to be more prudent in how they employ that capital. Perhaps there are relevant differences in culture between publicly-traded and closely-held investment banks. I do remember reading that this was a concern of some Goldman partners before the firm went public in the 1990s.

More Sunday Night Excitement

A lot of news for a Sunday Night:

- Lehman Brothers is filing Chapter 11.
- Bank of America is buying Merrill Lynch.
- The Fed is expanding the types of collateral it will lend against to include equities.
- AIG is planning asset sales to raise capital as part of a massive restructuring.

I wonder if at some point it might make sense for the Federal government to create its own vulture fund with one or two hundred billion dollars and start buying up distressed mortgages and mortgage-backed securities at steep discounts. Maybe that would put a floor under the prices of some of the complex assets derived from mortgage-backed securities, and if the Feds buy these securities at steep enough discounts, they might turn a profit on them when the credit markets revive. Just a layman's thought. Perhaps professional pundits will offer better suggestions.

David Einhorn on Lehman Last Year

Via Seeking Alpha again, Amit Chokshi's notes on David Einhorn's presentation on his Lehman (NYSE: LEH) short idea at last November's Value Investing Congress in New York:

Value at Risk (“VaR”) is not appropriate for measuring risk:

• Einhorn compared investment bank VaRs to actual results for recent quarters, which showed that actual results were off by multiples of VaR estimates in some cases.
• Risk managers should focus on the tails of bell curves and also be prepared for fat tail risk - 5-10 sigma events are not uncommon¹.

FAS 159: Profit from One’s Demise

• Fair value accounting standard that allows asset and liabilities to both be marked at fair value.
• This accounting mechanism allows for income to be recognized as liabilities are marked down to fair value.
• FAS 159 is acceptable for market risk but not for idiosyncratic risk.
• The Street is comfortable with FAS 159 but does not seem to grasp all aspects of the ruling.

Lehman Brothers (LEH) – short idea

• Looks vulnerable due to lack of transparency regarding writedowns
• Could be following its “playbook” from 1998 liquidity crisis

LEH had mortgage exposure but took no writedowns

The market recovered and LEH pulled through

Could that happen now?

• LEH stock has held up because of “good” quarters

2008 EPS estimates remain unchanged at $7.75 which would follow a record year in 2007

Sellside believes the chance of a writedown at LEH is minimal

LEH 10-Q reveals no significant loss on Level III investments which Einhorn is skeptical of

• In 2006, fixed income accounted for 48% of LEH income while securitizations accounted for 15% of income.
• LEH should be much more exposed to losses than what has currently been reported.

LEH either recognizes larger losses (which will be a negative surprise) or LEH will likely under-earn competitors that have taken larger losses and cleaned up their balance sheets relative to LEH.

Lehman was trading at about $60 per share last November when Einhorn gave this presentation. Today it closed at $7.25 per share.



¹Not to be picayune about it, but if I remember my statistics correctly, by definition, 5- and 10-sigma events are of course uncommon, and also by definition, bell curves (normal distributions) don't have fat tails. I think Einhorn's point (simplified, apparently, for his audience) was that in finance returns usually do not follow normal distributions; their distribution curves have fat tails, indicating that extreme events are far more likely to occur than they would under a normal distribution. This is true, and has been, as far as I know, widely accepted for some time.

"Freddie Mac is the Cheapest Stock I've Ever Seen"

So said value investor Richard Pzena¹, of Pzena Investment Management, at the 3rd annual Value Investing Congress in New York last November, according to the notes of attendee Amit Chokshi. Chokshi posted the following notes from Pzena's presentation on Seeking Alpha last November 30th (hat tip to commenter "cm1750" on GuruFocus):

* Pzena's talk was entitled 'Evaluating Financials in a State of Panic'
* The only time good businesses sell for cheap prices is during times of distress
* Financial stocks are cheap on a P/B basis against historical multiples
* Freddie Mac (FRE) is the cheapest stock Pzena has 'ever seen':
* Losses are absorbable and GAAP is not useful in evaluating FRE
* Pzena believes the mortgage payment resets that result in higher monthly payments will be handled by borrowers because they will be reluctant to forfeit the equity in their homes
* Fears in the market don’t necessarily impact FRE’s business but are impacting its stock
* FRE Loan to Value = 60% and are mostly in fixed high credit
* Believes FRE will follow similar action to P&C insurance companies

1. Hurricane/natural disaster occurs, P&C insurance companies experience losses, P&C companies raise prices/premiums, P&C stock goes up
2. Housing crisis has occurred, FRE and other industry players will raise fees, tighten credit standards, experience lower losses resulting in strong capital returns and thus improving stock price.

At the time, Freddie Mac (NYSE: FRE) was trading at about $30 per share. Today it closed at 95 cents per share. Off the top of my head, I can't think of a value investor who has made money going long on a financial stock over the last year and a half, but another investor at last November's Value Investing Congress, David Einhorn, has done well shorting Lehman Brothers (NYSE: LEH).



¹Richard Pzena went to Wharton with Joel Greenblatt, author of The Little Book That Beats the Market. In that book, Greenblatt appeared to be alluding to Pzena as "the smartest money manager I know" on p.72.