Lehman Bankrupt, Merrill Swallowed, AIG Wilting

Company Research, Market Commentary

Well, just another ho-hum Monday on Wall Street. Not much to report, except another major banking institution, Lehman Brothers (LEH), filed for Chapter 11 protection, Merrill Lynch (MER) has been gobbled up by Bank of America (BAC), and the headlines are sure to continue to roll in on the future of insurance giant AIG (AIG). There is a lot of data to digest today, so in keeping with Ockham’s Razor, we will try to quickly get to the main points of each of these events and what they mean.

To begin, although it was expected by many, the bankruptcy filing of Lehman Brothers has shaken financials. Lehman has been on death watch for a few weeks (or months) because it was very heavily leveraged and deeply dependent on the troubled mortgage backed securities in its portfolio. Lehman claimed more than $600 billion worth of assets in its most recent filing, $20 billion in common stockholder’s equity and the rest in debt. Only the now defunct Bear Stearns, had a higher gross leverage multiple than Lehman. That is simply too much debt to be supported by that little equity, and firms interested in purchasing LEH knew it. So, they (Bank of America and Barclay’s were the most likely suitors) needed a government backstop before they could be inclined to add LEH “assets” to their balance sheets. The Fed rightly did not provide any backing for this deal which would have further exacerbated the moral hazard that was building in the wake of the Bear Stearns, Fannie and Freddie deals. Lehman will now try to sell-off its investment management unit and its broker dealer to the highest bidders. Now, Lehman will have to reap what it had already sown and, as always, it will be the equity holders and not the bond holders that will take the biggest hit.

The proud and venerable name of Merrill Lynch appears to be headed under the umbrella of Bank of America. BofA will in all likelihood become the world’s largest bank with this acquisition. Merrill’s stock traded at three times BofA’s acquisition price just a year and half ago. It is interesting to see BofA actively seeking to gain market share (see Countrywide deal) as other competitors are just trying to stay off of the front page. Time will tell if it made a good acquisition or is just creating more problems for itself, such as: (1) how much risk is left on Merrill’s balance sheet, (2) will the corporate cultures mesh, (3) will BofA retain the best Merrill talent, etc. This strategy could a major boon for BofA shareholders when the mortgage and credit crises begin to dissipate. Time will tell whether Ken Lewis and gang are remembered as geniuses or fools, but in the long run we think this deal will be beneficial to BofA shareholders.

Lastly, will AIG be next in the line following Bear and Lehman? The stock is off more than 50% today as it looks to fill a $40 billion hole. AIG is asking outside investors to come to the rescue and inject the $40 billion in capital to shore-up some of its toxic paper. AIG has even reportedly asked the Federal government for a $20 billion bridge loan, but this looks unlikely to be approved given Treasury Secretary Paulson’s new-found fear of moral hazard. The state of New York will allow AIG to transfer $20 billion of liquidity from its insurance subsidiary to the parent holding company, which will buy it some time. AIG plans to spin off some of its divisions including: auto insurance, annuity services, and, possibly, its aircraft leasing company, International Lease Finance. We hope that the Fed will again reject the inclination to bail out AIG and thus further the moral hazard risk, so that the markets can begin to recover on their own. As such, AIG needs to work through its problems on its own.

In conclusion, it is clear that there is a lot of fear in the market over the future of financials. We are not willing to say that we have reached a bottom in financials, but it is at times like these—when it appears that the sky is falling—that a contrarian investor should start to look for opportunities. If you need a few reasons why we remain bullish on the market for the long term: crude oil hit a seven month low of $94 per barrel this morning, the market’s price-to-peak earnings ratio is 14x—its lowest since 1991—and the dollar continues to rebound against most other currencies. So, the pressure from high oil and commodities prices is abating, stock valuations have moderated considerably from unsustainably high levels and the economy is still growing —at a 3.3% clip according to the most recent revision of the second quarter GDP. These improving factors are being over-shadowed by overall glum market sentiment, and sentiment may stay low until housing begins to show signs of improvement.

Ockham Research Staff @ September 15, 2008

tags: AIG | BAC | Bank of America | Bear Stearns | Countrywide | financials | LEH | Lehman | MER | Merrill Lynch