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Generational Dynamics Web Log for 10-Jun-2008
Lehman Brothers shocks Wall Street with more unexpected asset writedowns

Web Log - June, 2008

Lehman Brothers shocks Wall Street with more unexpected asset writedowns

And there may be a smoking gun showing that UBS AG committed fraud.

Lehman Brothers was another investment bank that kept assuring us that they'd been particularly clever in avoiding investments in CDOs and other securities that later turned out to be worthless.

After Bear Stearns, Wall Street's smallest investment firm, imploded in March because of investor panic, and the Fed had to step in and prevent disaster. The historic Fed intervention prevented major worldwide financial meltdown and crisis, as I explained last month. This is not speculation -- Fed chairman Ben Bernanke said as much in testimony before Congress.


Don't they make a lovely couple?  Hedge fund manager David Einhorn and Lehman CFO Erin Callan. <font face=Arial size=-2>(Source: NY Times and Lehman)</font>
Don't they make a lovely couple? Hedge fund manager David Einhorn and Lehman CFO Erin Callan. (Source: NY Times and Lehman)

Since the Bear Stearns implosion, attention immediately began to turn to the next smallest investment firm, Lehman Brothers.

It turned into a personality battle of sorts. David Einhorn, who runs the Greenlight Capital hedge fund, was loudly claiming that Lehman was not valuing the assets on its books, and was not disclosing all the risks. On the other side was Lehman CFO Erin Callan, who has been out front reassuring investors that Lehman was OK.

In April, speculation got so bad that Lehman CEO Richard Fuld sought to calm things by stating, "The worst of the impact on the financial-services industry is behind us."

And so Wall Street was shocked, shocked on Monday, when a Lehman press release (PDF) announced:

"NEW YORK, June 9, 2008 Lehman Brothers Holdings Inc. (ticker symbol: LEH) announced today that continued challenging market conditions will result in an expected net loss of approximately $2.8 billion ... for the second quarter ended May 31, 2008....

Net revenues for the second quarter of fiscal 2008 reflect negative mark to market adjustments and principal trading losses, net of gains on certain debt liabilities. Additionally, the Firm incurred losses on hedges this quarter, as gains from some hedging activity were more than offset by other hedging losses. ...

Chairman and Chief Executive Officer Richard S. Fuld, Jr. said, I am very disappointed in this quarter's results. Notwithstanding the solid underlying performance of our client franchise, we had our first-ever quarterly loss as a public company. However, with our strengthened balance sheet and the improvement in the financial markets since March, we are well-positioned to serve our clients and execute our strategy."

The loss included a $4.1 billion asset writedown, mostly from CDOs and other residential mortgage backed securities.

This is a preliminary announcement, with the actual earnings announcement scheduled for June 16. Pundits are congratulating Lehman for warning investors early, so they won't be surprised on June 16.

But there's little doubt that Lehman was forced to make this announcement. Investors were getting increasingly nervous, the stock price was falling significantly, and there was increasing fear of a Bear Stearns-type panic.

It's the same old story: Richard Fuld and Erin Callan materially misrepresented the values of their assets for several months. Take your pick: Either they were lying, or they had no idea what the values of those assets are.

Either way, it means that nothing that any financial institution says these days can be trusted.

As we posted in April, Lehman has $200 billion of Level-2 assets and $42 billion of Level-3 assets on its books. These are the CDO and CDS type assets that can't be market to market because there is no market.

(For those interested in the math behind the creation of CDOs from CDSs, see "A primer on financial engineering and structured finance." For a discussion of credit default swap (CDS) counterparty risk, see "Brilliant Nobel Prize winners in Economics blame credit bubble on 'the news.'")

With Monday's announcement, Lehman has written down a total of $8 billion in assets of the $242 billion potential. In Monday's press release, the company made no claim whatsoever that the writedowns are over, and it can be assumed that they have a long way to go.

However, there's some uncertainty about this because Lehman also announced that it had sold off $130 billion in assets. If those assets turn out to be from the $242 billion in Level-2 and Level-3 assets, then Lehman may indeed dig itself out of this hole, albeit as a much smaller company.

A smoking gun for UBS AG?

As I've said often, there's no doubt that massive fraud occurred on Wall Street around the creation of the CDOs and other mortgage-backed securities. The circumstantial evidence is overwhelming. The Wall Street firms might claim that they didn't realize what would happen in 2002, or 2003, or 2004, or 2005, or perhaps even 2006, but there can be no question that they knew, or should have known, in 2007 that their valuation models were broken. And yet, the rate of abuses actually INCREASED in 2007.

Now we may have an actual smoking gun, in the form of a letter indicating that UBS warned some investors of problems, but not others.

The problem was not with CDOs, but with the hare-brained auction rate securities (ARSs) scheme, which has created more trillions of dollars in worthless securities.

The letter indicates that UBS knew that the ARSs were in trouble as early as December, but kept selling them to investors as late as February.

Effect of Ambac/MBIA downgrades will be widespread


Meredith Whitney, director of equity research at Oppenheimer
Meredith Whitney, director of equity research at Oppenheimer

I've frequently quoted Oppenheimer's Meredith Whitney as the best and most honest of the Wall Street analysts. And now, a prediction that she made in February is closer to coming true.

Part of the magic that allowed investment banks to turn CDOs and other nearly worthless mortgage backed securities into "risk-free" AAA rated securities was the "monoline" bond rating agencies, If you're an investment bank issuing questionable bonds, then you buy insurance from an insurer who promises to pay off the bonds if the issuer defaults. That way the bonds are "doubly-protected" -- either the bond will pay off or the insurance will pay off -- thus magically earning an AAA rating.

The three largest bond insurers are MBIA Inc., Ambac Financial Group Inc., and Financial Guaranty Insurance Co. (FGIC). Like any insurance company, they're supposed to evaluate the risk of guaranteeing insurance payouts, and then refuse to provide insurance if the risk is too high. These bond insurers didn't do that. Instead, they ignored the risk and charged fat fees to insure questionable securities without questioning them. This is essentially fraud.

Once the massive writedowns of securities began last Fall, it became pretty clear that the bond insurers had insured many bonds that were turning out to be worthless and shouldn't have been insured. This meant that the bond insurers themselves were on the road to bankruptcy, since they wouldn't be able to pay off all the insurance claims when the CDOs defaulted.

That fact threw into doubt the AAA ratings on corporate debt of the bond insurers themselves. (Keep straight that there are two different things here: The ratings on the bond insurers' own corporate debt, and the ratings on the CDOs that they insure.)

The ratings agencies (Moody's, S&P, Fitch) have been playing a game, stalling as long as possible, keeping the ratings on CDOs and bond insurers' debt at AAA. This is fraudulent, but it's OK because the government is openly encouraging this kind of fraud.

In February, Meredith Whitney predicted that Citibank, UBS and other banks would lose billions of dollars more when the bond insurers lost their own AAA ratings.

This part of the game-playing now seems to be coming to an end. Fitch has already downgraded MBIA and Ambac. Last week on Wednesday, Moody's indicated that a downgrade was near. And on Thursday, June 5, Standard & Poor's downgraded the ratings on MBIA and Ambac, the two largest bond insurers.

According to S&P:

"In our view, the impact of the downgrades on the structured finance market is wide spread... [W]e expect the deterioration of the creditworthiness and the resulting downgrades of MBIA and Ambac, with recent downgrades of other monoline bond insurers, to add to the pressures on certain broker-dealers' and banks' financial performance."

Meredith Whitney was more specific. In a note to investors on Monday, she wrote that Citibank, Merrill Lynch, and UBS AG alone will suffer $10 billion in additional writedowns.

However, the downgrades are expected to cause more widespread "collateral damage." Hundreds of billions of dollars (notional value) of CDOs and other mortgage-backed securities received AAA ratings only because of insurance by MBIA and Ambac. All of these ratings are now in jeopardy, and we can expected substantially more writedowns from other institutions.

The thing to understand from all this is that the credit bubble that was created in the early 2000s continues to leak faster and faster, and the deflationary spiral is growing.

As was shown in the case of Bear Stearns, all of these investments are interlocked in hedge funds, investment funds, and so forth. At some point, a multi-billion dollar loss is going to trigger a chain reaction and massive financial meltdown, as almost happened with Bear Stearns.

And once again, the point is that there's no one left on Wall Street who has any credibility at all. The ratings agencies stalled for months before doing what they had to do, essentially committing fraud in the process. That's the norm today on Wall Street, as everyone covers up to avoid the inevitable.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (10-Jun-2008) Permanent Link
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