How little we know

Lehman Brothers (LEH:NYSE) ends the weekend without a deal, and is rumoured in the NYT to be filing for bankruptcy protection after 158 years of independence. Merrill Lynch (MER:NYSE) CEO John Thain decides that he doesn’t want to tempt fate when the market opens tomorrow, and has sealed a sale to Bank of America. The same B of A that was obstensibly prepared to acquire Lehman as of Friday, provided it could get the same deal from the Federal Reserve that JP Morgan got with Bear Stearns. For reasons that defy logic, Treasury Secretary Hank Paulson wasn’t prepared to provide federal funds to grease the wheels for a Lehman transaction, despite having done the same thing for the smaller Bear almost 6 months ago to the day.

The financial system was “too interconnected” to allow for an orderly wind down of Bear, but not of Lehman? Apparently Mr. Paulson believes that the system has had time to prepare for these events, and that there has to be a “moral hazard”, at least eventually, or else capitalism will become a mockery of itself.

How little we know.

Former Fed Chair Alan Greenspan was interviewed last week and reminded us all not to confuse “liquidity” with “solvency”. Which could be taken as code for: don’t assume the Fed window being open to investment banks is the same thing as free equity to cure all asset pricing ills. Good point.

How little we know.

The spring of 2007 feels like a lifetime ago for a number of reasons, personal and professional. To think that the credit crunch started almost 18 months ago, and household name brand firms are still searching for a plan.

According to the last set of preliminary financial statements, the book value of Lehman is around US$27.29 (shareholders equity is US$28 billion). The same price the stock was valued at in June 2008. Yet LEH shares closed out the week almost 10% of that posted book value. If liquidation comes this week, is the market telling us that Lehman’s assets were posted US$25 billion too high? The problem is, on assets of US$600 billion, that’s not much of a delta — less than 5%.

If every financial institution has overvalued their assets by 5%, that would mean that every firm that’s levered 20 to 1 or higher is essentially without any shareholders equity. Let’s hope the marks aren’t that far off.

One thing is for sure: we know very little, and one cannot predict what is yet to come.

MRM