Weekend at Bernanke's

Four different stories came out of Wall Street this weekend, any one of which would have made an interesting start to the week.

First, sub-prime mortgages brought down Lehman Brothers house of cards. Lehman closed its doors to forestall creditors. Like Bear Stearns, which experienced a run on the bank earlier in the year, Lehman was a major fixed income investment bank. Home to the popular Lehman Bond Indicies, the bank manufactured a large percentage of the sub-prime loans that have triggered the 2008 financial crisis. Apparently they weren't able to dump all of the toxic paper to clients, and retained enough that these bonds, for which almost no market exists, when "marked-to-market" were marked down to almost worthless. Lehman reported a $4 billion loss last week, but still was able to report assets, a positive book value, and positive cash earnings (the mark-downs are a non-cash charge). Thus, even though Lehman was probably profitable on a cash basis, the fact that buyers would no longer finance its operations was too much for it. Several last minute attempts to sell Lehman to foreign banks failed because the Fed refused to make another sweetheart deal, as they'd done in March for Bear Stearns.

By the time I read about it, late Sunday night, it was old news. As the clock passed the midnight hour, the reports were of Lehman employees going in on Sunday to clean out their desks, enjoy one last beer and pizza with (former) co-workers. Lehman declared its parent company bankrupt. Subsidiaries are still open for business on Monday. But a broker with no access to funding is necessarily in a liquidating stage. The asset management subsidiaries will be sold to others. Who knows what Lehman creditors will receive. Shareholders have lost everything, as should have been the case with the Bear.

The Lehman saga, however, was only part of the story.

With Lehman gone, attention was bound to turn to Mother Merrill. One blogger is said to have speculated that Lehman was brought down by big Wall Street interests at Goldman who were wanting to hedge their own positions in Goldman shares, but owned restricted stock and were thus prohibited from shorting their own stock. Lehman, it was speculated, was merely a proxy for GS. With Bear and Lehman now gone, Merrill would be the next best short, given that they couldn't short their own shares. Merrill knew that it could never withstand the sort of shorting pressure and intense market pressure that killed off the other two free standing investment banks, so it struck up merger talks with Bank of America after being encouraged to do so by the Fed.

Elsewhere in New York, ten major banks are said to be putting together a $70 billion pool to help financial companies in distress. The Federal Reserve, having spent a great deal of its balance sheet bailing out Bear Stearns, needs help. The big banks figure that if they don't hang together, they will hang separately.

Perhaps the real question is demonstrated by the fourth story coming out of the Big Apple, that the giant insurance company, AIG, has approached the Fed looking to borrow as much as $40 billion because it, too, is having difficulty rolling over debt. The Treasury allowed investment banks to tap into the Federal Reserve in March, in an attempt to keep Lehman and Merrill alive. AIG figures that would help them out, too, and would also like help from Uncle Sam. The question is, if it takes $40 billion to bail out AIG, just how far is that new bank pool of $70 billion going to go?

• How could this happen?

The good news is that most of this news is "old news," simply confirmation of what we already knew, that banks had lost their senses and the markets were going to discipline them severely, with or without help from the regulators. The regulators, it seems, have been much too cozy with these big Wall Street firms for much too long. When Congress passes "privacy laws" that are essentially meaningless, the big firms on Wall Street figured out a way to turn these new laws into a big stick to wield against brokers who try to change firms, which has nothing to do with the original intent of the legislation but is just another example of how the regulators roll over for Wall Street. Some of the biggest buyers of these problems loans and credit derivatives are the highly regulated big national banks. The Adjustable Rate Security crisis happened right under the nost of the Securities and Exchange Commission.

Investors need to realize that the age old joke about, "I'm from the government and I'm here to help" is as big a joke on Wall Street as anywhere else. The S.E.C. isn't going to protect them from Wall Street greed.

Only common sense can do that. Had Wall Street and its regulators demonstrated a bit more common sense in the past decade, the current episode of debt destruction might not have been necessary. Instead, the market is acting like a slow moving car crash and I don't have any idea how many times the car is going to roll. As one Minyanville blogger recently noted, "Rome wasn't burnt in a day."

• Has the May-Investments Outlook Changed?

We're still pretty much on the sidelines when it comes to owning financial stocks, and especially banks and brokerages. However, this sell-off has advanced to the stage where "safe havens" are few and far between. Not even our bond positions have been able to catch a bid. The biggest problem for our portfolios hasn't been Lehman going off the air, but oil prices crashing to below par ($100).

We're in a "no place to hide" market and the only good thing that I can say about that is that high volatility, "throw the baby out with the bathwater" markets are generally experienced more near a market bottom than a market top. Let's hope that is the case this time as well.

In January of 2008 we told clients to expect a difficult first half but that markets would recover by year-end. We observed that after predicting a recession in 2007 (starting with our October 2006 economic update) that we were happy to report that things were not as bad as we'd anticipated; the job market was not as bad and profits outside of the financials and consumer cyclicals sector were hanging in there. The tax rebate earlier in the year also helped keep the economy moving along. After all, it's now September of 2008 and despite this weekend's headlines, the economists are still debating whether or not we're actually in a recession.

Even at our mid-year Economic Update, I gladly announced that our rosy conclusion was that the glass was absolutely half full!

Unfortunately, the last two months of economic statistics haven't been encouraging and the unemployment situation has taken a turn for the worse. Consumer sentiment, which was starting to turn back up (from very depressed levels) will now probably roll over. I keep looking for some good news on the horizon, but it's harder to find than a non-partisan politician. Our prediction for a year-end upturn is clearly at risk and the last thing I want to do is hold on to my forecast just so I don't have to admit it was wrong.

Though I am still officially an optimist at the moment, my confidence level in that outlook is practically nil. The markets are very volatile and will likely "break" in one direction or the other.

Some major piece of good news could result in a strong move up that could turn things around. For instance, if the Federal Reserve would temporarily suspend "mark-to-market" accounting requirements for financial companies, some of the pressure to dump assets would be eliminated. The Fed might want to re-introduce restrictions against naked short sales to make it harder for short sellers to force these companies into a "bank run" sort of scenario where a collapsing stock price sends a signal to the bond market to stop buying a certain company's debt.

There is some good news lurking out there. Tomorrow morning would be a great time for it to make an appearance!

Only 15 days left in September. And counting....

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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