In a day of frenetic speculation, various possible suitors for Lehman popped up: Goldman Sachs, Barclays, and HSBC all had their time in the sun. But the strongest rumours concerned Bank of America.
The week had started brightly following the US Treasury’s decision to take Fannie Mae and Freddie Mac into conservatorship. But after potential Lehman suitor Korea Development Bank spurned its opportunity, the bears pounced on a new target, forcing the broker dealer to release early its third quarter results and to reveal plans to shed nearly $40bn of real estate exposure.
As has been common in the credit crisis, once one bushfire has been extinguished, another one or two spark up somewhere else. Fannie and Freddie might have been saved, but that has merely shifted the attention on to other US firms in trouble. The fear now is that if Lehman goes over the weekend, yet another institution will be dragged to the guillotine.
"I think the market is coming round to the conclusion that about six US firms will fail or need to be bailed out," said a senior credit strategist in London.
Lehman, Merrill Lynch, Washington Mutual, AIG and Wachovia all have problems to a lesser or greater extent, but it was Lehman that dominated the airwaves.
This firm was at the very forefront of the volatility and bear market mood this week. It has been pursued by the credit crunch like an ailing boxer staggering from one corner to the next trying to avoid the jabs and upper cuts. But it now looks like the referee is giving the final count. "We think we’ll see a solution this weekend," said a dealer.
Lehman’s share price was hovering around $5 yesterday afternoon, and the continued speculation about its fate cast a long shadow over the markets.
"The whole Lehman business is creating great uncertainty in the credit markets and this isn’t good. The Fed knows it," said a CDS dealer.
If Lehman does collapse, it is possible that the Treasury will broker a deal in the same way it did for Bear Stearns. It will have to absorb the most distressed assets on its balance sheet while finding a buyer for the husk of the business.
HSBC line up
Lehman rallied 125bp from the earlier wides late in the London day after rumours that Goldman Sachs is positioning itself as a buyer, though sources in New York later disputed that it is interested. Goldman deals at around 200bp in the CDS market. As London dealers left their desks Lehman was around 625bp/650bp.
"I think these huge price swings reflect the uncertainty in the market. When the rumours about Goldman surfaced, understandably some shorts decided to take profits," said a London default dealer.
Barclays has also been mentioned as a possible buyer, as it has throughout the last six months. It widened about 7bp yesterday to 135bp/140bp. HSBC, another rumoured buyer, is 70bp/75bp, while Lloyds is 92bp/97bp and HBOS is 250bp/260bp.
But late in the New York day, Bank of America took its place at the forefront of those rumoured to be interested in buying Lehman.
Lehman chief executive officer Dick Fuld is believed to be touting his firm to buyers, according to several New York sources. Up until a few days ago, Fuld, a Lehman man to his fingertips, maintained that his beloved firm would stay independent at all costs.
The sell-off began only a day after the Fannie and Freddie news when it was rumoured that Korea Development Bank had pulled out of talks with Lehman about buying a possible stake — rumours KDB later confirmed. It said that the two parties had disagreed about the terms of an investment — which means Lehman valued itself more highly than KDB did.
The fall prompted Lehman to bring forward its third quarter earnings and reveal plans to shed nearly $40bn of real estate exposure and sell part of its investment management business.
Yet the move failed to placate the rating agencies — Moody’s announced it was putting the bank’s long and short term ratings on review with direction uncertain, warning that Lehman could fall below single-A. This in turn prompted further sell-offs as analysts said that a downgrade would lead to collateral posting, cause difficulties in rolling commercial paper and drive potential counterparties away. Standard & Poor’s also has Lehman’s A long term rating on rating watch negative.
Moody’s said that a "strategic transaction with a stronger financial partner" would bolster the bank’s A2/P-1 rating, but that if it was unable to secure such a partner in the "near term", a downgrade to the Baa category was likely, with the ratings remaining on review.
Counterparties such as Goldman Sachs and Merrill Lynch, however, reaffirmed that they were continuing to do business with Lehman.
Fears of a counterparty pullout led Lehman to push forward its preliminary third quarter results, which showed an estimated $3.9bn loss as a result of net markdowns of $5.6bn, mainly driven by its real estate assets.
The losses showed an acceleration from the second quarter, when Lehman posted losses of $2.8bn. The bulk of the writedowns came from its Alt-A mortgage portfolio, which Lehman was unable to hedge adequately.
"The majority of our writedowns were in Alt-A, driven by an increase in delinquencies, and loss expectations which were specific to Alt-A prices and did not affect the performance of our hedges," said chief financial officer Ian Lowitt during the earnings conference call. "Unfortunately there is no direct hedge for Alt-A assets as there is in subprime with ABX. Our strategy around hedging is to break the exposures into spread and HPA credit exposure. We use ABX to hedge the HPA exposure and a combination of CDX, CMBX, single name financial CDS and swaps to hedge the spread exposure. Our HPA hedges were ineffective as Alt-A prices dropped 20 to 25 points during the quarter, while ABX triple-A dropped on average eight points and ABX subs, that’s double-A through triple-B minus, dropped only four points. Our spread hedges were also ineffective as residential credit sectors widened significantly by 200bp to 600bp, while other spread sectors were more range bound. Our corporate hedges, for example, only widened 35bp."
Having failed to mitigate the risk in its portfolio, Lehman decided that the only way to preserve capital and reassure investors was to get rid of the exposure altogether. Consequently it announced that it plans to spin off $25bn to $30bn of commercial real estate assets, comprising loans, equity and securities, to shareholders through a new, public, but initially self-financed, vehicle. The spin-off would reduce Lehman’s nominal commercial real estate exposure to as little as $2.6bn, although it will be providing debt finance of 75% to 80% to the new vehicle, Real Estate Investments Global. Further capital will be provided by an injection of equity from Lehman, and the bank said REI Global will not have to mark the assets to market and can sell them off in an orderly fashion.
Lehman also said that it was in negotiations with BlackRock to sell $4bn of UK residential mortgage assets, believed to be whole loans. If completed as planned in the next few weeks, the sale would reduce Lehman’s residential exposure to $13.2bn globally. Lehman will also be providing financing for approximately three quarters of the assets’ value.
Finally, the bank will sell a 55% stake in part of its investment management division, including asset management, private equity and wealth management, but excluding middle market institutional distribution and its stakes in hedge fund managers. Lehman said that the sale would result in an increase in tier one capital and a $3bn increase in its tangible book value through the elimination of goodwill related to the Neuberger Berman business. It further claimed that the impact on earnings would be only be about 5%, based on 2007 figures, as it was retaining the higher margin business.
Rating agencies and analysts alike gave a cautious welcome to the moves, but insisted they weren’t enough to solve Lehman’s long term problems, which were mainly down to perception. "We believe these are partial steps in the right direction as it takes the necessary measures toward cleansing the balance sheet," said CreditSights analysts on Wednesday. "However recent media reports noted that discussions with various other banks/parties for capital contribution(s) still makes one believe that Lehman still needs to stockpile capital, possibly by another $3bn to $4bn plus."
By Thursday afternoon the warnings looked like becoming self-fulfilling prophecies, as investors took them as signals to sell or short, increasing the pressure on Lehman.
"Moody’s believes that Lehman’s financial flexibility has become more limited as its stock price has fallen to near all-time lows and the firm is experiencing a crisis of confidence," the agency wrote on Wednesday. "Although Moody’s believes liquidity remains firm and has not shown signs of material erosion, the potential for rapid franchise impairment remains a significant concern for Moody’s."
The difference a week makes
At the close on Monday, after a hearty rally across all sectors, it seemed to a lot of analysts and observers that the $200bn relief package for Fannie and Freddie announced over the weekend by treasury secretary Hank Paulson had allowed the market to turn the corner. What a difference a week makes.
By Friday, it is looking like the Treasury was going to have to get out its cheque book again and again. The Treasury has shown, with Bear Stearns and the government sponsored enterprises, that some institutions are too big to fail and that the US taxpayer will carry the can if need be. This week the non-partisan Congressional Budget Office said that Fannie Mae and Freddie Mac "should be directly incorporated into the federal budget".
The likelihood of heavily increased government expend-iture was expressed in sovereign CDS levels. At the close in London yesterday, the USA was at a mid of 17.5bp, slightly better than the UK at 17.7bp and slightly worse than Japan (rated mid double-A) at 16.4bp. Germany, meanwhile, is thought half as likely to default as the US at 8.2bp.
Problems from day one
Moreover, the new president — whether it is Barack Obama or John McCain — will have to face up to these challenges very early in their term of office. If this had happened two or three years into a term such expenditure would be a little easier to hide, but within about 45 days of taking the oath of office in front of the Capitol building, one of these men will be facing some searching questions about who will pay for all this mess.
Merrill Lynch has taken its place alongside Lehman and sold off by 60bp yesterday to 380bp/400bp. A Sanford Bernstein analyst this week put Merrill in the same category as Lehman in terms of the dangers they face and said that both are the most vulnerable firms on Wall Street. If it needs to be bailed out, a similar procedure to Bear Stearns is also likely to be followed.
Washington Mutual got a dreadful pummelling this week. It widened by the equivalent of 400bp on Wednesday to over 45 upfront points after it ditched its chief executive. This won’t do much to save WaMu, which is heavily exposed to the fractured Californian housing market and expected to lose $19bn over the next three years. It urgently needs more capital. One year default trades at the equivalent of around 2,400bp.
It is in a different position, as is Wachovia, to Bear Stearns, Lehman and Merrill, as it is not a counterparty to large numbers of CDS and fixed income trades. Its collapse would not entail the danger of systemic convulsion. It may be forced into liquidation by its regulator, noted analysts. At this point it might be restructured or split into various different units.
However, under new accounting rules any buyer will have to mark to market all the assets on the loan book, which is hardly an attractive proposition.
AIG presents a trickier set of problems. Like the investment banks, it is a counterparty to a large number of trades and it is now flirting with upfront territory in the CDS market.
It climbed past 500bp for five year default protection for the first time on Wednesday and yesterday sold off to 670bp/700bp, and it is feared that it too needs even more capital to shore up its damaged balance sheet. To date, it has recorded losses of over $20bn in CDS positions and most do not expect this pattern to be discontinued this quarter. In the last month it has widened by over 200bp.
The volatility in the financial sector forced both CDX and iTraxx HiVol indices to record highs. The CDX HiVol hit around 385bp while the iTraxx HiVol was at 208bp. The iTraxx Europe closed at 105bp/106bp with the Crossover at 550bp.
Here’s the good news
Elsewhere in the CDS market, Acom, the Japanese consumer finance firm, was buoyed by the news that Mitsubishi Financial is increasing its stake from 19% to 40%. It rallied by 15bp to 140bp/145bp, and the news also rallied Takefuji by 10bp to 590bp/600bp.
There has been an improvement in the levels of Finnish paper producers. UPM Kymmene has improved by 35bp over the last month to 300bp/310bp and rallied 15bp this week after it announced the closure of its least competitive mills and the reduction of the work force by 1600.
Stora Ensa, its rival, improved by 20bp this week to 960bp/980bp and is 200bp narrower over the last month. It is also closing unprofitable assets and has also announced it will invest in domestic roundwood forests which will lessen its dependence on expensive Russian imports.
However, both firms face the long term and probably irreversible decline in the demand for paper for newsprint.
ITV, the UK broadcaster, rallied by about 10bp to 300bp following renewed speculation that it will face a takeover.