Short Sellers, Mark-to-Market, and Mark Cuban’s Nonsense

It’s been a while since I have last posted. The markets have indeed kept me busy. I will try to get back to a normal posting schedule.

I did want to spend a couple of minutes discussing a few topics that I have been thinking about lately.

1) IT’S A BAD IDEA TO BAN SHORT SELLERS
While I admit that as a long-only manager, shorts can be very painful to my holdings. But I still think they play a very critical role in our trading. Very good short sellers will expose bad business models and force them to improve themselves or go out of business. They play an important part in our market ecosystem and to ban them can artificially inflate valuations. Beware when they come back…it could get ugly.

2) MARK-TO-MARKET IS EXACTLY WHAT WE NEED
Recently I have heard politicians discuss the possibility of modifying the mark-to-market accounting rules. Rather, they say we should potentially value these securities as if they were to be “held to maturity.” Therein lies the problem.

Investment banks and prop desks trade the securities. They are not in the business to holding them to maturity. Showing these assets as being “held to maturity” will only further inflate asset values and create an even larger bubble burst.

3) RECENT MARK CUBAN BLOG POST = GARBAGE
I have always been a fan of Cubes. He thinks outside the box and is a superb entrepreneur. I am a huge Maverick fan and I really believe he’s one of the best owners in sports, but check out this senseless post from his blog :

Tax the Hell Out of Wall Street; Give it to Main Street

Sep 30th 2008 9:02AM

Tax every single share of stock that is bought and sold 10 cents per transaction. One dime. If you buy a share of stock, your brokerage pays a 10c tax. If you sell a share, your brokerage pays a 10c tax. 1 share, 100 million shares. Its 10 cents per share.

Of course the tax will be paid for by those of us who are buying and selling stocks. So what. Here is the reality. If you are a true investor. Someone who wants to own a share of stock in a company you believe in, then its an amount that is not going to impact your investment decision making process.

If you are a professional trader or an institutional trader that trades continuously, then it may impact your decision making process, but only to the point of reducing your returns by a minimal amount. Its not going to change your inclination to trade. If you make 9.9pct instead of 10pct, you aren’t going to stop trading.

Whats the economic impact ?

If the NYSE, Nasdaq, Amex and OTC are trading 2 Billion shares a day, thats $ 200 Million Dollars PER DAY. If there are 260 trading days a year. Thats about 52 Billion dollars a year.

Thats real money.

Wow…where do I start. To make it easier, let me bullet point my thoughts:

1. So he wants to tax each share. Does does he not realize that if we begin to tax traded shares then we will see volume dry up? Low volume would create serious volatility in the market. Most traders know that light volume days mean more volatility thus lower liquidity for assets and a very inefficient market. Honestly, do we really want more volatility right now? I vote no.

2. I am sorry Cubes but your math is overly-simplistic. By taxing traded shares, then you would see much lower volume. Your tax revenue projections would, at best, be maybe 25% of your guesstimate.

3. There are so many arguments I could make on this post. I think the two above are enough for now…..however how about I propose the following:

TAX THE HELL OUT OF SPORTS OWNERS, GIVE IT TO MAIN STREET

1. Put a 15% tax on sporting event tickets and concessions. Not only would Main Street collect money on tax receipts, but it will force the consumer to save for retirement and not waste $200 for a family of 5 to see a football game.

Isn’t part of the credit crisis the fact that the consumer is “tapped out.” This should help cure part of the that problem.

2. Make the owners finance their own sports venues rather than pushing it on “Main Street.” They sell us on the idea of “perceived” economic benefits from having a sports venue. That’s the oldest trick in the book.

(I actually don’t believe we should “tax the hell out of sports owners”…rather, I want to point out how silly it is for a billionaire to tell others how to run their business when they themselves have been subsidized with taxpayer money.)

Go Mavs!

AIG Downgraded, Faces Cash Crunch.

UPDATE: AIG Ratings Cut by S&P and Moody's. Firms moves to raise capital otherwise they may be forced to file for bankruptcy later this week.

AIG is suffering a severe cash crunch as rating agencies cut the firm's credit ratings, forcing the firm to raise $14.5 billion to cover its obligations.

From the Wall Street Journal: With AIG now tottering, a crisis that began with falling home prices and went on to engulf Wall Street has reached one of the world's largest insurance companies, threatening to intensify the financial storm and greatly complicate the government's efforts to contain it. The company, whose stock fell 61% yesterday, is such a big player in insuring risk for institutions around the world that its failure could shake the global financial system.

AIG has been scrambling to raise as much as $75 billion to weather the crisis, and people close to the situation said that if the insurer doesn't secure fresh funding by Wednesday, it may have no choice but to opt for a bankruptcy-court filing.

The Fed is currently trying to have Goldman Sachs and JP Morgan Chase extend a $70 billion credit facility to help prop up AIG according to people familiar with the situation. This comes on the heels of AIG's stock sliding more than 60% on Monday.

WSJ: AIG Faces Cash Crisis As Stock Dives 61%

Tomorrow will be a big day for the market. Not only is AIG under the gun but traders fear that a domino effect could take place.

AIG was seeking help from the Fed but one problem that arises is that the Fed is really only to supposed to assist banks and not insurers therefore there are limitations as to what kind of help can be offered. At this point, Goldman and JP Morgan may have to come to the rescue.

From Bloomberg, with respect to the actual downgrades...

AIG Ratings Cut

S&P lowered AIG's long-term counterparty rating three grades to A- from AA-, citing a ``combination of reduced flexibility in meeting additional collateral needs and concerns over increasing residential mortgage-related losses.''

The ratings assessor also lowered AIG's short-term counterparty credit rating by two levels to A-2 from the top A-1+ rating, and cut its counterparty credit and financial strength ratings on most of AIG's insurance operating subsidiaries by three notches to A+ from AA+. The ratings remain on watch for a possible further downgrade, S&P said.

AIG's senior unsecured debt rating was downgraded by Moody's to A2 from Aa3. Moody's said in a statement that its decision was made ``in light of the continuing deterioration in the U.S. housing market and the consequent impact on the group's liquidity and capital position due to its related investment and derivative exposures.'' Moody's placed AIG's long-term and Prime-1 short- term ratings on review for possible downgrades.

Bank of America to buy Merrill while Lehman running out of options

Merrill to be bought out by Bank of America? Sure looks like it.

UPDATE (Sunday 3:57PM CST)
NY Times dealbook saying BofA and Merrill in talks.
Having personally started my financial career at Merrill, I am honestly shocked by this headline. Tough to believe that Mother Merrill will no longer be an independent entity.

From the New York Times: Bank of America is in advanced talks to buy Merrill Lynch for at least $38.25 billion in stock, people briefed on the negotiations said on Sunday, as a means to preserve that investment bank while Lehman Brothers looks likely to collapse.

The move suggests a desperate effort at triage on Wall Street, as Bank of America works to shore up the likely next victim of the credit crunch. A deal, valued at between $25 a share to $30 a share, could be announced as soon as Sunday night, these people said. Merrill shares closed at $17.05 on Friday.

Bank of America, the nation’s second largest bank by asset size, had been mulling buying Lehman, perhaps in a consortium with other financial players. But with financial aid from the government looking unlikely, Bank of America has moved on to Merrill, these people said.

As Lehman began to totter in recent weeks, investors feared that Merrill would be the next victim of the credit squeeze. Shares in Merrill, which has already reported tens of billions of dollars in losses, have plunged more than 68 percent over the past year.

Lehman continues to fight for its life after Barclays deal falls apart this afternoon. As I pointed out in my suitors list, Barclays has the capital but the problem was that any deal from Barclays would have required shareholder approval. Needless to say, that won't work.

Wall Street prepares for worst as Lehman deal stalls

Related Articles
Lehman Brothers basically done today
Lehman Brothers: New Plan but Same Problems
Lehman's credit at risk with Moody's

(Friday 2:05PM CST):
Fitch close to cutting Lehman credit rating
Fitch says Lehman rating will be cut without a deal

Lehman firesale looks likely says USNews
Lehman's Long Weekend

NYTimes talks Lehman Family Ties
The Family Ties in the Lehman Drama

There's continues to be lots of speculation today on which firms might be interested in taking on Lehman. And it’s no mystery now that Lehman is looking for a buyer. The firm confirmed that Dick Fuld is actively seeking the white knight scenario.

I am leaning towards a BofA - Lehman deal.

With that said, I decided to put a small list together of firms that could be involved in potentially buying Lehman. In no specific order…

Bank of America – represents the best chance of a US-based bank to take on Lehman. Of course, BAC struck a bad deal earlier this year (Countrywide acquisition) which leads me to believe that they probably still have a “bad taste in the their mouth” at the moment. However, they do have the resources to make it happen and coupling LEH with BAC might even make sense from a “net positive synergy” standpoint.

LEH would provide their strong equity underwriting platform to BAC’s extensive roster of heavyweight banking clients. BAC would also be able to leverage LEH’s oil and gas group to gain more market share in investment banking.

And finally, BAC would be able to step into the prime brokerage business (actually step back into it after they recently sold their platform to BNP Paribas). Although, I am not sure they want to get back into prime brokerage considering how bad the hedge fund market is right now with respect to the industry-wide deleveraging.

Plus BAC still has a few other problems which includes $5 billion settlement for the auction-rate securities debacle.

While I would say “spending” is a bit tight at BAC right now, they do have the balance sheet to put a deal together. They are definitely in the mix - the question is "how much?"

Probability: BAC is the most likely of all US firms to do a deal. But I am not sure any US firms are comfortable enough to take the risk.

Goldman Sachs – the match of Goldman and Lehman hit blogs this morning and, of course, CNBC’s Charlie Gasparino put an end to that rumor with his “sources.”

GS might be somewhat interested in doing this deal but I believe under two conditions: (1) at a price of about $1.5-$2.00 per share (“takeunder” price where its bought cheaper than its current market price) which most certainly Dick Fuld will push away and (2) assurances that the Fed would provide a liquidity backstop of-sorts as they did for the JP Morgan-Bear deal.

And let’s suppose hypothetically those conditions were to be met, it might still be asking a lot. GS, who steps up to earnings plate next week, might be facing their own host of debt-related problems at the moment. One of the largest holders of Level 3 assets on Wall Street, GS would be reluctant to take on the responsibility of trading more toxic debt into this beleaguered market environment.

Probability: Unlikely that it would happen with Goldman. They are probably too busy putting out their own fires and need to make sure that they don’t compromise the strength of their balance sheet. They probably figure they can win in the situation by simply eating up investment banking market share once Lehman gets swallowed up by another firm.

JP Morgan – after digesting Bear it would be a lot to ask from Dimon and his army of executives. No way they could do this kind of deal. The firm is stretched right now. Just wouldn’t make sense.

Citigroup – one word: impossible! The firm is too busy shedding non-core assets and dumping bad business units. Not only did they lose huge on Pandit’s hedge funds but are also suffering from writedowns in Fannie and Freddie Mac.

Probability: JPM and C are nowhere in the game - too many battles to fight on various other fronts. You have better odds on a Vegas table then betting that one of these two firms plays White Knight.

Korea Development Bank – might be the dark horse in all of the speculation. Up until about late last week, LEH and KDB were in close negotiations. KDB was said to have offered six trillion won (4.3-5.2 billion dollars) for a 25% stake. Think about what that sum of money could buy them now – the whole thing? Maybe so.

South Korean regulators would be the enemy to this deal. The chairman of the South Korean Financial Services Commission explicitly told KDB that such a transaction would be highly scrutinized.

Probability: At this new “discounted” price, I wouldn’t be surprised to see KDB roll the dice. In KDB's eyes, the "cheap just got cheaper."

Other firms to watch: HSBC and Barclays. Barclays intrigues me slightly to the extent that they enjoy about a $40 billion market cap and have plentiful resources to do a deal.

Lehman Brothers basically done today

LEH selling pressure overwhelming

(1) UPDATE (5:05pm CST): Word early this morning on another site, Naked Capitalism, was that Goldman Sachs could buy Lehman. I didn't think Goldman would be a player but I think can be if the Fed backstops their debt. However, at this point, I don't see that happening. Notice the words I use: "at this point."

Below is the post that hit the Naked Capitalism blog:

I heard this rumor from two sources, that Lehman is in its final day or two and Goldman is willing to buy the firm, and the second source, who volunteered the information, is sufficiently well plugged in that I trust the reading. This came from a former senior employee:

A couple friends of mine from LEH trading desk called me this a.m. to say that mgmt has taken employees aside to let them know that the end should come in next 24-48 hours. Ratings agencies apparently told them that the steps were not sufficient to prevent a d/g, and LEH mgmt asked them to hold off for a day or so to give them a chance to resolve situation (with sale of company). Apparently GS is willing buyer, but is buyer of last resort from LEH's perspective, b/c they would keep very few LEH employees.

If Goldman were to step in then they would probably wait until the stock price hits a buck, if it does. Then buy the firm for about $650 million. No need to spend $3 billion right now with all the toxic debt on the books. GS has their own problems with Level 3 and mortgage-backed securities.

(2) My current thoughts
The stock was down 40% today to $4.22. At this level, the market cap of the firm sits at about $3 billion.

I think thats still too much for anyone to move in and purchase up the firm ala a "white knight takeover."

To the best of my recollection, Bear closed shop at about a market cap of $250 million.

Its over for Lehman for at least three current reasons:

1) The dwindling share price is basically crushing any little leverage the firm might otherwise have in doing deals.
Lehman stock price

2) Counterparties and clients are getting nervous. So much of Wall Street is a confidence game.
Lehman's clients moving to protect themselves
Lehman struggles to shore up confidence

3) Moody's and/or S&P will step in shortly to finish off the firm.
Lehman Pushed to Fire-Sale After Moody's Warning, Share Decline

UPDATE (9:30am CST): Merrill Lynch analyst Guy Moszkowski has officially placed a "no opinion" on the stock as many other analysts are doing the same..

(3) Moody's: Ratings downgrade possible

From Reuters: Moody's Investors Service says that Lehman will have to complete a transaction such as a sale of a majority stake in the firm, or the entire company to avoid a ratings downgrade. In fact, they also stated that the bank will also need to take further action beyond the steps it announced on Wednesday to avoid a ratings cut.

Moody's said it would have downgraded Lehman's debt rating earlier on Wednesday, likely to the "triple-B" category, if it did not think a transaction was possible. Any deal would have to calm markets to preserve the ratings, the agency added.

Raising capital alone would also not preserve Lehman's rating, now "A2," as the firm suffers a crisis of confidence, Moody's said.

"Capital is one element but obviously confidence is a key element," said Bob Young, a team managing director at Moody's.

The rating agency on Wednesday put Lehman's ratings under review with the direction uncertain, citing the fluidity of the company's situation.

When it rains it pours. And keep in mind that when one rating agency downgrades the other usually does the same in a rather quick fashion.

Looks like #1 in my initial thoughts write-up is about to come true. Time is not Lehman's friend.

Sad day on Wall Street.

Lehman's credit rating at risk with Moody's after today's news

Moody's: Ratings downgrade possible

From Reuters: Moody's Investors Service says that Lehman will have to complete a transaction such as a sale of a majority stake in the firm, or the entire company to avoid a ratings downgrade. In fact, they also stated that the bank will also need to take further action beyond the steps it announced on Wednesday to avoid a ratings cut.

Moody's said it would have downgraded Lehman's debt rating earlier on Wednesday, likely to the "triple-B" category, if it did not think a transaction was possible. Any deal would have to calm markets to preserve the ratings, the agency added.

Raising capital alone would also not preserve Lehman's rating, now "A2," as the firm suffers a crisis of confidence, Moody's said.

"Capital is one element but obviously confidence is a key element," said Bob Young, a team managing director at Moody's.

The rating agency on Wednesday put Lehman's ratings under review with the direction uncertain, citing the fluidity of the company's situation.

When it rains it pours. And keep in mind that when one rating agency downgrades the other usually does the same in a rather quick fashion.

Looks like #1 in my initial thoughts write-up is about to come true. Time is not Lehman's friend.

Lehman Brothers: New Plan but Same Problems

Lehman decided to have their conference call today. The massive selloff of the stock over the past two days plus the negative credit implication by S&P forced management’s hand.

You can find their conference call HERE and their press release HERE.

Highlights from the release and call:

1. Estimated net loss of ($3.9) billion or ($5.92) per common diluted share.

2. Decreased residential mortgages from $24.9 billion in 2Q08 to $13.2 billion which includes a deal with Blackrock to unload $4 billion in UK assets.

3. Decreased commercial mortgages from last quarter’s $39.8 billion to $32.6 billion.

4. Intends to spinoff the commercial assets into a new entity named REI Global. Current Lehman shareholders will receive shares in REI. The spinoff should be completed in 1Q09.

5. Spinoff will require Lehman to inject capital of 25% into new entity and then debt finance the remaining portion.

6. REI will take custody of SunCal and Archstone investments.

7. REI will be able to show assets as on a “hold-to-maturity” basis thus allowing for more prudent selling.

8. Lehman also intends to sell off 55% of their Investment Management Division (“IMD”). IMD will include Neuberger, private equity and their wealth management arm. If, and when, the sale takes place, the firm will see a positive impact of at least $3 billion towards their capital base from the goodwill associated from the NB acquisition in 2003.

9. Firm also intends to cut their dividend to $0.05 per share which will allow them to retain $450 million annually

It is apparent that Lehman is in full survival mode. And even with these actions going into effect, there are still some serious hurdles that Lehman must face. Time is not on the firm's side and deals must be done swiftly but with a great deal of prudence.

My initial thoughts of Lehman moving forward:

1. Not enough time to shore up balance sheet before S&P downgrades their credit worthiness. Of course, a downgrade would have a significant impact across various business lines – violation of debt covenants, counterparty sentiments, etc.

2. For the REI deal to work, management is counting on a good price for IMD and I am afraid that Lehman is selling from a position of weakness. Will they get their asking price? I am not so sure. To further complicate matters, they intend to use funds supplied from that sale to inject capital into REI.

3. It is possible that even after an injection of capital into the REI spinoff, approximately 75-80% of REI will be debt financed by Lehman. Again, the firm still maintains some form of credit risk even after transferring the assets.

4. I still think there will be further writedowns on the commercial assets before they are transferred over to REI (assuming the deal gets done).

5. The sale of the $4 billion in UK assets to Blackstone are requiring Lehman to seller finance.

6. The firm enjoyed much success from their ability to leverage. Unfortunately, that leverage will no longer be deployed as liberally as it once was. Thus, the earnings power that was based on higher leverage inputs will be negatively impacted.

I will continue to review conference call and the press release. At this point, the firm is still in a very dire position. I will have more later. Please stay tuned.

Lehman Brothers: Time is Up!

It appears at this point that the Lehman situation is going to hit a climax next week. There are so many questions that surround this entity and I believe the management team is in full gear to get the firm sold (or infused with fresh capital) before next week's conference call.

UPDATE: The conference call took place about 6 hours after this post. I will spend some time reviewing the call and examining the data in their release.

If you are interested in doing some homework before the call and the earnings release next week then I would recommend you review the following:

Lehman Brothers May 2008 10-Q
Be sure to pay attention to their discussion of the Level 3 assets on Page 29.

Lehman Brothers June 2008 Conference Call Transcript
Review the questions asked by Mike Mayo from Deutsche Bank - he really pressed them last time

Lehman Brother Financial Supplement from Last Quarter
You will want to reference Attachment II

Also, if you have a Merrill Lynch account be sure to spend a few minutes reading Guy Moszkowski's comments about the Lehman. Guy is a very good analyst but I would be willing to be that Lehman's results will be far worse than what he is currently predicting. (I will discuss this topic later this week)

In preparation for the Lehman call, I have put together a number of questions that I think would give us a clear view of Lehman's financial condition. The questions are as follows:

1. How much of their commercial related positions did they end up writing off for this quarter? They had roughly $30 billion on the books according to Attachment II of the financial supplement they provided investors last quarter.

2. What is the status of the undeveloped SunCal investment? How much more of a writedown did they take on that asset? I believe they had only taken about a $700M gross writedown last quarter.

3. Where do the Level 3 assets sit at this point? Their last 10-Q had it sitting at $38 billion. Let's hope for the sake of shareholders they were able to trim this down.

4. Are they still investigating the "Good Bank/Bad Bank" Model? Note: of course, this strategy could allow the firm to shed toxic assets however there are two real problems with this setup: (1) it will be tough to find a good manager to run it knowing that its a train wreck and (2) they will need to find financing for the new entity - which I would think might be very tough at the moment.

5. Will they give us more disclosure on the whole loans? The mezzanine side of the whole loans could give us clarity on more issues awaiting to surface.

6. Did they make any transfers/sales/negotiations with R3 Capital Partners? If so, please elaborate.

7. Where are they at with Neuberger? If they sell Neuberger, is there any expectation that they might compromise their credit rating which could also trigger another host of credit-related issues.

8. What are their thoughts on the S&P CreditWatch "negative" implication slapped on the firm this week?

I intend to add more questions to my list plus make a few predictions. Please stay tuned.

Thanks for reading.