Until very recently, Lehman (NYSE:LEH) was insisting that they were doing fine and had sufficient reserves. Clearly, they were way off base. There were countless analysts reviewing their financial reports in excruciating detail and, unfortunately, all that collective wisdom and experience was largely unable to dispute it. Similar situations occurred with Merrill Lynch (NYSE:MER) and AIG (NYSE:AIG). I wonder why?
There is something fundamentally wrong with how the financial statements are prepared and the disclosures made to the investors at large. The same thing happened at Bear Stearns, Fannie Mae (NYSE:FNM), Freddie Mac (NYSE:FRE), etc. First, there is a strong denial of any capital shortage issues, followed by a blessing from the Federal Reserve that they are fine, which is then followed by the Wall Street massacre, in which average investors and employees lost their life savings (not to mention cascading effects.) These are not private companies; their financials are supposed to give us a good window into what is happening. I wonder, how is it possible that they go up in smoke so quickly, despite all the analysis? Did the executives themselves not know? Why was the Fed unable to figure out the actual financial status, with all the top-notch economists at their disposal?
My fear is that the financial reporting system and the requisite disclosures in place for these firms is misdirected, and far short of what is needed. It tells us everything, except what we really need to know: how much risk exposure is there?
There has to be a process in place to allow a strong visibility into the risk exposure, in order to restore the shattered investor confidence. This has to occur sooner rather than later, or we risk another financial blood bath.
I would love to hear your thoughts on this matter.
Monday, September 15, 2008
Lehman, Merrill Lynch, AIG: A Crisis of Confidence
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5 comments:
Nice catch. The answer is however and unfortunately simple, and contains far reaching consequences. In my years as a Banker, rule #1 in lending is to look first at the debt to equity (D/E) ratio. Anything approaching or over 2 :1 required serious consideration for additional security.
Lehmans D/E is 30 :1
In plain language that means for every dollar of debt, they have only 3.3c of equity. If there is an asset write down of 3.25% or more, then they are insolvent.
Take a look at any Banks balance sheet. This is the dirty little secret of Banking, that actually means Banks survive only by the grace of the Government.
Total Liabilities 668,573.00
Total Equity 22,490.00
Colin, if we use that metric, that would exclude most public financial companies. The biggest component of equity on the balance sheet is typically (or should be) retained earnings. For a public company, if I see a large amount of retained earnings, the first question that would come to my mind, is why isn't that company leveraging that cash to invest or grow their business? Is the best use of their earnings to simply sit there idle?
I checked some big financial firms balance sheet and looked at their D/E ratio.
Goldman Sachs
Liabilities: 1,043,327,000
Equity: 44,818,000
Bank of America
Liabilities: 1,554,184,000
Equity: 162,691,000
Morgan Stanley
Liabilities: 996,735,000
Equity: 34,493,000
@Anonymous ... I think we are saying the same thing. Banks are highly levered as you indicate, and the balance between maximisation of return versus risk is as old as the hills.
Here are some non-financials and note the D/E is nothing close to the Banks.
GE
Total Assets 846,988.00
Total Liabilities 728,602.00
Total Equity 118,386.00
6 :1
Amazon
Total Assets 6,322.00
Total Liabilities 4,092.00
Total Equity 2,230.00
1.8 :1
Google
Total Assets 29,179.79
Total Liabilities 3,266.77
Total Equity 25,913.01
0.1 :1
IBM
Total Assets 120,928.00
Total Liabilities 92,663.00
Total Equity 28,264.00
3.3 :1
There's good debt and bad debt. I think simply looking at ratios without knowing how the money is being used is risky.
I agree to your comment andrew.
Nice article. Maybe I will have a link to this.
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