The travails at one of the smaller investment banks in the world, Lehman
Brothers, this week helped to increase investor focus on the phalanx of lies
that underpin valuations across financial markets. Since I last alluded to the
potential problems of this firm (Cheap
talk, pricey banks, Asia Times Online, June 5, 2008), events have moved
rather quickly; its share price is down from around US$31 to Thursday's close
of $22.70.
The reason for the share price decline wasn't so much the article of course,
but rather the company's announcement on Monday (June 9) that it expected a
$2.8 billion loss for the quarter ended May 31, and that it would also raise $6
billion in new capital, a part of which would come from Asian investors, in
particular an
unnamed South Korean financial institution.
Close on the heels of the share price decline following these announcements,
the company fired two senior managers, its chief financial officer and chief
operating officer, on Thursday June 12, while allowing the chief executive to
keep his job. It is perhaps not an exaggeration to point out that American
executive accountability has never been lower than it appears to be at present,
but at least remains higher than what we can see in Europe or Asia.
Lehman had, along with other investment banks, spent the past few months
denying that it needed to raise any further capital, unlike the bigger
commercial banks such as Citibank, specifically stating in many forums that it
had hedged various problem assets and therefore did not expect to post losses.
A couple of months later, the story not only unraveled at breakneck speed, but
all investment banks are also showing an increase in their holdings of
so-called Level 3 assets, which represent the "we don't know what these are
worth so let's just pretend they're worth what we paid for them" school of
securities investments.
Given all that, this week's announcement of losses combined with capital
raising showed the investment banks in poor light, as it exposed lies on many
fronts. In effect, the bank reported losses it did not previously expect,
requiring capital it said wasn't needed previously, and still held securities
that no one understood. The obvious question becomes - who's next? In essence,
it is a confidence crisis. The problem with this particular genie is that it
will never go back into the bottle.
For financial investors, while the Fed's actions since the Bear Stearns deal to
improve access to liquidity for the investment banks (see also
Trust goes down the drain", Asia Times Online, March 18, 2008) have had
the salutary effect of avoiding "bank run" situations, they do not fix the core
underlying problem of how they can avoid losses on their existing exposures
while attempting to earn revenues from new areas.
In any event, the Fed guarantee works for creditors, not for stock investors.
Losses require investment banks to post more capital, in turn diluting existing
shareholders even as future expected earnings decline. This is what is known in
stock markets as "death spiral valuations", as every fresh loss not only hits
the current share price but also creates further dilution due to the issue of
new shares to cover those losses.
Needless to say, it is not a great deal for investors to buy shares in such
companies - a fact that is emphasized by Lehman, which most recently raised
capital at $28 a share, stock that is now trading well below that. The same
thing has happened to all Asian and Middle Eastern investors on their
investments in US financial stocks, which I characterized as the simplest way
to lose money in financial markets today.
It is certainly not only Lehman Brothers that found itself in a spot of bother
this week. From the other end of the world, Australian company Babcock and
Brown has seen its share price halve from A$11 last week to A$5.25 as of
Friday's close in Sydney. In common with the Lehman story, a specific loss on
taxes soon erupted into a bigger problem as investors discovered a so-called
"market capitalization" clause in the company's debt borrowings.
Under such clauses, when the total stock market value of a company declines
below a certain point, lenders can choose to cut financial exposure to the firm
or demand higher interest payments (or in some cases, both). In the case of
Babcock and Brown, which is described as a specialized investment management
group, this capitalization level was set at A$2 billion (US$1.87 billion),
which must have seemed low enough for creditors and shareholders last year but
has been quickly breached this year as financial stocks globally declined.
On the back of the Babcock and Brown story, financial markets are getting more
edgy about other such potential death-spiral companies out there. This decline
in confidence naturally leads the markets down, as it probably should; but also
opens a can of worms in terms of what else is out there that people may be
lying about. As it turns out, there are rather a lot of such things.
Inflation scare
Almost the first thing that everyone looks at now is the inflation scare around
the world. Even the US Federal Reserve has acknowledged that inflation poses a
key risk to its ability to cut interest rates. As I wrote in my previous
article, big bond managers have signaled their displeasure with the situation
by selling US government bonds. Yields on the benchmark US Treasury 10-year
bonds have increased from 3.9% last Tuesday night to around 4.21% on Friday
(June 13) morning.
A number of columnists have pointed out that inflation calculations are filled
with lies and assumptions and vastly understate the problem of rising prices in
order that central banks can continue to keep interest rates far below where
they should be. As people finally start reacting to higher prices by cutting
their consumption, both companies and governments are beginning to notice,
essentially ignoring statistics that underplay the problem.
Asia starts selling
The other facet of rising US government yields is of course the actions of
Asian central banks. Belatedly realizing that their own inflation problems
aren't getting better any time soon, Asian central banks have at long last
started selling US dollar assets this week to push up the value of their
currencies (this helps to cut the prices of imports, which has a big impact on
domestic prices). This was part of my set of recommendations in the previous
article, and it is actually possible that Asian central banks might do more
such intelligent stuff in coming weeks.
Rising interest rates mean that dividends are not worth as much, further
driving down stock prices. The financial market impact of rising bond yields
though is yet another death spiral, as this quickly feeds into the borrowing
costs of companies and individuals, reducing their disposable income further
and therefore ushering in more cuts in consumption. Companies will have to
figure out other means to cut costs, including laying off people, under such
circumstances. Some will even have to declare bankruptcy, further hurting the
already troubled financial sector.
On that note, it is interesting how the financial markets reacted to the June
12 retail sales figures in the US, which showed a 1% increase against
economists' expectations of around 0.5%. The reason for the increase was of
course the George W Bush rebate checks that had been sent to US households. It
appears that most Americans took the money and spent it at the mall, or perhaps
more likely at the supermarkets to buy food and fuel.
Alongside the higher retail sales, the data also showed rising unemployment
claims, with more than 3.1 million Americans claiming jobless benefits now.
This is likely to worsen in coming months as more companies react to the
slowing economy and higher interest rates by cutting capital expenditure and
also firing employees.
Lying about oil
Meanwhile, the price of oil continues to rise, reaching a record of just under
$140 a barrel this week, despite increasingly shrill rhetoric from the Fed and
the European Central Bank about being mindful of commodity-driven inflation.
Seeing that monetary policy is still loose and the value of the US dollar still
rather suspect, investors have continued to purchase physical commodities such
as oil even as it has doubled in price from this time last year.
Americans and Europeans are increasingly turning to smaller cars to cut their
fuel prices, leaving princely sports utility vehicles rotting in their lots.
All of a sudden, the marketing lies about America's cultural infatuation with
big vehicles on specious grounds of safety and utility have unraveled due to
the price of fuel. This story may only just be starting, as more such declines
in large inefficient vehicles are forecast, as is the likelihood that people
will stop driving luxury cars that cost too much to maintain.
It is not just in such developed countries that people have begun adjusting to
high oil prices. Similar events have taken place elsewhere, and perhaps the
most entertaining this week was the news item that the price of donkeys in
Turkey has increased sevenfold from 26 euros (US$40) to 180 euros in the past
few months. The reason is of course that farmers can no longer afford to use
their tractors due to fuel costs and have turned back to the 2,000-year ass
technology.
Now that I have broached the subject of asses, the Group of Eight finance
ministers' meeting in Osaka, Japan, this weekend should be entertaining for the
whole new set of lies that will be promulgated. The only thing that the
ministers should watch out for is that financial markets have become much more
unforgiving in the past few days, so the old convenient lies will have the
exact opposite effects to those that are intended.
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