Mukesh over at the excellent Moneyaisle blog makes a crucial point that the financial’s of Lehmans, Merrill, and AIG are all provided publicly and to analysts, yet no-one foresaw the crisis and the speed with which these Banks failed.
Lehman, Merrill Lynch, AIG: A Crisis of Confidence | Moneyaisle Blog
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.
I disagree with Mukesh on one point. There is nothing wrong with the financial disclosure of Bank. There IS a problem however with analysts view on those financials.
Let me put these Banks and other Banks financial’s in perspective. In so doing, I will use a banking approach, quite the same approach Banks use to analyse any business loan application before deciding to grant credit. Its important to note this is the Banks’ own approach.
First some facts:
| Bank | Assets | Liabilities | Capital | D/E | Risk % |
| Lehmans | 691 | 669 | 22 | 30:1 | 3.2% |
| Merrill | 966 | 931 | 35 | 27:1 | 3.6% |
| Barclays | 1,366 | 1,343 | 22 | 61:1 | 1.6% |
| Bank of America | 1,717 | 1,554 | 163 | 10:1 | 9.5% |
| Bank of Montreal | 375 | 357 | 18 | 20:1 | 4.8% |
The primary rule in lending is to look at the debt to equity (D/E) ratio first. Anything approaching 2:1 is considered risky, because that suggests the lenders have more at stake than the company owners. That’s why Bankers will request additional outside personal security to shore up the relationship between equity in the company and outside debt. I am sure you are getting the picture here. Banks are dramatically overextended on that measure. While the variance between the hyperextended Barclays and the relatively conservative Bank of America is enormous, even the best of this random bunch is consequently highly levered.
The Risk % shown is simply the percentage of Equity to Assets. Think about your home. If your equity in the home is 3%, then a 3% reduction in your home value means you are in negative territory. You owe more than your home is worth. Its no different here. If the Banks asset value drops by the % shown in the risk column they are bankrupt, and operating illegally according to Basel rules. Bank assets consist of loans and mortgages. So if their sub-prime mortgages have to be written down by the amount represented by that percentage, then they have a problem.
That’s precisely why Lehmans are in trouble. Their asset value has been, or is to be written down by more that that percentage. Not to hard, given how small that percentage is. Banks are very highly levered.
How did this happen, you might ask? Banks have traditionally had the ability to borrow from the Central Bank and manage their balance sheets. It was never a problem when write offs were measured in millions, but once we get into 10’s of billions territory things are different. In addition Banks make enormous profits, and a significant part is paid out in industry leading dividends, while the remainder remains to bolster capital.
Bankwatch 
Colin,
Thank you for the kind words about the MoneyAisle blog, and for the thoroughness of your response. My concern in this area is that there should be a way for the reporting on the bank’s side to allow for some analysts to forsee crises like the ones we’re witnessing, so that investors are able to prepare for them better, and so that these same investors aren’t always the ones left holding the bag for mismanagement.
The challenge, going forward, is to have access to accurate data so that one can see a trend line much earlier (for example, a year ago.) Lehman’s asset valuation methodology has left quite a bit to be desired, especially in the early phase of this crisis – last year.
@Mukesh … could not agree more, although the at least some of the data might be there, and there is blame to be associated with the analysts. As much as the blogoshpere has a reputation for being an echo chamber, mainstream media is no different.
I am simply a spectator, yet, had these blog post headlines …. note the dates, and I was just reflecting what I saw and read.
Dec 2007: “The subprime debacle also posed a question: What if it’s not the only problem?”
Oct 2007: BMO first in laying the groundwork to mitigate against sub prime
Oct 2007: “Do investors honestly believe that $45 billion of reserves … control a $6.3 trillion banking system”
Oct 2007: “But the Dow keeps chugging along. I can’t figure out why” | Sub Prime is understated so far
Oct 2007: “If the banks are bad, … will … become worse if the government … encourages them”
Sep 2007: First the bad news … | Sub Prime crisis – the next 6 – 12 month view
Mar 2007: Econbrowser: Bubble, bubble, toil, and trouble
Mar 2007: America’s subprime lenders create a domino effect problem amongst lenders
Finally this ironic comment from Raines, Chair of Fannie Mae in 2001 – quoted in this blog Tuesday, 23 May 2006 – (2 1/2 years ago) :
“Our low costs help to explain why a Fannie Mae mortgage is anywhere from $22,000 to $200,000 cheaper than a similar jumbo or subprime mortgage over the loan term.
It is Fannie Mae’s job to lower the cost of homeownership, and technology allows us to bring our affordable mortgages to more home buyers, and expand our market share, without expanding our costs.
For example, one of our largest costs is associated with risk sharing. Bear in mind, we don’t simply take mortgage risk. We manage mortgage risk by sharing it with others in the market. Credit risk we share mostly with mortgage insurance companies. And we share interest-rate risk with investors who purchase our callable debt securities, or with our derivative counterparties.
That’s why, of the $42 billion of revenue on our mortgages available for managing mortgage risk last year, $1.8 billion went to mortgage insurers and others to share the credit risk and $33.8 billion went to investors to fund the loans and share the interest-rate risk.
Technology is a powerful tool to reduce these risk management costs”