The Insolvencies of Non-Bank Financial Institutions

by: Reggie Middleton March 19, 2008    

Reggie Middleton

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My blog has been quite popular as of late, most likely because it may appear to some that I have a crystal ball. My last five or so warnings have resulted in 50-point or so price drops in the shares of the companies in question. Let me be both modest and honest: I am not that smart and do not have a crystal ball. There is a simple premise behind all of this that allows me to understand what is going on, but this premise does not get any press play and is not harped on by the analyst community. Many major players in our financial system are simply insolvent. Plain and simple. The liquidity issues that you see are simply a result of that insolvency, not a cause. When you lever up on assets at the top of a bubble and that bubble pops, you become insolvent, delevered or not. If forced to delever, the balance sheet insolvency now becomes an income statement insolvency as the cash outflow outstrips the cash inflows, but it all stems from the original balance sheet insolvency - not the other way around.

Borrowing more money, no matter what the terms, will not aide you in your dilemma. That is, of course, unless you can borrow large amounts of that money quickly on non-recourse terms. But that is not really borrowing money, it is someone giving you money with the option to pay it back. It is the equivalent of a straight bailout, isn't it? That is what just happened last weekend, which leads me to the next paragraph...

I have been alleging that many investment banks, monoline insurers, home builders and commercial banks are effectively insolvent. Nouriel Roubini wrote an accurate piece on the topic. Between that and the the five or six major analytical pieces that I put together, I believe a pattern emerges. (Please take note of the dates the pieces were written and the share prices at the time of the post). I believe the pattern is indisputable. You could have made a fortune on the short side of these analyses, and you could have lost a fortune on the long side. Just ask the employess and shareholders of Bear Stearns, Ambac (ABK), MBIA (MBI), Lennar (LEN), etc. My condolences go out to the rank and file employees of all of these companies, whose savings have been lost in the share price devaluation. Hopefully, there is a lesson to be learned here:

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As you can see, the path was not impossible to determine, as practically all of these companies shared the same catalyst to their downfall: excessive leverage at the top of an asset and credit cycle bubble. Now, the Fed is attempting to lend directly to institutions over which it has no jurisdiction. If I am not mistaken, the Fed's balance sheet is only good for $400 billion or so. There are a lot of potential "runs on the non-bank" coming down the pike, enough to drain the coffers. This is an ingenious, albeit very risky endeavor. Moral hazard abounds. I know the Fed believes that they have nixed the moral hazard argument in the butt by wiping out the Bear Stearns shareholders, but this is an imperfect argument. The shareholders have to approve this $2 buyout deal, and $2 is low enough to risk a battle with the Fed and their agents. This is a major flaw in the plan that I see as coming back to bite the markets. If this happens when the next shoe drops, I can see the Fed getting overwhelmed.

As an investor and analytical pundit, I will be looking for the next shoe to drop, which I believe I have found. I will keep you posted.

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This article has 4 comments:

  •  
    Mar 19 09:40 AM
    The next shoe to drop will be the credit card companies themselves as people who have been paying mortgages they cannot afford and buying food and gas with their cards will begin to default.
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  •  
    Mar 19 10:05 AM
    Excellent article. I would have preferred that that they not bail out any investment firms. Let them fail, and fail quickly. Instead we are in for slow deaths, in the, paid for by all of us.
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  •  
    Mar 19 10:40 AM
    I agree--excellent article. We all know that leverage works "brilliantly"... whether on the way up or down--potentiating profits on the way up, and vice versa on the way down.

    Where I part company with the author of this article and a whole host of others I've read that complain about the Fed's handling of this mess is that none of the authors say what the Fed SHOULD have done and why that would have turned out better.

    We all know there are trillions of dollars of derivatives/leverage of all sorts out there that are in the process of being unwound, moving negative balance sheets to negative income statements (and insolvency in many cases). I believe TIME will cure this (maybe a lot of time)--and the Fed is simply trying to buy the system time.

    What else would you have the Fed do?

    As to the Fed's own liquidity--if it runs out, Congress will authorize more (think Resolution Trust Corporation). Yes, it will run more deficits, but the alternative will increase deficits even more (due to lower income tax collections).

    Finally, I completely disagree about moral hazard re: BSC. Even if the shareholders get $6 (it's trading at about $5 right now), they are still pretty much wiped out. Heck, even if they get $10, for most shareholders, that's a 90% loss, or more.

    Hardly a bailout, in my view.

    But BSC shareholders (and my heart goes out to the innocent employees--reminds me of Enron) won't get $10. Who else is going to put up $6 billion in a reserve fund for BSC contingent liabilities? If this was such a great deal for JPM, I don't think the Fed would have needed to guarantee it. Maybe in 5 years from now, it will be viewed as a wonderful deal for JPM, but the opposite could also happen.


    Jack Yetiv
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  •  
    Mar 19 04:23 PM
    How sure are you about the $400 Billion limit for the Fed? Seems to me that a quick executive order or a quick congressional bill would take care of expanding this line of credit as much as needed.
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