Sunday, September 4, 2011

Liquidity Lessons Re-Learned

When interviewing various investment managers, one of my favorite approaches is to discuss their mistakes. Managers who do not admit mistakes or provide shallow answers are unlikely to be future managers of my clients’ accounts. A number of the world famous managers who I have known over the years are often very quick to discuss their mistakes and frequently how these errors have changed something about their own approaches to investing. I believe we all should periodically review our own mistakes, with an honest attempt to avoid similar ones in the future. Ideally, we should only make new mistakes in the future.

One of my mistakes was that I owned the stock of Lehman Brothers at the end of its fall. Technically I never bought the stock, but got it when Lehman acquired a money management firm for stock. Toward the end, my mistake was that I did not believe comments from European-based managers that Lehman would fail. I relied on the firm’s published balance sheets, statements from management, and regulatory capital requirements. Even if one was smart enough at the time to write off Lehman’s real estate equity holdings, it still had sufficient capital to continue to stay in business. Like others, I was looking at the wrong thing and did not fully comprehend the structure of the business. The critical issue for Lehman Brothers was liquidity. Its ability to borrow in the overnight market rapidly disappeared at the very same time as its prime brokerage clients were drawing down their balances, which were essential to maintain Lehman’s level of business. What was not clear to me, was that Lehman’s separately incorporated (and guaranteed) subsidiary had much looser credit terms than the New York prime brokerage operation. I will let various investigations and books determine whether the hedge funds that withdrew some or all their money from Lehman’s London accounts were also the sources of the rumors of the firm's decline. I do not know whether Lehman in the end was a victim of a “bear raid” by short sellers or just a firm that lost control of its finances. No matter the cause, the firm is no longer with us, and its demise was a tragedy for many good, honest hard working people within the firm, as well as brokerage clients who sustained major losses.

I should have known better! My Grandfather lectured me, either on walks or sitting in his study, about his experiences as the senior partner of an important brokerage firm. One of the things he said that I did not completely value until now, was the statement, “In periods of duress one can not borrow money, even if one has cash sitting in a safe deposit box.” There were two things I did not fully appreciate. First, the ability to borrow when times are tense is critical to survival. Second, that cash or other hidden assets are not good collateral if the lender can not see them or seize them.

This brings us to Europe this week.

Sovereign Debt and Bank Capital

While most of the attention focused on the Jackson Hole conference was on the minuet of Chairman Ben Bernanke, the most market-moving comments came in the last panel, when Christine Lagarde, the new head of the IMF, called for the recapitalization of major European Banks. The reaction on the Continent was severe shouting, that the former French Finance Minister did not understand the situation. The comments quickly focused on the distinction between liquidity and capital for the banks loaded with sovereign debt, particularly of the Mediterranean and Irish varieties. Similar to my unfortunate experience with Lehman and the warning from my Grandfather many years ago, the ability to borrow was particularly critical when the lenders questioned the value of the capital. New cash capital automatically improves their ability to borrow.

I suspect that the falling value of European bonds is the market’s way of downgrading the bonds before the credit agencies do it. Bond prices reflected in yields, and the prices for Credit Default Swaps (CDS) are more substantive than a bunch of letter grades from the agencies.

The US Impacts

If the credit values of European issuers fall, two things happen on this side of the pond. First, various US financial institutions and some multi-national companies should look at whether they need to repair their own balance sheets. Already we have seen considerable flows out of some US money market funds containing European exposure, with assets shifting to US Treasury-only funds. Second, if the Europeans do go on a wave of capital raising, they will have to offer rates high enough to draw capital from other parts of the world, including the US. Quite possibly we will see signs of this in a Labor Day-shortened week. Regardless of what the President says in his jobs speech, (scheduled just prior to the opening of the National Football League regular season Thursday night), we could be in for high volatility. I for one will be watching the Asian markets tonight (Sunday) and the European ones on Monday.

Crisis Betting

If we get increased turmoil, as investors what should we do? I speak with the bias of an investment manager of portfolios of mutual funds and the portfolio manager of a private financial services fund. I believe it is too late to be doing any meaningful amount of selling. In terms of buying, my bias is combined with a contrarian nature. In this week’s Barron’s there is a series of interviews with 12 established market strategists. They were asked which sectors they favor and which they would avoid. Only one would invest in financials, and three would avoid them. Considering that these stocks have led both on the way up and on the way down, I expect that these stock prices will rise along with any general market rise. However, as I started this blog post with some thoughts on liquidity and capital, adding to the subject, I believe the market is questioning the values resident on a number of balance sheets of leading banks and some insurance companies. Thus, the price-to-book value or the Tangible Common Equity Ratio may, in truth, be higher than what the other bulls are using. Statistical cheapness has never been a convincing argument for me. With a long term view, I feel that some of these stocks are attractively priced because of their sheer brain power. Those brains will be able to figure out new ways to make money coming out of the world’s liquidity and capital needs. I am looking for the rainbow after the storm.

What do you see?

To read last week’s Blog from Mike Lipper, click here.

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