Wednesday, July 9, 2008

Is There Another Bear Stearns Lurking Out There??

There’s lots of talk about another Bear Stearns lurking out there. Fannie Mae and Freddie Mac tumbled on a report by Lehman Brothers that stated Fannie and Freddie might need to raise additional capital. The headline regarding this research report was dripping with irony. Fannie and Freddie are sponsored by the US government...

Well, some quick numbers for those that think there might be another bank that is at risk. I took a look at some numbers of the banks out there that get lots of press regarding the possible bad loans they might be hiding on their balance sheets. Merrill (MER), Lehman Bros (LEH) get all the press given that the price of their credit default swaps imply increased risk of failure. But I took a look at Goldman Sachs (GS), Wachovia (WB) and Wells Fargo (WFC) in addition to Bank of America (BAC), Citigroup (C) and Washington Mutual (WAMU). It’s pretty interesting:

I’m not sure about UBS, because they file a 20-F, and sometimes the balance sheet data is funny, but everything else was sourced from Y! Finance and 10-K's as of the close of 1Q 2008. What’s interesting to note is that GS, MER and LEH all stand out with leverage ratios greater than their peers, and north of 25x times the book value of their equity. (For example, a crude, ironic analogy for LEH: If Lehman’s assets were the house’s value, then they bought a house for $786 billion with 3% of their own equity down, and took out a loan worth $761 billion…The bad news is that if the house value falls (asset value) then LEH has to bring a check to pay off the mortgage... For a review on leverage, etc. please see my previous posts here.)

Taking this simple analysis one step further, look at the average leverage multiple ex-GS, UBS, MER and LEH. It’s 27% lower, at 13.1x vs. 17.9x. So it begs the question; what is the magnitude of a potential writedown for LEH, etc. if LEH’s leverage multiple were in-line with its peers leverage multiple??

While this analysis is not an indictment against LEH, etc. the math represents a quick and rough "back of the envelope" calculation. If nothing else, Bear Stearns’ leverage was around 8.0x in their November 2007 10-K filing, where their total assets were $96 billion and the Book Value of Bear's shareholder equity of $12 billion, although it should be noted that estimates were around 32x before all hell broke loose. With all the government rhetoric around potentially extending federal backstopping of troubled banks at taxpayer and shareholder expense, it's worth looking beyond the headlines to see if there’s any merit to the fear. These simple calculations suggest there may be some merit and the potential to the US equity markets could be huge if another failure occurs. The bigger question is the moral hazard the government now creates setting the precedent of potentially bailing out another one these banks if they fail. Stay tuned.