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Tuesday, September 16, 2008

LEH, MER, and BAC Foolishness

When Enron filed for bankruptcy, it had assets of $63B pre-bankruptcy. MCI-Worldcom had assets of $100B pre-bankruptcy. Due to extensive leverage and derivatives contracts, Lehman Brothers controls $600B of assets, even though their net worth was only a few billion dollars.

This makes Lehman Brothers the biggest bankruptcy ever.

The notional value of a derivative contract is typically a lot higher than the market value. It's unclear if $600B refers to notional value or market value.

When you use a lot of leverage, wrong bets run against you quickly.

Lehman Brothers is another example of how limited liability incorporation encourages irresponsible behavior. Without limited liability incorporation, shares of Lehman Brothers might be trading for negative $10/share or less.

Once it was obvious to Lehman Brothers' management that bankruptcy was possible, the incentive is for them to take bigger and bigger risks. It does not matter if you file for bankruptcy with a net worth of -$1 or -$100B. Either way, management loses their jobs and the shareholders get nothing.

Therefore, management of an insolvent corporation should take bigger and bigger risks. If they recover, then they get to keep their cushy jobs and pay themselves huge bonuses. If they are wrong, then they file for bankruptcy and cheat their creditors. The balance sheet of a bank is typically incomprehensible, making it practically impossible for creditors to verify the creditworthiness before making a loan. Even after filing for bankrupty, most of Lehman Brothers' management will find cushy jobs at another large bank, due to their "experience" and their connections.

Due to negative real interest rates, it makes sense for management to take risks with leverage. Over time, the odds are in your favor. You are borrowing at 2% and buying bonds or tangible assets that yield a greater return. If only you could hold onto your positions during an economic bust, it's a great deal.

Unfortunately for Lehman Brothers, it isn't in the "too big to fail" range. Financial industry insiders let Lehman file for bankruptcy to preserve the illusion that the economic system is fair. "Lehman went bankrupt. Therefore, the economic system is fair."

In other news, Bank of America bought out Merrill Lynch for $0. It was an all-stock deal. Merrill Lynch stock will merely be traded for Bank of America stock at the appropriate ratio.

Is this a good deal for Bank of America shareholders? Who cares?

The deal increases the size of Bank of America by 20%-30%. Insiders at a large corporation loot and pillage, lining their own pockets. With 20% more assets at their disposal, management of Bank of American may not loot and pillage 20% more each year! Plus, the investment bankers that advise the deal earn a hefty fee.

Based on the current trend, all the big banks will merge together. All the Depression-era protections, such as the Glass-Steagall Act, have been repealed. Of course, the true culprit for economic woes is the Federal Reserve, which is never blamed.

Even if I'm fully aware of the flaws in the monetary system, it does me no good unless I have $100B in assets *AND* political connections. You only reap the full rewards of a corrupt economic system when you're in the "too big to fail" category. I can manage my personal investments wisely, but if I use leverage I risk bankruptcy during the next economic bust.

The only way to avoid subsidizing financial industry profits is to boycott the Federal Reserve and income tax.

1 comment:

DixieFlatline said...

FSK, Peter Schiff seems to believe that BoA took on Merrill in order to get big enough it is deserving of a bailout.

What do you think about this?

Here is the link

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