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September 15, 2008

Clients are no doubt stunned by the developments of the weekend. Bedrock institutions whose history dates back a century or more are failing as in the case of Lehman Brothers or are being forced into a shotgun marriage with a balance sheet that can absorb their iniquities such as the Merrill Lynch/ Bank America merger.

There is one common element to the dismantling of these storied capital market firms; the taint of billions of dollars of mortgage assets marked down slowly by their managements but savagely by hedge funds and investors who lost confidence in the veracity valuation adjustments that never quite seemed to lock into a reliable number.

Some of the securities that were invented by the “rocket scientists” on Wall Street are so complex, that one wonders if anyone truly understands them. Ironically, sometimes the very firms that created these instruments are the ones to have been hurt the most by them.

Lehman was late to recognize the severity of the real estate situation. Last October, it completed a $22 billion buy-out of Archstone-Smith, thereby increasing its risk exposure at what proved to be the worst possible time. In the end if someone would have stepped up to buy Lehman this weekend, a large part of the value would have been the people and the reputation. The problem is that ownership of the Lehman entity would have entailed assuming a giant potential liability as well.The immediate impact of Lehman’s liquidation will be dramatic credit spread widening and ultimately negative valuation marks for the remaining players in the market. If such a broad based decline in marks on asset values occurs, this will force other brokers and participants in these securities to mark down their assets accordingly and hence, will pressure all capital ratios.

Funding costs for many banks will rise and banks depending on wholesale funding beyond their core depositors will have a very difficult time. Selling distressed assets will be very difficult, and troubled institutions will need to sell their most valuable assets in order to generate capital. The price of remaining independent will rise for many financial institutions as the bar for capital adequacy will rise.

As one would anticipate, following such a momentous weekend, the Fed is initiating some defensive action. The Federal Reserve Board on Sunday announced several initiatives to provide additional support to financial markets. The collateral eligible to be pledged at the Fed’s two major lending programs has been expanded significantly. These changes represent a significant broadening in the collateral accepted under both programs and should enhance the effectiveness of these facilities in supporting the liquidity of primary dealers and financial markets.

So what should clients do?

First and foremost, clients should not panic. Bear markets do come and go and fortunately, capital markets spend on average only about 20% of their time in this phase. What makes this crisis different?During the 1987 crash, stocks had ignored the fact that the Fed had tightened rates from the beginning of the year. Mergers and acquisitions were taking place under very benign oversight by the regulators. Corporate raiders such as Carl Icahn, Boone Pickens, and Saul Steinberg struck fear in the hearts of incumbent managements who frequently fought these raids by leveraging their balance sheets. In contrast, most of corporate America today has utilized little leverage and in fact, is tending toward de-leveraging.

There is also little resemblance to the S&L crisis in our view. The S&L crisis came about as a result of a massive withdrawal of deposits from troubled institutions that were then placed into short-term instruments with higher yields – known as disintermediation. To avert the problem of disintermediation, banks and thrifts steered deposits to an institution if it would lend certain customers money. The appetite for deposits caused the thrifts and banks to accept bad loans. This has not occurred in the present crisis.

In the Long Term Capital Management crisis, the arrogance of mathematical certainties following a developing monetary crisis in Asia, and over-leverage led to the firm’s demise as well as panic in financial markets. Though arrogance in hedge funds is not unknown, and several noteworthy failures have occurred, it appears that failures have been limited and well contained thus far.At Value Architects, we focus on companies that generate free cash flow in excess of the needs of the business. Consequently, the companies in your portfolio are not dependent on capital markets or willing lenders to finance their operations and their growth.

In financial services, we have avoided direct investment in the capital markets firms. Our exposure to “troubled” names such as Citigroup or AIG has been systematically reduced to an overall exposure of less than 2% of total portfolio.

We focus on the intrinsic value of these businesses, in essence, a discounted cash flow analysis estimate based on our best estimates of the operating characteristics of a business. We insist on buying your portfolio at prices that represent at least a 20% discount to the intrinsic value, what Benjamin Graham called a margin of safety.

Panics are frightening experiences, not unlike surfing a tsunami. Jitters and emotions evolve that cause thinking to be less than rational at times. But the discipline of understanding how value evolves, how securities work together to reduce risk in a portfolio, and keeping an open mind to evolving risks and opportunities should serve clients well.

As always, we welcome your questions and comments.

Richard H Konrad, CFA, CFP®