Equity markets are certain to open sharply lower on Monday after a series of events that came to a head yesterday in the financial sector.  Specifically: 

• After flurried negotiations in recent days between Lehman Brothers and several potential investors failed to result in a deal, the troubled Investment Bank declared bankruptcy last evening.  In recent days, the Federal Reserve made it clear that they would not provide any capital backing similar to that provided to facilitate the deal between Bear Stearns and JP Morgan in March.  After a weekend of evaluation of Lehman’s balance sheet, potential suitors including Bank of America and Barclays concluded not to move forward with any deal in the absence of backing by the Fed. 

As of Sunday evening, reports suggested that Lehman will place its parent company (Lehman Brother Holdings) into bankruptcy protection, while its various subsidiaries are expected to remain solvent during the liquidation phase.  

Derivatives markets were opened Sunday for a rare emergency trading session at the direction of the Federal Reserve.  This highly unusual event represented an effort to sort through open OTC derivatives transactions in which Lehman was one of the counter-parties and find ways in which specific contracts could be effectively closed out or offset.  The underlying goal was to reduce the overall market risk that would be associated with a bankruptcy filing by Lehman.  At this point, it is still too early to evaluate the results of those efforts.

• Merrill Lynch reached a deal to be purchased by Bank of America for an estimated $44 billion after the Federal Reserve apparently pushed the Investment Bank to find a solution to its own capital woes.  Should the deal close under current terms, that represents a per share price of about $29 resulting in a substantial premium from its Friday close of about $17 per share.

Ultimately, this is likely to be perceived to be a positive by the market as it appears to substantially reduce the risk of another major Investment Bank failure in the near term, and would indicate that the current market prices of these institutions may be under their intrinsic value.  In addition, Bank of America has effectively stepped in to guarantee the trades and obligations of Merrill Lynch.

• American International Group (AIG), the large international insurance and financial services conglomerate, announced plans for a major reorganization and the sale of assets (perhaps including business units) in an effort to raise up to $40 billion in capital.  The firm appears to be at risk of experiencing a financial downgrade brought on by the erosion of its capital base, largely due to fears of further write downs in its Mortgage Backed Securities (MBS) and Collateralized Debt Obligation (CDO) holdings.  (Published reports from Sunday noted that the firm had become one of the largest underwriters of credit default swaps, including many tied to the sub-prime mortgage industry.)  On Friday, Standard & Poors announced a negative outlook for the firm’s credit, prompting AIG to actively and rapidly move forward with capital raising efforts.

The primary risk is that an actual credit downgrade would trigger the ability for counterparties to withdraw capital from their contracts with AIG.  In that event, AIG would become insolvent and could also be forced into liquidation or bankruptcy within a very short period of time.

Reports from late Sunday evening indicated that several private equity firms that had previously investigated potential investments in AIG (JC Flowers, KKR, and TPG) all had withdrawn their bids.  As other potential sources of capital apparently dried up, AIG sought a $40 billion bridge loan from the Fed.  At the time this is being written, no resolution on this matter had been reached.  However, given the Fed’s refusal to provide any capital backing for Lehman or Merrill, it appears unlikely that the Fed will intercede in this instance.

• The Federal Reserve announced several initiatives to help shore up the markets.  Included in those actions were:
  • An expansion of allowable collateral to be pledged at the Primary Dealer Credit Facility (PDCF) to include certain securities beyond exclusively investment grade debt.
  • An expansion of allowable collateral to access the Term Securities Lending Facility (TSLF) to include all investment grade debt.
  • Additional capital will be made available in TSLF auctions (a $25 billion increase to $150 billion) and frequency for certain auctions will be increased from bi-weekly to weekly.

Other global central banks including the European Central Bank and Bank of England also both pumped emergency funds into the market overnight.

• A large global consortium of 10 banks have funded a collateralized borrowing facility of $70 billion ($7 billion each) to provide liquidity to the markets.  The institutions include Bank of America, Barclays, Citibank, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan, Merrill Lynch, Morgan Stanley, and UBS.  Preliminary indications are that any institution could borrow up to a third of that capacity to meet capital needs.  The goal is to create a backstop against potential losses resulting from the anticipated and imminent bankruptcy of Lehman Brothers and to ease the potential resulting pressure on the financial system.  This step is being taken as a means to supplement those actions already taken by the Federal Reserve and other global central banks.  

What has happened in the market in reaction and what do we expect in the short term? 

First, the convergence of events is certain to lead to a selloff in the US equity market on Monday as confirmed by the various equity index futures.  Investors can likely expect heightened volatility in the near term as the market absorbs these events and reassesses the risk in the market. 

Numerous equity markets in Asia, including Japan, Hong Kong, and China, were closed on Monday due to a holiday.  Absent another surprise to the upside in the interim, Asian stocks are also likely to fall when markets open there on Tuesday. Stocks in Europe tumbled across the board, as major indices declined 4-6% overnight. 

Treasury bonds rallied, driving yields lower across the curve.  The 2-year yield fell 0.40% to 1.8%, while the 10-year Treasury yield dropped nearly a quarter of a percent to around 3.5%.  The Dollar weakened on Sunday against many currencies including the Euro and Yen, although it subsequently rebounded against the Euro and was trading fractionally higher Monday morning.  Gold and other precious metals rallied.  Oil futures moved lower overnight Sunday. 

While they are likely to be volatile until the current news flushes itself through the market, Fed Funds futures are now pointing to an increasing possibility of a previously unexpected cut in the Fed Funds Rate. 

Our Views

There is no question that the financial sector is experiencing extreme stress unlike any seen in decades.  In addition to the events of last weekend, the placing of Fannie Mae and Freddie Mac in conservatorship (effectively under the control of the Federal Government) is indicative of the nature and magnitude of the challenges that the markets face.  The degree of intervention that the Federal Reserve has undertaken is also indicative of their commitment to take even unconventional steps that they deem necessary to avoid a broader crisis from developing.  There have been many statements by the Fed governors and the U.S. Treasury that they do not wish to repeat the mistakes that were made in other banking crises. 

Although the bankruptcy is a negative for Lehman and its shareholders, it can be viewed as a positive incremental step in the broader cleanup of the financial sector.  Perhaps more importantly, the buyout of Merrill Lynch is being widely viewed as a positive development.  The size of the premium paid by Bank of America suggests that its stock had become materially undervalued.  Had there not been perceived value in the transaction – even without any kind of Fed backing – management at Bank of America would not have made the investment. 

Despite the bankruptcy of Lehman Brothers and the buyout of Merrill Lynch, it should be noted that individual investor assets managed by both firms should be accounted for separately from the institutions’ balance sheets.  As such, while there is no guarantee, those assets should likely be safe and not subject to the firm’s general creditors to the extent that proper recordkeeping and accounting guidelines were followed.  However, equity investors in Lehman Brothers stock should reasonably expect to receive little if anything for the value of their shares.  Likewise, owners of Lehman Brothers debt are likely to suffer some loss of capital, but the amount will only be determined after the bankruptcy proceedings take their course.  In terms of the scope of potential loss for investors, it is worth noting that Lehman Brothers represented a very small piece of the S&P 500 Index as of the close of the market on Friday, September 12.            

It is impossible to determine whether or not this most recent purge represents the bottom of the current market correction.  The possibility of future financial and credit market dislocations remains real.  However, both the private sector and government remain actively engaged in a range of efforts to reduce the stress on the financial system.  At this point, however, achieving some stability in the housing market continues to be the greatest x-factor that needs to be resolved.  For all the apparent uncertainty in the market, however, we know that the point of capitulation in the market is typically reached when investor fear peaks.  Whether or not we will reach a bottom in the short-term is not a certainty, but the potential exists for that to be the case. Whether we are at the threshold of cyclical capitulation or not, stocks look increasingly cheap – a point that has been made to us by numerous equity managers with whom we frequently consult. 

As the markets digest this round of market events, we believe it is critical that investors focus on key considerations to guide their actions.  It should be noted that none of these considerations represents a departure from conventional financial and portfolio management.  Despite this recent spate of activity and the fear that is plainly evident in the market, investors with a disciplined, long-term view should view this as an opportunity to do the following: 

1. Re-visit one’s range of goals – both short-term and long-term – and current situation within a broad, objective context may help to calm any concerns.
2. Re-affirm one’s strategic asset allocation.  As always, this remains the fundamental decision within which all other portfolio decisions should be made.
3. Evaluate the adequacy of one’s liquidity. 

Each time the markets come under extreme pressure, the specifics differ to an indeterminate degree from the prior correction.  The epicenter of the current financial dislocation is different from those in the bear market of 2000-2002, just as the causes behind that event were different than those behind the correction in 1998 or the crash of 1987.  Market corrections are painful, but remain a natural part of the business and economic cycle as excesses are wrung from the market and speculators head for the exit. 

There are some similarities that are worth noting, however: 

• Nobody has demonstrated the ability to consistently call the bottom of such markets.
• At the bottom, investor fear reaches an apex and wields its greatest cyclical influence as speculators liquidate their positions.
• Once a bottom is reached, risky assets are typically best-positioned to outperform over the next leg of the market cycle.
• While the timing always remains in question, markets tend to rebound sharply after the point of capitulation has been reached.
• Patient investors who remain committed to their long-term asset allocation strategy position themselves well to participate in the subsequent rally.
• While such markets can create great fear, they also create substantial opportunity.

It is noteworthy that, even in the face of perhaps the greatest banking crisis since the 1930s, financial institutions with strong balance sheets are using the opportunity to buy assets at liquidation values.  JP Morgan’s purchase of Bear Stearns in March and BOA’s pending purchase of Merrill Lynch suggest that opportunities exist for those with available capital to invest, the ability to tolerate a high degree of risk, and a long-term investment time horizon.  If these institutions did not believe they would be better positioned once the current dislocations subside, they wouldn’t have made those strategic investments. 

We believe the same can be said for individual investors in the current environment.  The very nature of corrections such as this causes current equity prices to fall, while sweetening the pot for future equity investors by re-pricing risk premiums higher.  The seeds for future market opportunities are now being sown.  Investors who remain appropriately invested relative to their long-term goals should put themselves in an optimal position to balance their current liquidity needs while participating in the next upward leg in the market cycle. 

As we noted earlier herein, a cyclical market bottom can only be pinpointed with the benefit of hindsight.  Some of the indicators of a potential bottom are present, however.  Significant fears are already being priced into the market and market volatility (as measured by the VIX index) remains near levels last experienced as the market exited the last bear market in 2002.  One striking difference from that correction is that equity valuations are materially lower than they were at the end of the last bear market – a factor that should prove supportive of future returns. 

While the market correction of the past year has been significant, the losses incurred remain well within the historical range of prior market losses.  While challenging to endure, these types of corrections occur with some degree of frequency as a natural part of the market cycle. 

Conversely, when bear markets turn positive, they have a tendency to do so quickly and without warning.  Those who have remained fully invested in the face of market losses have already experienced the pain of equity loss.  Rebalancing back to one’s strategic allocations when stocks become oversold allows the investor to secure a future benefit when rationality returns to the market and equity prices rebound.

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other source believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.