Roundtable: Why You Should Care That Lehman Went Bust

Lehman Brothers (NYSE: LEH  ) will soon be no more. Merrill Lynch (NYSE: MER  ) is being acquired by Bank of America (NYSE: BAC  ) . And AIG is desperately trying to shore up its capital.

These events are, without exaggeration, the biggest Wall Street headlines in a decade.

Even though Lehman Brothers was larger and older than Bear Stearns -- its existence predates the Civil War -- it was the first to get that dreaded dose of tough love. There was no Barclays or Bank of America deal, no "good bank"/"bad bank" arrangement -- for the first time this year, the government allowed a large financial player to fail.

The implications of this failure are massive, and they'll be absorbed over a period measured in months, not days. For one, Lehman's 25,000 employees face an uncertain future. Its customers, many of them big financial institutions, will have to unwind what are bound to be extremely complicated transactions. And investors will have to figure out what to make of the largest U.S. investment bank failure since Drexel Burnham Lambert in 1990.

To get after that last issue, I asked a panel of Fool advisors and analysts to share their thoughts on these events. Here's what they had to say.

1. As of Friday's close, Lehman traded hands for $3 and change, down more than 90% from its 52-week high. Not many average Joe investors held this stock. So why is this failure so far-reaching?

Bill Mann, advisor: Lehman matters for its role in the financial markets far beyond its own capitalization. Lehman owned some $600 billion in assets, some more liquid than others, all of which are likely to be sold during bankruptcy. There should be no doubt, for example, that some of the extreme levels of volatility in emerging markets have come from Lehman Brothers selling heavily to raise cash in the face of this crisis.

Andy Cross, advisor: Lehman is the latest financial butterfly to flap its wings, and it'll have ripple effects throughout the entire world of finance. What's interesting in this case is that the Federal Reserve put its hand up to say "enough." After bailing out Fannie Mae and Freddie Mac, and backing the JPMorgan Chase buyout of Bear Stearns earlier this year, the Fed apparently decided that Lehman did not qualify as "too big to fail."

Tim Hanson, senior analyst: This isn't just about Lehman. The company's bankruptcy filing this morning is the latest symptom of a sick financial sector. In a way, this whole experience illustrates just how intertwined the global economy actually is. What started as the admirable goal of helping a few more people own their own home and jumpstart a slowing economy in the wake of crisis (Sept. 11, 2001) ended up inflating a massive housing bubble, encouraging financial institutions to take on unprecedented amounts of risk, taking down a number of venerable financial institutions, and decimating consumer confidence. This has essentially put us back to where we started: looking for ways to jumpstart a slowing economy in the wake of crisis. It will, however, take time. Lehman now must unwind its enormous trading positions, which will put greater downward pressure on asset values in the near-term.

2. Can U.S. taxpayers in any way rejoice that this marks a tide change in how the government handles large, failing financial institutions (or non-financial institutions)?

Mann: I think we can describe this past weekend's events as an accidental victory for capitalism. Several big banks and several government entities sat in a room with the express purpose of figuring out how to rescue Lehman Brothers. The government stated that it would not guarantee Lehman's liabilities, and one by one the banks dropped out of the bidding.

Now, recent activities in subprime securities notwithstanding, these big banks are run by fairly smart people, all of whom came to an obvious conclusion: If they did not step in and help rescue Lehman Brothers, their own stocks were going to be mauled. And yet they still decided that taking on the risk wasn't worth it.

In the end, no one stepped in, and Lehman filed bankruptcy and will be wound down. While it probably feels a lot worse today around the globe as the financial system takes a massive shock, I believe that Lehman's failure will help clean out the system faster than if billions of capital were being used to prop it up.

Of course, the cynic in me also says that Wall Street probably has learned two additional lessons. First, if you're going to fail, be the first to do so. Bear Stearns got help. Lehman got bupkis. And second, if you're going to take on risk, don't just put your company at risk -- make sure you rope in whole segments of the global economy.

Cross: The optimist in us all searches for the silver lining when we see a 158-year-old firm collapse under its own heavy leverage and poor risk management. I'm encouraged that the U.S. government apparently knows when to say "no." Too bad so many once-stout investment and traditional banks didn't have the same discipline when they were writing or selling risky loans and financial instruments.

Bill Barker, senior analyst: In any way? Well, rejoice is a little strong, but let me count the ways investors can be grateful:

  1. Less taxpayer money used to largely reward undeserving executives.
  2. There should be a renewed sense of urgency on the part of any financials with deeply flawed models and sketchily capitalized balance sheets to fix their problems now instead of waiting for help.
  3. The market is all about getting rid of uncertainty.

In its own bizarre way, the government's clear statement that it won't bail out every company like Lehman makes these resolutions a bit more certain. Either these companies succeed or they fail -- completely. It's slightly easier to do the math and value companies when you get into binary outcomes, rather than having to calculate multiple scenarios and assign various probabilities to outcomes that you can't even quite define. In the long run, I think this helps valuations of these companies, though obviously none of them are going to fetch better prices today.

Hanson: I'm not sure U.S. taxpayers (i.e., us) have much at all to rejoice about right about now. Our economy is fragile, we have a tremendous and growing deficit, and our obligations continue to pile up. The fact that the government did not step in here hopefully indicates that aside from the unwinding that has to take place, the Lehman fallout won't be that bad. Going forward, the government may decide that it does not want to risk having to deal with large, failing financial institutions and decides to start breaking them up -- which would be bad news for Bank of America and its growing collection of financial assets.

3. In 2008, there have been several high-profile failures or near-failures: Bear Stearns. IndyMac. Fannie Mae. Freddie Mac. Now Lehman Brothers. The FDIC increased its "problem bank" list by 30% last quarter; there are now 117 banks on that list, totaling $78 billion in assets. Given all of this, do you think we're closer to the beginning of this mess, or the end?

Cross: My crystal ball is fuzzy on those details. And I think anyone giving you a straight answer has a bridge to sell you in Brooklyn. From what I can tell we still have a few chapters left in this story. But investors who are well-diversified across industries and market caps should be able to weather this storm, even if a few of your stocks are taking a beating today.

Barker: We're far closer to the beginning of the number of companies that are ultimately going to fail. There will be far more than the handful we've seen so far. But I think that we're much closer to end of general destruction of market capitalization of these companies, and the ultimate total of write-offs that we'll see from them. We've already seen far more than $500 billion in mortgage-related write-offs, and I think that's closer to the end than the beginning.

Hanson: Given that this mess is almost seven years old now, odds are we're closer to the end. That's not to say there won't be an alarming climax, but the remaining big financial institutions (Bank of America, JPMorgan, Goldman Sachs, and Morgan Stanley (NYSE: MS  ) ) look to be in better health than the companies mentioned.

4. For financial-related stocks, the bad news has been relentless. What would you tell investors about fishing for bargains in financials right now?

Mann: Don't be fooled. Lots of financial companies are exhibiting enormous dividend yields and look extremely cheap on a price-to-earnings and price-to-book basis. But earnings and book value are historical measures, and many banks and financial institutions have fundamentally changed. One of the fundamental rules for dealing with a burning building is not to run into it if you're already safely outside. Let others be heroes.

That said, in every sector there are good and bad companies, and the financials are no different. There are bank companies that have little to no exposure to the worst segments of the real estate market, and they're gobbling up market share. These are among the financial companies that have dropped the least. Companies like PNC (NYSE: PNC  ) , Wells Fargo (NYSE: WFC  ) , and BB&T (NYSE: BBT  ) are quite cheap, even though they don't look like it next to their scorched cousins.

Cross: I'm not ready to double down on financials yet, but for investors who are willing to take on a bit more risk you could look at a few banks. BB&T is one of the best out there. But again, make sure you're diversified -- in this environment, these bank stocks could continue moving south even if the companies' fundamentals are relatively strong.

Barker: Don't -- please don't.

All right, with more color: Invest in what you know. Invest in what you understand, or are capable of coming to understand. If you think that you can figure out the balance sheets of financials -- great. But you're in a very, very, very small group if you're actually able to gauge what's going on there. You might invest in Berkshire Hathaway, because if anybody's going to make the right move scavenging from this mess, it'll be Buffett and Munger. But doing it on your own? There are better opportunities out there.

Hanson: All stocks have been punished recently, not just financials. As a fellow investor pointed out to me on Friday, it's either the end of the world or an incredible buying opportunity. Either way, as a modern day Pascal might wager, we should be buying, and the best opportunities are in the non-financial stocks that have been punished without even being tied to the current crisis. There is a caveat: It could get worse before it gets better. In other words, be absolutely certain that any money you put in the market today is not money you need to pay near-term bills. Be prepared to leave today's investments alone for the next three, five, or forever years.

Brian Richards does not own shares of any companies mentioned. Bill Mann, Andy Cross, Bill Barker, and Tim Hanson each owns shares of Berkshire Hathaway, as does The Motley Fool. Berkshire Hathaway is a Stock Advisor and Inside Value selection. BB&T, JPMorgan, and Bank of America are Income Investor recommendations. Read about The Motley Fool's disclosure policy here.


Read/Post Comments (16) | Recommend This Article (30)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 15, 2008, at 3:29 PM, JPMorgan666 wrote:

    All banks & governments should stop lending people money period for a year or two. Now that would tell you what all these companies are really worth.

  • Report this Comment On September 15, 2008, at 4:33 PM, PSU69 wrote:

    I bought more GS today.

  • Report this Comment On September 15, 2008, at 4:41 PM, lrphoenix wrote:

    It is very surprising to me that virtually all of you and your comments are related to the past. What a waste of time and space. With the possible exception that history doesn't mean much today, which is merely stating the obvious, none of you said anything. The lack of recent history not being at all useful, wouldn't it be much more useful to point the way forward instead of trying to say something by saying nothing at all? Muster some courage! Or do you think that you really don't have any idea? If so, what is the shame in saying that very thing?

  • Report this Comment On September 15, 2008, at 5:14 PM, TMFMmbop wrote:

    Heck, we have plenty of opinions about the way forward. What do you want to know?

    Tim

  • Report this Comment On September 15, 2008, at 5:15 PM, maccdw wrote:

    We're seeing the latest consequence of s systemic flaw which can be traced back to Reagan and the lifting of banking regulation. This has been brewing for 25 years, and no administration since Reagan has done anything to restore checks and balances. This, folks, is what you get in your unfettered free-market environment. Deregulation lead to many small organizations becoming chartered as "banks" when they were simply brokers.

    The Fool commentary provided here seems to ignore all of this.

    We would be better served if certain Fools would take the time to connect the dots, and in plain English.

  • Report this Comment On September 15, 2008, at 5:54 PM, bretco wrote:

    It seems as though many industries that were deregulated have had their balance sheets head south....banks, airlines, telecommunications, railroads, now insurances....

    Maybe unfettered free-market competition isn't quite everything its cracked up to be.

    But then again, would we be better off with some bureaucrat making the important decisions?

    I don't think so.

  • Report this Comment On September 15, 2008, at 6:06 PM, RINDER wrote:

    This crisis is about greed ... Tim Hanson's comment "What started as the admirable goal of helping a few more people own their own home ... completely avoids the real problem.

    There was no noble goal other than squeezing revenue out of an untapped and under-qualified segment of the market. There was nothing noble or admirable about it. From start to end this was a bad idea and painting like a great idea that didn't pan out is completely irresponsible.

    This is just payback time for the next set of institutions who got too far over the ethics / greed line. Financial institutions threw qualifications out the window, created "new products" and then sold them throught the market presumably to spread out risk. Actually all it did was infect the entire industry and everyone pays.

  • Report this Comment On September 15, 2008, at 10:06 PM, jaypaul71 wrote:

    I am glad there was no assistance for Lehman for a few reasons.

    1) Their balance sheet must be so bad that no sane company has been willing to buy them.

    2) After Lehman is out of busines, their assets and clients will be with better companies that have continued to invest in sound businesses.

    3) It will make room for more small financial companies.

  • Report this Comment On September 15, 2008, at 11:09 PM, luscious25 wrote:

    deregulation is the cause of this mess there needs to be more safeguards in place to protect investors and avoid messy situations like this i agree with maccdw this was twenty five years in the making the government is too loose with regulations on the market and the finacial world look at enron look at today it was all avoidable. it's nice we want to open more doors to make homes available for more people but it wasn't done in a realistic way. i hate that we tax payers our being shouldered with the mistakes of big businesses but some of us helped cause and some of profited off of it when it was hot. i am not sure the market should go back to the way it was corrections need to be put in place before we can securely move on.

  • Report this Comment On September 16, 2008, at 12:29 AM, TopViet wrote:

    Today, I just sit out to watch the market.

  • Report this Comment On September 16, 2008, at 12:39 AM, ptolaw wrote:

    It is my opinion, this internet article on PNC and regional money center banks provide average investors misguided optimism. Examining the index more fully and reviewing in more detail current SEC filings by each bank certainly provide for a more cautious overview.

    This internet article should also point to SEC filings. Professional investors know where to access the important data. If, this internet article and commentary on CNBC are also for the average investor then properly guide them to the data! The PNC Financial Group (PNC), yearly chart and recent K-8 filing of September 9, certainly show an overpriced stock with “significant” downside risk, a term PNC directors use in the company’s SEC filing. Promoting this company to average investors is disingenious.

    The company’s stock is owned primarily by other investment banks, as much as (67%), many of which are in need of capital, such as Fidelity Investments. PNC’s most recent K-10 is disturbing to say the least! Its substantial exposure to Lehman, Fannie and Freddie preferred, delinquent commercial loans, and accounting irregularities at newly acquired Sterling Bank, bring me to the opinion that PNC Financial Group, stock price is simply propped up by market makers, and does not accurately depict its true value or a good investment.

    Moreover, I do believe, recommendations based on stock price charts and/or current stock prices DO NOT tell the entire story. Commentators and contributors should at least, when forming the ethical bases for reporting as to a specific stock’s worthiness for investment consideration, at least inform the public to review all SEC filings prior to taking any action. Commentators and contributors do a disservice to the average investing public by not identifying certain short falls which are currently acknowledged by the company.

  • Report this Comment On September 16, 2008, at 1:17 AM, jobedied wrote:

    We went through this in a similair way in the 1920,s the S and L crisis of the 1980's

    and now. The tax payer will always bail out the greedy hubris filled speculators. We are capitalists and the tax payers are the sheep that supply the monitary energy. We must not forget to blame the baby boomers for the problems of social sucurity and if we can some how get some blame to those environmental concerned folks this to will pass . The blame spin game must start hard and fast push the blame on the American people every good poltician knows how to play groups against each other, the press falls for it also. One old banker dieing of cancer on trial and the Texas two step starts to work. Bottom line folks very simple greed and hubris is the cause of all this. The sad part is the folks that caused this will still be in the drivers seat , and people that pay social security taxes, federal income taxes, uninployment taxes,medicade taxes,sales taxes, will bail out the monsters that will continue to rule.

  • Report this Comment On September 16, 2008, at 1:18 AM, jssusi wrote:

    The phrase of saying "too big to fail" is just too idealist to hear from the Fed especially on this current bleak economy. Why saved Bear Sterns and abandoned Lehman? and what about the initial incentives/tax credits to own home through a mortgage come from several years ago that now leading to this housing mess? The regulators have failed and they are too arrogant to admit it. I tend not to agree with today's event for not bailing out lehman without considering the impacts to the fragile economy. There were many instances in the third world countries (a country is tenfolds bigger than a private company) where in the event the government got bankrupt then an international institution would still be able to help them out through strict conditions and continuous monitoring for a certain period of time to get them out of the billions/trillions debts. I just don't buy that this way will give lessons/punishments. Yes, punishment to the employees!! How to keep telling americans to stay confident if the market keeps crashing? I agreed for not putting tax money into helping a small group of greedy people but mistakes were already made and the Fed for sure has had a role in it, no matter how small it is. The decision seems to be shortsighted, just creating further mess and bad reputation to the global investors..

  • Report this Comment On September 16, 2008, at 1:20 PM, Pelligro wrote:

    It's not the "little guys" who own the credit swaps and debt related derivatives. The "big guys" at the major brokerage houses are finding their hedge funds in the toilet and will probably not be receiving their usual 6-figure bonuses this Chrismas. Even better, bankrupt firms will not be paying exorbitant "golden parachutes" to their incompetent senior executives....there is a God! Meanwhile, as a "little guy", I'm investing in WFC an PNC and thanking the gods for at least a "few good men".

  • Report this Comment On September 18, 2008, at 7:25 PM, Richard233 wrote:

    The problem is we don't have true deregulation. When a guy goes to Las Vegas and puts down a bet he does not expect that if he loses that someone will come over and hand him his money back.

    Since the taxpayer's represenatives have guaranteed the "bet" we have to act in those instances to reduce the damages.

    The history of this problem goes likes this.

    1) Interest rates are cut.

    2) Money flows to Real Estate to earn money.

    3) Demand rises, so the price rises. As the price rises, tax revenues increase both from the earnings on the sales and on the property taxes. Because this give those in power revenue to do stuff that makes them and theirs happy, they do what they can to continue it.

    4) Prices rise to the point where it becomes unaffordable/overpriced, so gimmicks are created to allow people who can't really afford it to get in.

    These loans were made on the premise that once the trial period was over, it was no longer the original lenders responsibility if it failed. Basically pulling a fast one.

    5) Prices stop rising, so fewer people can payoff the gimick loans, leading to what we have today. Which is.

    6)People abandoning homes because they cannot pay or it makes no sense for them to pay.

    7) Falling prices leads to some lowering of revenues, so states like California, which spent money based on the concept of this going forever, has the mess it has magnified.

  • Report this Comment On September 19, 2008, at 12:43 PM, fibreoptik wrote:

    "...three, five or forever years..."

    Hanson, you're a genius! :p

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