Hurricane hits Wall Street firms

The weekend's momentous events saw the end of investment bank Lehman Brothers as it filed for Chapter 11 bankruptcy.*

As the assets of Lehman are sold off to meet their obligations to their creditors, other firms holding similar assets will potentially see the market value of assets held on their own books revalued, probably downward.

For some of them, this latest shock to their balance sheet would likely be enough to push them over the brink as well, and therefore they will have to find a firm with stronger capitalization to buy them, or share Lehman's fate.

As we explained in July in the post entitled "The dark side of making hay while the sun shines," the proximate cause of this wreckage was hedge-fund style behavior by some departments within Wall Street investment banks.

The management teams of these firms allowed bankers to rake in more and more banking fees by putting together more and more securities composed of or related to mortgages: see this graph illustrating the surge of CDO issuance beginning in 2003. In doing so, they knowingly or unknowingly were betting the firm in order to make outsized profits during the mortgage-boom years.

Those bankers and their managers made big bonuses during the mortgage boom; those who worked in other parts of their firm are now the ones who are paying the price, as they watch the value of their shares in the company plummet. In the case of Bear Stearns, in which fully 31% of the company's shares were owned by employees of the firm, the drop was to $10 a share. In the case of Lehman Brothers which had a similar percentage of employee ownership, it will be to zero.

In this regard, the crisis among Wall Street firms this weekend resembles the devastation of the weekend's other major disaster, the landfall of Hurricane Ike. Unlike that storm, however, many of the employees at firms such as Lehman were endangered by the decisions of their firm's leadership, and will now be left with nothing.

Among the lessons of this financial storm: Be careful about owning shares in companies that have complex balance sheets (and don't be too ready to loan them money either). As evidenced by the numerous cases this year of firms saying they didn't need more capital right before they needed more capital, it is evident that even the leadership of those firms didn't always know the depth of their own balance sheets.

On the other hand, one false lesson that many in the media and many politicians will want to draw from this entire disaster is a supposed need for "more regulation." As we explained in a posting back in March, shortly before the Bear Stearns fire sale, government regulation helped create the problem in the first place. Excessive Fed over-steering, described in "The long shadow of the Y2K bug," as well as Congressional interference in mortgage lending practices (such as laws that encouraged banks to loan to people who may not have been ready to own a home) created the situation that investment banks exploited to their own long-term detriment. In light of that, perhaps the best news to come out of this weekend was the fact that the government representatives from the Fed and Treasury opted not to back up bad assets with taxpayer dollars in order to facilitate a sale.

Unlike a physical hurricane, this disaster was man-made, and preventable. Like a real hurricane, the damage will be widespread and have an impact that will be felt throughout the economy.

For individual investors, one further lesson might be what we hinted at the end of our post "Wall Street firms back at the well" -- the widespread consumption of "wealth management" services at firms with active investment banking departments is really a relic of a bygone era, and a model with more disadvantages than benefits for the management of a family's wealth.

Yet, as we have also stated before and continue to believe today, there will be opportunities presented from this financial storm to those who are patient and have capital available to put to work.

* The principals of Taylor Frigon Capital Management do not own securities issued by Lehman Brothers (LEH).

For later posts dealing with this same topic, see also:

• "It's a panic, not a Great Depression" 01/21/2009.

• "Managing Investments in the New Era" 02/18/2009.

• "If Rip Van Winkle took a one-year nap before September 15, 2008" 09/14/2009.

• "Rip Van Winkle, 2010" 10/11/2010.

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