Lehman Brothers: Take Two! (Fed's Drama Unfolds)

Palwasha is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

"I am a most unhappy man. I have unwittingly ruined my country. A great industrial nation is controlled by its system of credit. Our system of credit is concentrated. The growth of the nation, therefore, and all our activities are in the hands of a few men. We have come to be one of the worst ruled, one of the most  completely controlled and dominated Governments in the civilized world no longer a Government by free opinion, no longer a Government by conviction and the vote of the majority, but a Government by the opinion and duress of a small group of dominant men."

These were the words of the 28th President of United States, Woodrow Wilson, a few years after he signed the Federal Reserve Act of 1913. He regretted, true, but little did he know the severity of the repercussions 100 years down the road.

Let’s fast forward from 1913, past the Great Depression, moving straight to the year that witnessed the worst recession after the Great Depression -- the first "Lehman Moment."

The Fed: the Guardian Angel or the Devil?

Let’s recall 2008, the year of the fall of Lehman Brothers. It is the same year the Fed bailed out Bear Stearns. Their justification?

“Given the exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain.”

Later that year, they refused to bailout Lehman Brothers. This time the Fed’s crystal ball did not show them the "exceptional pressures" and damage that were to follow. Interestingly enough, the same month that Lehman Brothers went bankrupt, the Fed pledged capital to Fannie Mae and Freddie Mac and also helped convert the two largest competitors of Lehman Brothers, Goldman Sachs and Morgan Stanley, from investment banks into bank holding companies, thus giving them the privileges to acquire additional federal funding like other commercial banks. Was the Lehman Brothers fiasco pre-planned? The last CEO of Lehman, Richard Fuld, points his fingers toward the Fed, or more specifically toward Henry Paulson, the then Secretary of Treasury who, prior to getting nominated by Bush, was Chairman and CEO at Goldman Sachs, Lehman Brothers' biggest rival. On a personal note, when I think of him, I get flashes from the movie Inside Job. (Watch it, if you haven't yet). Alas! What the Fed does, the Fed does. 

That of which thou not know!

To understand why the Guardian Angel (a.k.a. the Fed) rests its merciful hands on the shoulders of these two lucky biggies, Goldman Sachs Group Inc. (NYSE: GS) and Morgan Stanley (NYSE: MS), I analyzed their profitability and leverage ratios against two peers -- Wells Fargo & Company (NYSE: WFC) and JPMorgan Chase & Co. (NYSE: JPM). I initially thought the two banking sharks, with a boost from the Fed, would turn out to be the most profitable with better ability to raise additional capital. But basic analysis proved otherwise. 

For profitability, see below the trend of return on equity from 2008-2011 (I’ve not included 2012, since quarterly earnings distort the analysis). Morgan Stanley showed the worst profitability performance followed by Goldman Sachs. Wells Fargo showed increasing ROE over the four years with JPMorgan Chase closely following suit.

<img src="/media/images/user_13250/picture1_large.png" />

The two leverage ratios I used are long-term debt to capitalization ratio and the financial leverage ratio of assets to equity. Again, although showing a decreasing pattern, Morgan Stanley and Goldman Sachs have the highest long-term debt against capitalization when compared to peers Wells Fargo and JPMorgan Chase. Wells Fargo shows the best trend with LTD/Cap decreasing over the past four years, increasing only slightly for the first quarter of this year. 

<img src="/media/images/user_13250/picture2_large.png" />

Wells Fargo also has the lowest leverage ratio, which has been consistently decreasing over the years, allowing it to finance more of its assets using equity than debt. Goldman Sachs currently has the highest leverage with the most of its assets financed with debt, followed by JPMorgan Chase and Morgan Stanley.

<img src="/media/images/user_13250/picture3_large.png" />

The cherry on the top is the prices of their Credit Default Swaps (CDS). The Oracle of Omaha once described derivatives as "the financial weapons of mass destruction" and rightly so -- the CDS are one of the derivatives cited to be the cause behind the 2008 financial crisis. The CDS issuer takes the obligation to pay the buyer in the event the party on the underlying loan defaults. For this protection, the buyer of the CDS pays the issuer a series of payments. So the price of the CDS basically depicts the default risk of the underlying. The greater the default risk, the higher the price, the poorer the quality of the CDS. Morgan Stanley takes the cake with the most expensive CDS, followed by Goldman Sachs and then JP Morgan Chase. Wells Fargo has the cheapest CDS.

Further, I looked at their S&P ratings. Both Morgan Stanley and Goldman Sachs have an A- rating with a negative outlook. JPMorgan Chase is a notch up with an A rating. Wells Fargo deserves an ovation with an A+ S&P rating.

Overall, both Morgan Stanley and Goldman Sachs are worse performers than JPMorgan Chase based on the metrics used above. And if (for real, I wouldn’t) I were to invest in any of these four stocks, I’d rather go long Wells Fargo (even if it’s trading close to its 52-week high) than risk my money with another Lehman Brothers-like stock.

Banking Sector stocks drive a hard bargain!

In general, why I say I would personally never invest in a banking sector stock (others may disagree) is simple. Not only are their financial statements loaded with financial jargon, their operations are also difficult to understand. Another reason for my reluctance (again, this is my personal opinion) is that banks make money out of nothing. You ask, do they make any positive contribution to the economy? My answer, zilch!

Let me make it easy for my readers to understand, without getting into economics jargon. The Fed prints money and injects it into the economy. The banks receive deposits and make loans out of this money in circulation. For the loans they make they charge interest. But with the same amount of currency in circulation, where does the money come from to pay off the interest above the principal? Nowhere. The creditors get richer and richer. The debtors get poorer and poorer.

I rest my case with Henry Ford’s words.

“It is well enough that people of the nation do not understand our banking and money system, for if they did, I believe there would be a revolution before tomorrow morning.”

PalwashaS has no positions in the stocks mentioned above. The Motley Fool owns shares of JPMorgan Chase & Co. and Wells Fargo & Company and has the following options: short APR 2012 $21.00 puts on Wells Fargo & Company, short APR 2012 $29.00 calls on Wells Fargo & Company, short OCT 2012 $33.00 puts on Wells Fargo & Company, and short OCT 2012 $36.00 calls on Wells Fargo & Company. Motley Fool newsletter services recommend Goldman Sachs Group and Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus