Bernanke's Bluff: When the Truth is Found to Be Lies

Lehman and the liars
By Chan Akya
Jun 14, 2008

The travails at one of the smaller investment banks in the world, Lehman Brothers, this week helped to increase investor focus on the phalanx of lies that underpin valuations across financial markets. Since I last alluded to the potential problems of this firm (Cheap talk, pricey banks, Asia Times Online, June 5, 2008), events have moved rather quickly; its share price is down from around US$31 to Thursday's close of $22.70.

The reason for the share price decline wasn't so much the article of course, but rather the company's announcement on Monday (June 9) that it expected a $2.8 billion loss for the quarter ended May 31, and that it would also raise $6 billion in new capital, a part of which would come from Asian investors, in particular an unnamed South Korean financial institution.

Close on the heels of the share price decline following these announcements, the company fired two senior managers, its chief financial officer and chief operating officer, on Thursday June 12, while allowing the chief executive to keep his job. It is perhaps not an exaggeration to point out that American executive accountability has never been lower than it appears to be at present, but at least remains higher than what we can see in Europe or Asia.

Lehman had, along with other investment banks, spent the past few months denying that it needed to raise any further capital, unlike the bigger commercial banks such as Citibank, specifically stating in many forums that it had hedged various problem assets and therefore did not expect to post losses. A couple of months later, the story not only unraveled at breakneck speed, but all investment banks are also showing an increase in their holdings of so-called Level 3 assets, which represent the "we don't know what these are worth so let's just pretend they're worth what we paid for them" school of securities investments.

Given all that, this week's announcement of losses combined with capital raising showed the investment banks in poor light, as it exposed lies on many fronts. In effect, the bank reported losses it did not previously expect, requiring capital it said wasn't needed previously, and still held securities that no one understood. The obvious question becomes - who's next? In essence, it is a confidence crisis. The problem with this particular genie is that it will never go back into the bottle.

For financial investors, while the Fed's actions since the Bear Stearns deal to improve access to liquidity for the investment banks have had the salutary effect of avoiding "bank run" situations, they do not fix the core underlying problem of how they can avoid losses on their existing exposures while attempting to earn revenues from new areas.

In any event, the Fed guarantee works for creditors, not for stock investors. Losses require investment banks to post more capital, in turn diluting existing shareholders even as future expected earnings decline. This is what is known in stock markets as "death spiral valuations", as every fresh loss not only hits the current share price but also creates further dilution due to the issue of new shares to cover those losses.

Needless to say, it is not a great deal for investors to buy shares in such companies - a fact that is emphasized by Lehman, which most recently raised capital at $28 a share, stock that is now trading well below that. The same thing has happened to all Asian and Middle Eastern investors on their investments in US financial stocks, which I characterized as the simplest way to lose money in financial markets today.

It is certainly not only Lehman Brothers that found itself in a spot of bother this week. From the other end of the world, Australian company Babcock and Brown has seen its share price halve from A$11 last week to A$5.25 as of Friday's close in Sydney. In common with the Lehman story, a specific loss on taxes soon erupted into a bigger problem as investors discovered a so-called "market capitalization" clause in the company's debt borrowings.

Under such clauses, when the total stock market value of a company declines below a certain point, lenders can choose to cut financial exposure to the firm or demand higher interest payments (or in some cases, both). In the case of Babcock and Brown, which is described as a specialized investment management group, this capitalization level was set at A$2 billion (US$1.87 billion), which must have seemed low enough for creditors and shareholders last year but has been quickly breached this year as financial stocks globally declined.

On the back of the Babcock and Brown story, financial markets are getting more edgy about other such potential death-spiral companies out there. This decline in confidence naturally leads the markets down, as it probably should; but also opens a can of worms in terms of what else is out there that people may be lying about. As it turns out, there are rather a lot of such things.

Inflation scare

Almost the first thing that everyone looks at now is the inflation scare around the world. Even the US Federal Reserve has acknowledged that inflation poses a key risk to its ability to cut interest rates. As I wrote in my previous article, big bond managers have signaled their displeasure with the situation by selling US government bonds. Yields on the benchmark US Treasury 10-year bonds have increased from 3.9% last Tuesday night to around 4.21% on Friday (June 13) morning. (And as I pointed out months ago with charts, June is the time for the annual "US Bond Massacre which Wall Street stages every year as part of its wash and rinse cycle - Jesse)

A number of columnists have pointed out that inflation calculations are filled with lies and assumptions and vastly understate the problem of rising prices in order that central banks can continue to keep interest rates far below where they should be. As people finally start reacting to higher prices by cutting their consumption, both companies and governments are beginning to notice, essentially ignoring statistics that underplay the problem. (You can take that loss of confidence problem and mix in a loss of credibility. Essentially the Fed and Treasury are playing Liars Poker with overseas and small investors in order to provide time for the insiders to cash out. Ugly, but essentially the plot line in play. - Jesse)

Asia starts selling

The other facet of rising US government yields is of course the actions of Asian central banks. Belatedly realizing that their own inflation problems aren't getting better any time soon, Asian central banks have at long last started selling US dollar assets this week to push up the value of their currencies (this helps to cut the prices of imports, which has a big impact on domestic prices). This was part of my set of recommendations in the previous article, and it is actually possible that Asian central banks might do more such intelligent stuff in coming weeks. (How does he square this with the rally in US equities and the dollar? I would hesitate to draw conclusions from the US bonds decline which is seasonal. - Jesse)

Rising interest rates mean that dividends are not worth as much, further driving down stock prices. The financial market impact of rising bond yields though is yet another death spiral, as this quickly feeds into the borrowing costs of companies and individuals, reducing their disposable income further and therefore ushering in more cuts in consumption. Companies will have to figure out other means to cut costs, including laying off people, under such circumstances. Some will even have to declare bankruptcy, further hurting the already troubled financial sector. (The dominos will start falling again sometime soon - Jesse)

On that note, it is interesting how the financial markets reacted to the June 12 retail sales figures in the US, which showed a 1% increase against economists' expectations of around 0.5%. The reason for the increase was of course the George W Bush rebate checks that had been sent to US households. It appears that most Americans took the money and spent it at the mall, or perhaps more likely at the supermarkets to buy food and fuel.

Alongside the higher retail sales, the data also showed rising unemployment claims, with more than 3.1 million Americans claiming jobless benefits now. This is likely to worsen in coming months as more companies react to the slowing economy and higher interest rates by cutting capital expenditure and also firing employees. (We agree wholeheartedly. The US consumer has hit the wall, and until wages rises, he will be on life support which only extends his consumption, but does not invigorate it and make it sustainable. - Jesse)

Lying about oil

Meanwhile, the price of oil continues to rise, reaching a record of just under $140 a barrel this week, despite increasingly shrill rhetoric from the Fed and the European Central Bank about being mindful of commodity-driven inflation. Seeing that monetary policy is still loose and the value of the US dollar still rather suspect, investors have continued to purchase physical commodities such as oil even as it has doubled in price from this time last year. (Don't look at oil priced in US dollars to draw conclusions, although even deflated in gold or euros the oil prices look overbought. Some of this could be due to the artificial manipulation of the currencies by the Central Banks. Yes they do it. They admitted it on several occasions. It is not a 'conspiracy theory.' It is only a matter of 'how much and how will it end.' - Jesse)

Americans and Europeans are increasingly turning to smaller cars to cut their fuel prices, leaving princely sports utility vehicles rotting in their lots. All of a sudden, the marketing lies about America's cultural infatuation with big vehicles on specious grounds of safety and utility have unraveled due to the price of fuel. This story may only just be starting, as more such declines in large inefficient vehicles are forecast, as is the likelihood that people will stop driving luxury cars that cost too much to maintain. (We saw the same phenomenon in the 1970's in the US - Jesse)

It is not just in such developed countries that people have begun adjusting to high oil prices. Similar events have taken place elsewhere, and perhaps the most entertaining this week was the news item that the price of donkeys in Turkey has increased sevenfold from 26 euros (US$40) to 180 euros in the past few months. The reason is of course that farmers can no longer afford to use their tractors due to fuel costs and have turned back to the 2,000-year ass technology.

Now that I have broached the subject of asses, the Group of Eight finance ministers' meeting in Osaka, Japan, this weekend should be entertaining for the whole new set of lies that will be promulgated. The only thing that the ministers should watch out for is that financial markets have become much more unforgiving in the past few days, so the old convenient lies will have the exact opposite effects to those that are intended. (The carry trade in the Yen and the Swiss franc are the wellsprings of central bank liquidity these days. This trade however leads to distortions. The problem with all this central planning is that when you 'squeeze here' something else 'pops up there.' We only wonder how much damage the bankers can do before they are hung in the public squares around the world, figuratively speaking. They are right to be fearful. - Jesse)