Category 2 Hits Texas, Cat 4 Hits Wall Street

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
September 16, 2008

IN THIS ISSUE:

1. Lehman Brothers Files For Bankruptcy

2. Bank of America Buys Merrill Lynch

3. Largest Bank/Brokerage In The World

4. Will AIG Be The Next Giant To Fall?

5. Emergency Sunday Wall Street Trading Session

6. Where Our Clients’ Assets Are Held

7. Conclusions – History In The Making, Perhaps

Introduction

Hurricane Ike, a massive Category 2 storm, ravaged the coastal areas of southeastern Texas and western Louisiana on Saturday as it moved inland. Galveston and Houston were severely damaged, both by the winds and the massive storm surge. Damages are preliminarily estimated to be in the $25 billion area. As this is written, the death toll is estimated at 33 for those in the storm’s path.

While the nation’s attention was focused on Hurricane Ike over the weekend, there was another storm brewing on Wall Street. We awoke on Monday to learn that Lehman Brothers, America’s fourth largest investment bank, was declaring bankruptcy. We also learned that brokerage giant Merrill Lynch had been acquired by Bank of America, reportedly for $45-$50 billion in stock.

If those two landmark events weren’t enough, we also learned on Monday that American International Group (AIG), the 18th largest company in the world, was entering a major restructuring plan, which would include a major sale of assets in order to raise a huge amount of cash – estimated to be $70-$75 billion - to avoid a fate similar to Lehman Brothers.

It was also revealed that AIG is seeking up to $40 billion in loan guarantees from the Fed. It was reported on Monday that the Fed said NO over the weekend. AIG’s share price plunged over 60% early Monday and closed down over 50% at the end of the day, and is sharply lower again today. Not surprisingly, there is widespread speculation that AIG may be the next US financial giant to fail.

These latest dire financial events last weekend came on the heels of the announcement just over a week ago that mortgage giants Fannie Mae and Freddie Mac had been nationalized by the federal government due to the mortgage/credit crisis. Likewise, the Lehman, Merrill and AIG developments are also largely due to the housing slump and the subprime mortgage/credit crisis.

Stocks immediately plunged on the opening yesterday morning as investors around the world worried about the safety of their money. Unlike the Bear Stearns bailout by the government in March, the Fed allowed Lehman Brothers to go bankrupt. Likewise, the takeover of Merrill Lynch, the world’s largest brokerage/investment banking firm, sparked concerns among investors worldwide. The Dow plunged more than 500 points on Monday.

This week, we take a look at the latest developments on Wall Street and what they may mean for the investment markets. I will also summarize where our clients’ money is invested. For the record, we do not hold any client accounts at Lehman Brothers or Merrill Lynch.

Let’s get started, as there is a lot to cover.

Lehman Brothers Files For Bankruptcy

Founded in 1850, Lehman Brothers Holdings Inc. had grown to become the fourth largest investment bank in the US, with operations around the globe. The firm was a major player in investment banking, equity and fixed-income sales, research and trading, investment management, private equity and private banking. It has also been a primary dealer in the US Treasury securities market.

During the housing boom of the last decade, Lehman became increasingly active in the home mortgage market and the packaging and selling of mortgage-backed securities. A Lehman subsidiary, BNC Mortgage, was a large player in the subprime mortgage market. In August of 2007, Lehman shut down BNC, but this was not the end of the firm’s subprime troubles. According to published reports, here’s how Lehman imploded.

In 2008, Lehman faced an unprecedented loss due to the continuing subprime mortgage crisis. Lehman’s loss was apparently a result of having held on to large positions in subprime and other lower-rated mortgage tranches. Whether Lehman was unable to sell the lower-rated bonds, or made a conscious decision to hold them, is unclear. In any event, huge losses accrued in lower-rated mortgage-backed securities throughout this year.

In the second fiscal quarter, Lehman reported losses of $2.8 billion and was forced to sell off $6 billion in assets. In the first half of 2008 alone, Lehman stock lost 73% of its value as the credit markets continued to tighten. In August 2008, Lehman reported that it intended to release 6% of its work force, some 1,500 people, just ahead of its third-quarter-reporting deadline in September.

On September 10, Lehman announced a third quarter loss of $3.9 billion and their intent to sell off a majority stake in their investment-management business, which included Neuberger Berman and other subsidiaries. Lehman’s stock plunged another 40% on September 11. According to reports, the company was desperately seeking a merger partner at that point and well into last weekend.

It is still uncertain whether Lehman formally requested a Fed bailout, but the government reportedly let Lehman know that it would not come to the rescue with loan guarantees as it did with the Bear Stearns bailout. According to the Wall Street Journal and other sources, Lehman entered into negotiations with Bank of America (BofA), Merrill Lynch and Barclays Bank late last week and over the weekend.

According to the WSJ, BofA pulled out of the Lehman talks as it considered Merrill Lynch to be a better fit. Barclays Bank also reportedly declined to make an offer to purchase the firm. On Sunday, The New York Times reported that Lehman would file for bankruptcy protection for its parent company, Lehman Brothers Holdings, on Monday while planning to keep its subsidiaries solvent during the bankruptcy proceedings.

In negotiations over the weekend, a group of Wall Street firms agreed to provide capital and financial assistance for Lehman’s liquidation in an effort to avoid chaos in the markets. The Federal Reserve, in turn, agreed to a swap of lower-quality assets in exchange for loans and other assistance from the government.

Interestingly, the International Swaps and Derivatives Association (ISDA) orchestrated an emergency special trading session on Sunday to allow market participants an opportunity to potentially offset positions in various derivatives on the condition of Lehman’s impending bankruptcy. More details on this emergency Sunday trading session will follow below.

Shortly before 1 a.m. on Monday morning, Lehman Brothers Holdings announced it would file for Chapter 11 bankruptcy protection. Lehman’s bankruptcy will be the largest failure of an investment bank since Drexel Burnham Lambert collapsed amid fraud allegations 18 years ago.

Bank of America Buys Merrill Lynch

As everyone reading this knows, Merrill Lynch (ML) is one of the world’s largest brokerage firms with offices in 40 countries and territories, with apprx. 60,000 employees worldwide and total client assets of approximately $1.6 trillion. ML is also a global provider of wealth management, underwriting and various advisory services. The company was founded in New York in 1914 by Charles E. Merrill.

Obviously, Merrill Lynch is a global powerhouse in the financial industry. Yet along with Lehman Brothers and many others, ML became a large player in the mortgage markets in the 1990s, including a significant presence in the subprime mortgage market. By late 2007, ML announced that it was writing down $8.4 billion in losses related to the “national housing crisis” (read: subprime), and that its CEO, Stanley O’Neal, had resigned.

During the 12 months from July 2007 to June 2008, Merrill reported losses of $19.2 billion. Over the last year, ML’s share price tumbled from above $75 to below $20 as this is written.

In August of this year, New York Attorney General Andrew Cuomo threatened to sue Merrill Lynch over its alleged misrepresentation of the risk on mortgage-backed securities. A week earlier, ML reportedly offered to buy back $12 billion in mortgage-backed debt and later said they were surprised by the lawsuit. Three days later, the company reported a hiring freeze and revealed that they had charged almost $30 billion in losses to their subsidiary in the United Kingdom.

On August 22, Merrill’s CEO John Thain announced an agreement with the Massachusetts Secretary of State to buy back all auction-rate securities from customers with less than $100 million on deposit with the firm, beginning in October 2008 and expanding in January 2009. Bloomberg reported earlier this month that ML had lost $51.8 billion in mortgage-backed securities as a result of the subprime mortgage crisis. In short, Merrill Lynch was in trouble.

Enter Bank of America (BofA). Charlotte, NC-based Bank of America is the second largest bank in the US based on assets, behind Citicorp. But BofA has more branches (5,700 and counting) than either Citicorp or JP Morgan Chase.

Ken Lewis, BofA’s CEO since 2001, side-stepped the subprime mortgage crisis. Lewis reportedly shunned subprime mortgages as he believed these risky loans could backfire – as they did. He focused instead in building more branches, including international operations, acquiring other financial firms and expanding its asset base.

In late 2006, BofA acquired US Trust Company ($100 billion in assets) from Charles Schwab for $3.3 billion. In late 2007, BofA acquired the US assets of ABN AMRO, the large Dutch bank, for a reported $21 billion. These are just two examples of BofA’s numerous acquisitions.

On August 23, 2007 Ken Lewis decided it was time to test the waters in the subprime mortgage business, as BofA announced a $2 billion repurchase agreement for Countrywide Financial. Countrywide provides mortgage servicing for nine million mortgages valued at $1.4 trillion as of the end of last year, and was a big player in subprime mortgages.

Following that initial investment, on January 11, 2008, Bank of America announced that they would buy Countrywide Financial outright for $4.1 billion. This acquisition, which closed on July 1, 2008, gave the BofA a substantial market share of the mortgage business, and access to Countrywide’s expertise, technology, and employees for servicing mortgages. The acquisition was seen as preventing the potential of bankruptcy for Countrywide.

The point is, Bank of America avoided the subprime debacle and has a long history of aggressive acquisitions.

Largest Bank/Brokerage In The World

On Sunday, Bank of America announced it would purchase Merrill Lynch for $38.25 billion in stock. The Wall Street Journal reported later that day that Merrill Lynch was sold to BofA for about $44 billion or about $29 per share. Other reports on Monday indicated the purchase price was near $50 billion.

BofA gets Merrill’s investment-banking expertise and sprawling, powerful brokerage force, which is a natural fit for BofA’s own increasing focus on domestic banking and brokerage. Over 90% of Merrill’s “Thundering Herd” of brokers is focused on the US, which is BofA’s strength as well. ML’s wealth management is a stable business and its recurring revenue makes up 70% of the unit’s overall revenue, up from 59% in 2003 according to a ML executive.

In return, Merrill gets BofA’s financial stability. Still, Merrill comes with plenty of exposure to toxic assets, including $8.8 billion of gross exposure to collateralized debt obligations (CDOs).

The combined company would have leadership positions in retail brokerage and wealth management. By adding Merrill Lynch’s more than 16,000 financial advisers/brokers, BofA would become the largest brokerage in the world, with more than 20,000 advisers and $2.5 trillion in client assets.

The combination brings BofA global scale in investment management, including an apprx. 50% ownership in Black Rock, Inc., the largest publicly traded US investment management firm, which has $1.4 trillion in assets under management. BofA reportedly had $589 billion in assets under management prior to the ML acquisition.

Merrill Lynch’s stock closed at $17.05 per share last Friday, and some are questioning why BofA agreed to pay $29 per share for the giant brokerage. Numerous analysts speculated as to why BofA offered such a price when ML’s stock was probably headed lower, perhaps significantly lower. Nevertheless, BofA CEO Ken Lewis offered the following upon announcing the deal:

“Acquiring one of the premier wealth-management, capital-markets and advisory companies is a great opportunity for our shareholders… Together, our companies are more valuable because of the synergies in our businesses.”

Interestingly, Bank of America has apparently had its eyes on Merrill Lynch for many years. According to several reports, BofA chairman Ken Lewis, and his predecessor Hugh McColl, had more than a passing interest in acquiring the nation’s largest brokerage firm. Thanks to the subprime mortgage/credit crisis, BofA got ML on the cheap.

Will AIG Be The Next Giant To Fall?

Rumors are flying that American International Group (AIG) is also in serious financial trouble. AIG is one of the largest insurance company in the world. The company describes itself as follows on its home page on the Web:

“American International Group, Inc. (AIG), a world leader in insurance and financial services, is the leading international insurance organization with operations in more than 130 countries and jurisdictions. AIG companies serve commercial, institutional and individual customers through the most extensive worldwide property-casualty and life insurance networks of any insurer. In addition, AIG companies are leading providers of retirement services, financial services and asset management around the world. AIG’s common stock is listed on the New York Stock Exchange, as well as the stock exchanges in Ireland and Tokyo.”

Unfortunately, AIG has been one of the largest underwriters of complex debt securities known as “credit default swaps” that are used as insurance for a wide range of products, as well as a large portfolio of mortgages including subprime loans.

On Monday, New York Governor David Patterson approved a transaction in which various AIG subsidiaries would loan the parent company apprx. $20 billion to bolster its capital as it faces potentially disastrous credit downgrades. Actually, there are questions regarding whether the governor of New York has such authority, and if such loans are legal.

Specifically, many of AIG’s subsidiaries are not domiciled in New York. Such is the case in Texas where AIG is domiciled here. It is my understanding that Texas insurance regulators would have to approve a large loan (potentially several billion dollars) from AIG Texas to AIG’s parent which is domiciled in New York state. The same may be true in numerous other states (and foreign countries) where AIG subsidiaries are domiciled. Thus, we may be hearing more about this $20 billion loan in the days and weeks ahead.

AIG has also sought a $40 billion bridge loan from the Federal Reserve as a lifeline, as the three-part rescue plan it had devised appeared to be crumbling. Once again, it does not appear that the Fed will come to the rescue, at least not directly – yet.

While AIG reportedly has over $1 trillion in assets, the insurance giant is seeking $70-$75 billion in emergency lending, according to several sources. The Fed has apparently tapped Goldman Sachs and JP Morgan Chase to attempt to form a Wall Street lending consortium to come up with the money. It remains to be seen what will happen. My question is, what’s in it for Goldman, JP Morgan and other banks that will be asked to join this lending consortium?

It is interesting to note that the current US Treasury Secretary, Hank Paulson, is the former chairman and CEO of Goldman Sachs. I’m just speculating, but it would not surprise me if some kind of deal between the large banks and the government is struck to save AIG from failure.

Shares in AIG tumbled more than 60% on Monday morning as investors grew concerned that the firm lacked capital to withstand cuts to its debt rating. Ratings agencies had threatened to downgrade the insurance giant’s credit rating by Monday morning, allowing counterparties to withdraw capital from their contracts with the company. S&P, Moody’s and Fitch credit rating services actually lowered AIG debt rating this morning (Tuesday), and AIG’s stock plunged another 35-40% in early trading this morning after the credit ratings announcements.

AIG’s problems are not new. The company reportedly lost $13.2 billion in the first six months of 2008, largely owing to declining values in mortgage-related securities held in its investment portfolio and collateralized debt obligations it owns. As of the most recent quarter, for example, AIG reportedly had $20 billion of subprime mortgages marked at 69 cents on the dollar and $24 billion in so-called “Alt-A” mortgage related securities valued at 67 cents on the dollar.

Thus, there are widespread fears that AIG will be the next giant financial institution to fail. If AIG fails in all of its guarantees, there will be huge (hundreds of billions) exposure for banks worldwide. In addition, millions of Americans own products (insurance policies, annuities, etc.) directly from AIG and/or its affiliates. The Lehman bankruptcy would pale in comparison to the failure of AIG. Therefore, I will not be surprised if the Fed ultimately steps in to rescue AIG if that becomes necessary.

There are also concerns that Washington Mutual, another huge financial services firm, and others, may also be in trouble. AIG is not likely to be the last of the bad news.

Emergency Sunday Wall Street Trading Session

Fading hopes for a Lehman rescue deal last Saturday raised the risk the firm would have to file for bankruptcy on Sunday or early Monday morning. In fact, Lehman hired law firm Weil Gotshal & Manges to prepare a potential bankruptcy filing, the Wall Street Journal reported on Saturday in its online edition.

Bill Gross, chief investment officer of PIMCO, said a Lehman bankruptcy risked an “immediate tsunami” because of the unwinding of derivative and credit swap-related positions worldwide in the dealer, hedge fund and buy-side universe (mutual funds, pension funds, etc.). The implications for the financial markets were huge.

As a result, the International Swaps and Derivatives Association (ISDA) announced late Saturday, with the apparent blessing of US securities regulators, that there would be a special trading session on Sunday afternoon for the purpose of allowing derivatives market participants an opportunity to unwind Lehman-related market positions. ISDA indicated that the special session was actually suggested by the Federal Reserve.

Major players in the $455 trillion global derivatives market rushed Sunday to scale back exposure to a potential bankruptcy filing by Lehman Brothers in the rare emergency trading session. The session opened at 2 p.m. New York time and was due to run until 4 p.m. However, the ISDA later extended the emergency session for another two hours, and reportedly some banks continued to offset their Lehman exposure even after the official session ended.

Trading involved credit, equity, rates, foreign exchange and commodity derivatives. Trades were contingent on a bankruptcy filing by Lehman before the markets opened on Monday. If there was no bankruptcy filing by Lehman, the Sunday trades would have been reversed.

Implications For The Investment Markets

On Monday, the Dow Jones plunged 504 points, or 4.42%, to 10,917.51, moving below the 11,000 mark for the first time since mid-July. It was the worst point drop for the Dow since it lost 684.81 on Sept. 17, 2001, the first day of trading after the 9/11 terror attacks.

In percentage terms, the drop was the steepest since July 19, 2002. It was also the sixth-largest point drop in the Dow, just behind the 508.00 it suffered in the October 1987 crash. The Dow is now down apprx. 23% from its record high of 14,198.09 last October.

Broader stock indicators also fell. The S&P 500 index declined 59.00, or 4.71%, to 1,192.70 — also its biggest drop since just after 9/11 and the first time it closed below 1,200 in three years. The decline on Monday violated the previous S&P low in July, which many had hoped was the bottom in this bear market.

S&P 500 Chart

Clearly, the trend is down in the equity markets, and investors worldwide are wondering how bad things may get. Obviously, a lot depends on what happens with AIG, as discussed earlier. If AIG goes down, the negative implications are much larger indeed than the failure of Lehman Brothers.

On the other hand, if some kind of a deal is struck to rescue AIG, even temporarily, stocks would likely get a bounce. In today’s trading session, the Dow Jones Industrial Average tested its July 19 low of 10,732, but did not penetrate it, and then reversed to close up 141 points on the day. I expect there will be technicians who will argue that we’ve seen a double bottom. We’ll see.

Bottom line: If AIG goes down, I would expect the stock markets to plunge yet again, even harder. As a result, I will be surprised if the Fed ultimately let’s AIG go down. The financial implications are just too great, in my opinion.

Even if AIG manages to stay afloat, investors are worried that there may be other large financial institutions that are in trouble. Investors hate uncertainties, and we are far from the point where the financial industry is out of trouble. This argues that the bear market in stocks continues for at least a while longer.

Finally & Most Importantly:
Where Our Clients’ Accounts Are Held

As noted in the Introduction, we do not hold any client accounts at Lehman Brothers or Merrill Lynch. As most of you know, my companies specialize in investment programs that are professionally managed by third party Advisors that we carefully select. Our business is concentrated in three particular areas: 1) our AdvisorLink program which is mutual fund-based; 2) our Absolute Return Portfolios which are also mutual fund-based; and 3) our futures funds.

Client accounts in our AdvisorLink program are held at one of the following mutual fund families and/or trading platforms – Fidelity Institutional Brokerage, Rydex Mutual Funds, TD Ameritrade or Trust Company of America. These are not investment banks.

Client accounts in our Absolute Return Portfolios, which are carefully selected groups of mutual funds, are held at TD Ameritrade.

Assets in our four futures funds are custodied in segregated accounts at MF Global, which is considered one of the leading international brokers for exchange-traded futures and options and a leading intermediary in the markets for other major financial instruments around the world. MF Global provides access to the world’s largest and fastest growing financial markets through offices on five continents and affiliations with more than 70 financial exchanges.

Established in 1783 by James Man as a commodities brokerage firm in London, MF Global is probably better known to many in the investment world as E D & F Man. MF Global spun off from the Man group in 2007 with a public offering and is listed on the New York Stock Exchange as NYSE: MF.

Conclusions – History In The Making, Perhaps

While the US economy is holding up at least reasonably well, the subprime and mortgage related financial crisis is taking its toll on Wall Street financial institutions, one by one. The worsening confidence among lenders and borrowers continues to complicate matters in the financial markets. The question is, have we seen the worst with the bankruptcy of Lehman Brothers and the fire sale of Merrill Lynch, or is there much more to come? That remains to be seen.

Stock markets worldwide don’t like this kind of uncertainty, and they have reacted accordingly. How much more the bear market in US stocks has to go remains an uncertainty. A great deal depends on how much more bad news is to come over the next few weeks. Questions remain about AIG and how many other large financial firms may be waiting to announce similar problems.

I sincerely hope that we are not witnessing history in the making, and that the worst of our financial problems have already been revealed. But the fact is, we just don’t know yet. The housing/subprime repercussions continue to unfold.

Normally, I would take this opportunity to promote the active management strategies I recommend – that have the flexibility to go to cash or hedge long positions during downward trends in the stock markets – but given the latest serious developments in the financial markets, on the heels of the devastation on the GulfCoast, I will forego any advertisement.

I will say that we have recently seen a marked increase in calls from E-Letter readers that have grown increasingly uncomfortable with performance results from their traditional investment advice providers. This is what usually happens in bear markets.

As always, feel free to call us for an independent second opinion and review of your investment portfolio.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

The Resilience of American Finance
http://online.wsj.com/article/SB122152085270539225.html

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http://www.ibdeditorials.com/IBDArticles.aspx?id=306370630265658

Do Wall Street’s Woes Help McCain or Obama?
http://www.usnews.com/blogs/capital-commerce/2008/9/15/do-wall-streets-woes-help-mccain-or-obama.html