Wednesday, September 17, 2008 0 comments ++[ CLICK TO COMMENT ]++

Hussman: Lehman Customers and Counterparties Should Be Fine; Ambac Has Minimal Exposure to Lehman

In his latest commentary, John Hussman says that customers and counterparties of the bankrupt Lehman Brothers will be fine. He points out an oft-ignored detail that, although Lehman was backing $600 billion of assets with only $20 billion on common equity, there is $100 billion of bonds backing the firm. So, the $100+ billion from bondholders should be able to cover losses. The chance of customers or counterparties losing money seems slim.

But I'll repeat what I wrote about such issues in the April 7, 2008 comment:

“In any event, SEC Chairman Cox is right – Bear Stearns' customers and counterparties were never at risk of loss. Though counterparties don't have the SIPC protections, they did in the Bear Stearns instance have a substantial capital wall and legal safe harbors specifically designed to limit systemic problems. There was a willing buyer for Bear's entire book, so the book didn't need to be unwound, just sold in its entirety on day one. Major U.S. financial companies have enough capital (shareholder equity and bondholder debt) to provide a cushion in the event of substantial writeoffs, without customers or counterparties being at risk of loss in the event of outright bankruptcy. The only instance where there would be a question would be if the book value of the failing company was negative after entirely zeroing out all shareholder equity and bondholder debt, or if the only way to liquidate the book was to unwind it. That was not the case for Bear Stearns."


In Lehman's case, $20 billion in shareholder equity is a very thin pool of funds to eat through when you're not confident in the true market value of the $600 billion in assets held by the company. But it's crucial to recognize that if you include both shareholder equity as well as Lehman's debt (bonds and subordinated debt), you've got a $143 billion cushion to eat through before any customer or counterparty would be at risk. With that kind of cushion, the issue is not, and probably will never be whether customers or counterparties are at risk. The only issue is whether you save the bondholders.

John Hussman, like myself, is not a fan of the Bush tax cuts. When all is said and done, the George Bush administration, along with Alan Greenspan, who was promoting the tax cuts, are going to end up destroying a chunk of America.

Essentially what we've got here is an economy where the government provided a boatload of tax cuts, the benefit of which was invested directly and indirectly into mortgage securities, which helped to finance irresponsible lending, which produced a housing bubble, and now that the bubble has burst and the mortgage securities are losing money, those same bondholders are looking for the government to bail them out.

That's messed up.

I second that. It's ridiculous to save bondholders when shareholders lose everything. Ideally, both--shareholders and bondholders--were responsible for profitting from these firms and deserve whatever their fate is according to the free market.

Ambac Exposure to Lehman

Ambac also outlined its exposure to Lehman Brothers, which seems quite small:

Ambac’s direct exposure to Lehman is limited to six interest rate and currency swap transactions where Lehman is the swap counterparty. Ambac has an insignificant net current payable balance, to Lehman. Ambac is exploring contract termination options to mitigate against any future credit risk to Lehman.

Ambac has no direct Lehman exposure in its financial guarantee or financial services investment portfolios. In addition, Ambac has no financial guaranty or CDS obligations related to Lehman. Ambac has reinsured surety exposure covering operational risk of lost or missing customer assets, not market value declines, at several broker-dealers, including Lehman Brothers, with a maximum aggregate exposure of $137 million. Ambac is not aware of any lost or missing customer assets at this time.

Ambac has indirect exposure to Lehman in two ways:

1. Ambac’s Financial Services business has approximately $1.3 billion in outstanding GICs backing Credit Linked Notes where Lehman is the CDS counterparty to the transaction...

2. Ambac also has exposure to structured and municipal transactions where the issuer may have entered into a swap or a GIC with Lehman as a counterparty...

As John Hussman pointed to above, it is likely that customers and counterparties will be fine. Lehman has to eat through $143 billion of capital before customers and counterparties take losses.

(On another note, Lehman is well on its way to being liquidated. Barclays just picked up the investment banking operations (without much mortgage exposure) for $1.75 billion. Most of the money is for the building. )

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