Toward the end of July, I suggested that traders should be extremely suspicious of rallies in beleaguered financial stocks like Wachovia (ticker: WB), Citigroup (C), and Washington Mutual (WM), and look to sell or get short on strength. After hitting highs above $19, $22, and $6 respectively, those stocks now sit under $15, $19, and $3. I believe that was the right call to make, but I also believe the prudent thing to do now is to not overpress one’s good fortune. That’s why I believe the right move here is to tighten stops, be less aggressive, and focus on preserving (not growing) capital and living to trade another day.
Lehman (LEH) is facing equity death-spiral issues in that the stock is falling because they haven’t raised capital, but their ability to raise capital is impaired because of their low stock price. It’s a vicious cycle, and it’s difficult to break. But if the current variables in place remain constant – and that’s admittedly a huge if – Lehman will survive and could be the contrarian trade of the year. The trouble is that if either Lehman’s counterparties cut back on trading with it, or the Fed reduces the firm’s access to the borrowing window, Lehman could go down quickly. Of those two scenarios, the first is the far more likely cause, as the reasons for the Fed brokering the Bear Stearns-J.P. Morgan marriage all hold for Lehman as well. But on the first point: confidence in a financial institution is in many ways its currency, and the price of the common stock is in many ways a reflection of that confidence. So with each day Lehman’s share price falls, it becomes more and more likely that a chain reaction is set off involving a halt to deal flow, which would force Lehman to fire sale itself.
If Lehman’s stock price can find some support, it will buy time for the management team to pursue asset sales, restructuring, and capital infusions. If there were less stress in the capital markets, this wouldn’t be too difficult – Lehman does have a collection of very valuable assets – but that is not the world we’re in today, and every hour matters for Lehman right now. Given the imbalance between debt value ($370 billion) and market cap (under $3 billion), it’s likely that a reasonable offer for Lehman’s equity (say, $5/share) would be pushed through by debtholders buying up the common if they felt the acquirer would make good on the debt. Still, the volatility and uncertainty make this complete speculation, so recognize any stock or options plays here for what they are.
The impacts for the broader financial system are intriguing. It’s cliché, but true: the market hates uncertainty. Lehman has been one of the market’s concerns for months now, so a resolution to their status that minimizes additional stress and uncertainty would go a long way to shoring things up. A Fed agreement to backstop Lehman’s bad debt, as was done with Bear, accompanied by a bid for Lehman by a well-capitalized institution like Bank of America (BAC) would go a long way toward reassuring investors of the stability of the financial system. Should that happen, it would combine with the recent Fannie/Freddie takeover to suggest that the financial markets’ problem children can be dealt with, and could be enough to turn large institutions optimistic going into year end.