Lehman Brothers v Morgan Stanley

We hope everyone is having happy holidays. Last time, we defended Lehman Brothers from Andrew Ross Sorkin’s attack in Too Big to Fail. We’ve stolen some time from the seasonal festivities to take another look at the numbers, and we still feel there’s a strong case to be made for the way Lehman Brothers managed its finances right before its fall.

We compared Lehman to Morgan Stanley from November 2007 through August 2008, the three reporting periods leading up to Lehman’s collapse in September 2008. We looked at the progress each firm made improving three key measures of financial strength: leverage, exposure to mortgage-backed securities, and liquidity reserves.

We calculated leverage as the ratio of total assets to shareholders’ equity, exposure to mortgage-backed securities as the book value of residential and commercial mortgage-backed securities as a percent of shareholders’ equity, and liquidity reserves as total cash and unpledged liquid securities. To gauge the improvement in each measure, we calculated its value in August as a percent of its value in November.

 

In Sorkin’s account, Lehman Brothers went bankrupt because it had too little capital to absorb the potential losses from its real estate investments. But Lehman did much more to reduce leverage and cut exposure to mortgage-backed securities than Morgan Stanley, yet Morgan Stanley survived.

It’s true that Morgan Stanley did a better job of boosting liquidity than Lehman, but it needed to. Morgan Stanley did much more prime brokerage business with hedge funds than Lehman. It was the run-off in prime brokerage funds that brought Bear Stearns down, and it nearly ruined Morgan Stanley too. In the week after Lehman failed, Morgan Stanley went through nearly all $180 billion of its liquidity reserves and had to go to the Federal Reserve for rescue.

So what’s the risk management lesson in all this? Did Lehman Brothers deserve to die? Did it commit suicide, or was it killed? Could it have done anything to save itself? Too Big to Fail makes Lehman’s fate seem inevitable, and we agree.

Like any investment bank, Lehman relied on confidence-sensitive financing, and in September of 2008 the financial markets lost confidence in Lehman – and Morgan Stanley and Goldman Sachs. Nothing they could do about leverage, exposure to mortgage-backed securities, or liquidity reserves mattered.

It’s nothing new. As Walter Bagehot observed more than a century ago, “Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone.”

Off-Balance-Sheet Debt at BT Group

The heavy burden of hidden debt
BT Group, plc, is one of the world’s largest telecommunications companies. Since the telecom crash in 2001, it’s been struggling with operating, management, and reporting problems. You can add financial problems to the list as well.

Its leverage – or “gearing”, as the English put it – is high. Reported debt to capital (adjusted for actuarial losses in its pension plans) is 66%. That’s based on the numbers reported on the company’s balance sheet.


Look beyond the balance sheet, and leverage gets much worse. BT has retirement benefit obligations that exceed pension plan – or “scheme,” as the English say --- assets by £2,870. If you consider that to be debt, leverage increases to 71%. Treat operating leases as a form of debt financing, and BT’s leverage climbs to 75% (capitalizing annual rental expense at 8x).

Off-balance-sheet debt equivalents
What explains the difference between BTs reported leverage and its adjusted leverage? Why treat pension and lease obligations as the equivalents of debt? How do you tell if an off-balance-sheet liability belongs in your leverage analysis?

We use these criteria. To be the equivalent of debt, an obligation has to:

• Be a financial obligation, not money owed to a supplier
• Have an imputed or actual interest rate
• Have a fixed payment schedule
• Allow the holder to demand payment in full on default
• Be a substitute form of capital

By these standards, unfunded pension obligations are debt because they are financial, are discounted at an interest rate, and often have a payment schedule that is enforced not just by pensioners but by government regulators as well. Operating leases are debt because they are another way of financing assets. If BT securitized its trade receivables, that would be another form of off-balance-sheet financing equivalent to debt.

U.S. and international reporting rules are precise about what debt is, but those rules don’t always capture the economic reality of how companies finance themselves. Sometimes reported leverage understates real leverage. That’s the case for BT.

Hovnanian Takes a Half-Step in the Wrong Direction

Getting Better and Worse
The worst seems to be over for the housing industry in the United States. It may even be on the mend. In the competition for building sites, companies with less financial risk will have an advantage. Hovnanian Enterprises, the sixth largest homebuilder in the country, has been doing some interesting financial deals to improve its competitive position

Hovnanian had the highest leverage among its closest competitors. At the end of 2008, the company’s debt-to-capital ratio was 88.7%, while its rivals averaged 66.2%. With competitors buying foreclosed land from banks at historic-low prices, Hovnanian is forced to spend money on debt service instead.

Worse, Hovnanian had even less financial flexibility than the competition. Looking at maturities of debt over the next five years, Hovnanian had 28.3% of its debt coming due, while its competitors had only 23.0%. Worse still, the company’s debt was much more concentrated in a single year, as the chart below shows.

Maximum 1-year debt maturities as a percent of total debt are the highest value for debt maturities over the next five years as a percent of current period total debt.

Having so much of its debt maturities crowded into a single year is a problem for Hovnanian. It has a lot more refinancing risk than the companies it competes with. If its credit quality gets weaker or the capital markets take another dive when all that debt matures, Hovnanian will be in serious trouble.

Less Progress than Meets the Eye
To its credit, Hovnanian saw the problem and did something about it. Through exchanges offers, open market repurchases, and cash tender offers in the first three quarters of 2009, Hovnanian repaid $780 million of its debt. About $271 million of that was debt maturing in the next five years.

Unfortunately, Hovnanian’s efforts reduced leverage but reduced flexibility as well. Maximum 1-year debt maturities actually increased to 37.7% of total debt. The company had more success retiring its longer-maturity debt than the debt coming due in the next five years.

Financial leverage is a risk in its own right, but embedded in leverage is another risk: financial flexibility. And financial risks are closely connected to competitive risk. Good financial strategy manages all of those dimensions of risk effectively. Hovnanian seems still to be struggling to do that.