Liquidity or Solvency? Its Complicated.

The current problems with Lehman Brothers, AIG, and Merrill Lynch are uncovering a number of issues that will no doubt change the way we look at the health, valuation, of operations of businesses going forward. Of interest is how the current environment has resulted in Lehman Brothers being a company with liquidity that is not solvent, compared to AIG that may be solvent (for now), but has a liquidity issue. Just last week the WSJ Deal Journal blog highlighted some of the various anomalies between Lehman's valuation and its apparent asset values as its stock price plummeted. As of Friday, the closing price of Lehman put the market capitalization of the company at around $3 billion. Yet, many analysts highlighted that the current price reflected little on the true value of the company. Analysts expected the company to receive about $3 billion for a 55% stake in Neuberger Berman - as much, if not more than the value of all of Lehman. The bonus pool for Lehman's 24,000 employees itself was estimated to be around $3 billion. On the other hand, the company has $25-30 billion in toxic real estate assets to deal with, and there-in lies the issue for Lehman. How much is the exposure, how much are they worth, and what are the potential losses? Even with the ability to spin off the real estate into another company, and further inject it with $5-7 billion in liquidity, solvency was still not guaranteed. As Ken Lewis, the CEO of Bank of America stated today, the difference between the balance sheets of Merrill and Lehman was "night and day". Time will tell on BAC's move on Merrill. In the mean time AIG is scrambling to find capital to sure up its balance sheet and keep from getting a ratings downgrade, and subsequent higher cost of capital - as if selling off assets was not a high enough cost. The Fed window may stay closed to AIG, but funds might travel out the back door before all is said and done (New York is already granting permission to access $20 billion in capital from subsidiaries, see WSJ article).

So, are the issues with Lehman, AIG, and even Merrill a result of bad risk management, lack of good regulation, poor accounting rules, circumstance, or some combination of each. The easy answer is some combination of each, but the situation is of course more complicated than that. Good risk management should help us to avoid failure, if not excessive loss when circumstances go against us, but there are no guarantees. Regulation can force us to set aside risk capital, even when we don't want to, but again, it could be argued that a good risk management system that is actually both honest and honestly followed could serve a similar purpose (whether it does and would be followed, and whether that is why regulations exist in the first place is another issue and debate). That leaves of course accounting, and I suspect this area in particular will receive a lot of attention in the coming months, especially with regard to mark-to-market. The questions of whether each of these companies would have the same liquidity issues if accounting rules were different will certainly get some play, causing it to be a busy fall, possibly followed by an busy winter, spring, and summer. For all the regulators and agencies tasked with these problems, they may come to question the validity of the old proverb: "may you live in interesting times." Right now, something a little more boring would be nice.

Update: On another site a reader responded that leverage was the problem, and any new regulations will probably overstep. I could not agree more. Just looking at things a little down stream. In fact, the mark-to-market issues may be nothing more than an identification / realization of the leverage problem. Nonetheless, I suspect the regulators will be busy trying to prevent a similar problem. Hopefully, any changes will be measured and focused with few unintended consequences.