June 4, 2008 – 10:31 am

As the market intensifies its punishment, Lehman Brothers’ cash continues to dwindle and the bank’s desperation grows. This asphyxiation is rendering the most extreme dichotomy of psychotic behavior – that of at once selling off and buying back its own shares. Let’s examine the madness.

Perhaps the most intriguing parallel, though, is the crude attempt at self-preservation made by the investment trusts in 1929 and the banks now.

In the great crash, investment trusts with vast cross-holdings in each other tried to stem their collapse by buying up their own stock in what the economist JK Galbraith in his book, The Great Crash 1929, described as an act of “fiscal self-immolation”. At the time, “support of the stock of one’s own company seemed a bold, imaginative and effective course,” Galbraith wrote, but ultimately the trusts were just “swindling themselves”.

Yesterdays downgrade by Standard & Poor’s probably provided a short term trading bottom, but long term solutions are in short supply. Lehman now faces a sundry of disasters such as spreads on credit-default swaps parting like the Red Sea, June puts that are deeply out of the money, and an overall feeding frenzy on banks. And now perhaps the biggest stick to bludgeon Lehman is a change to accounting rule FAS 140.

Accounting changes could force US banks to take thousands of billions of dollars back on to their balance sheets in the coming months in a move that is likely to curb further their lending and could push them into new capital raisings, analysts have warned.

Analysts at Citigroup said a planned tightening of the rules regarding off-balance sheet vehicles would force banks to reconsider arrangements and could result in up to $5,000bn of assets coming back on to the books.

The off-balance sheet vehicles have been used by financial institutions to keep some assets off their balance sheets, thereby avoiding the need to hold regulatory capital against them.


All told, banks will be required to bring $5T (that’s trillion with a T) back onto their balance sheets. So, we see that the banks’ psychotic actions are only a reflection of the absurd regulatory environment in which they operate.

The absurdity is not $5 trillion coming back on bank balance sheets. Rather the absurdity is with accounting rules that let banks hold this much stuff off balance sheets in the first place. It makes a mockery of stated leverage, value at risk, and capitalization ratios. Banks claim to be well capitalized but the ratio is a mere 6% and that 6% does not include the effects of hiding $5 trillion off balance sheets.


In such an environment, who can wonder how such a psychotic dichotomy of contradictory statements can flourish. The bank denies that it needs cash as it raises $4B in a rights issue. And even if Lehman’s denial that it accessed the FED window is true, the rights issue dilutes its own worth, like a snake eating its own tail.

So far, the bears led by David Einhorn, a hedge fund manager who’s betting Lehman shares will fall, have been patiently stalking, but they are inching ever closer to striking distance. Before Lehman reports on June 16, the only question left is who can devour the snake first, the bears or the snake itself?


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