The weekend of September 14th 2008 certainly will be known as a most remarkable weekend for American high finance. Both Lehman Brothers and Merrill Lynch have disappeared; the first to bankruptcy, the second to a Fed-directed merger with Bank of America. Several people have contacted Lars Toomre to ask various questions about might lie ahead in the near and longer-term future, and what "I" might know.
As a former employee of Lehman Brothers, I am sad to see that franchise disappear seemingly into thin air. Yet as readers of this blog no doubt are aware, I have been very contemptuous particularly of the former Capital Market managements of Citigroup, Merrill Lynch and UBS and their risk management teams. Clearly, the leaders of those firms really did not understand what types and amounts of risk they were taking on with all of their accumulation of sub-prime mortgages, CDOs, SIVs and other structured finance products. Why they had to own so many billions of these products made no sense except if they were making the bet that they could make a spread between the asset yields and where those products could be funded.
Back in the late fall of 2006 and early winter of 2007, I became extremely worried about the irrationality of the fixed-income markets. On February 5th 2007, I wrote the post It's All Fun and Games Until Someone Gets Hurt where I highlighted
Toomre Capital Markets LLC has been quite concerned about the irrationality of the United States fixed-income markets. Recently, the current coupon mortgage-backed security has traded with a negative option adjusted spread ("OAS"). Buyers of the current coupon MBS apparently were paying little heed to the fact that the underlying mortgages could be pre-paid. Rather the demand for nominal yield far outweighed the risk of prepayment. It will be very interesting to observe what happens with this market sector in the coming months as the Federal Reserve seemingly remains on hold. Is it a time to reach for yield? Or is it a time for safety ahead of one of the bond market's periodic up-heavals?
That post was followed up by one the next week entitled Hedge Funds, Investment Banks and the Value of Liquidity? In that post, I wrote "The financial markets now are full of much liquidity. Are investors, speculators and their bankers appreciating and pricing in liquidity risk? Toomre Capital Markets LLC would suggest that liquidity risk presently is greatly under-valued in the search for 'alpha', absolute return and portfolio yield. The stretch to get ten percent return (after fees) appears to be making rational people start to do irrational things."
Apparently, the folks running Lehman Brothers were not fully paying attention to what they were doing with their mortgage business. Somewhere in my reading of the past few days, I saw reference to why Michael Gelband resigned as the head of Lehman Brothers fixed-income division in June 2007. Apparently, the Lehman Brothers COO Joe Gregory did not want to reduce the risk profile of the fixed-income business (and may even have wanted to expand the risk even further to help fund the firm's global expansion plans).