What is really the amount of equity on a bank’s balance sheet?

     An interesting thing happened last week in the Lehman Brothers drama.  They finally announced the final settlements for the bankruptcy case that started 3 years prior.  It appears that what some banks view as an asset, are really not one.  Let’s look at the settlement for the moment, and then later derivatives.  

     At the time of bankruptcy it was reported that Lehman had $639 Billion in assets.    They also had $450 Billion in liabilities.  Naturally this would mean they had $189 Billion in net worth once they settled all claims.  Bloomberg is reporting that when everything is finally settled total claims will be around $370 Billion (I assume $80 were not valid claims or were settled in trades).  The interesting thing is that once all the assets are sold they feel that they will likely only get $89.5 Billion in cash back (estimated in the future $65B, $23 B today, and $1.5B in fees).  In my estimation their “assets” were worth only 14¢ on the $1.  Does that mean that other banks are similarly impaired?

     It was further reported that there was a battle between the amount to settle derivative trades versus senior bond holders; specifically Goldman Sachs (derivatives) and hedge fund Paulson & Co (bonds).   Bloomberg is reporting that senior bond holders will only get 21.1¢ on the $1; while derivative holders will get 27.9¢ to 32¢ on the $1.  Speculating here- Goldman recovered more on the derivatives than a hedge fund on the “senior” bonds.  Why is this?  Is it because the hit to Goldman’s “equity” would have been too large?  Goldman is a bank versus a hedge fund.  Did the Fed step in and try and change the payout?  

     Regardless of my suspicions, I think the settlement of derivatives points to the next systemic risk- equity based on derivative contracts are not worth the paper they are printed on.  This is important because so much of JP Morgan, Goldman Sachs, Bank of America, and Citibank (listed in order of derivative traders) “equity” are based on the derivative contracts that they hold.

     There is a fable in Japan where two brothers have a barrel of wine that they want to sell at the market in a distant town to make a bunch of money.  Along the way to the market one of the brothers wanted to stop and have a jug of wine.  Knowing this to be unfair to the other brother, the first brother wrote out an IOU for the value of one jug of wine, which the other brother gladly accepted.  Further down the road the other brother decided he too was thirsty and wanted a jug of wine.  To compensate his brother he too wrote out an IOU for the value of the wine.   The trip to the market was long and hot.  The brothers wound up stopping multiple times for a new jug of wine, each time writing the other an IOU.  This continued until the brothers were too drunk to go further.  They just sat on the edge of the road drinking jugs of wine and exchanging IOUs.  The next morning the brothers awoke with massive headaches, an empty barrel of wine, and a stack of IOU’s. 

     I think if you substitute brothers for the four banks, and the IOU’s for the derivative contracts you will see that the barrel of money is all gone and all they have is IOU’s that they exchanged between themselves, with no real money to pay them back.   Thus this will end the giant confidence game and all four will fail.  It just takes the weakest of them to fail.

     Full Disclosure  

     I do not own or trade any of the stocks mentioned nor do I intend within the next few days.