Valuation uncertainty and leverage April 13, 2010 at 6:06 am

I like Steve Randy Waldman so I don’t want to cricitise him too much, but I think he makes an error in the following:

On September 10, 2008, Lehman reported 11% “tier one” capital and very conservative “net leverage“. On September 15, 2008, Lehman declared bankruptcy. Despite reported shareholder’s equity of $28.4B just prior to the bankruptcy, the net worth of the holding company in liquidation is estimated to be anywhere from negative $20B to $130B, implying a swing in value of between $50B and $160B. That is shocking. For an industrial firm, one expects liquidation value to be much less than “going concern” value, because fixed capital intended for a particular production process cannot easily be repurposed and has to be taken apart and sold for scrap. But the assets of a financial holding company are business units and financial positions, which can be sold if they are have value. Yes, liquidation hits intangible “franchise” value and reputation, but those assets are mostly excluded from bank balance sheets, and they are certainly excluded from “tier one” capital calculations. The orderly liquidation of a well-capitalized financial holding company ought to yield something close to tangible net worth, which for Lehman would have been about $24B.

What’s wrong? I suspect at least the following:

  • First, the costs of bankruptcy are considerable. The Enron liquidation, for instance, involved fees of more than $600M, and Lehman is a lot more complicated than Enron. Therefore we can chalk up at least a couple of billion to bankruptcy costs, and probably more.
  • In bankruptcy you are a known, forced seller (and terminator of derivatives contracts). The Lehman bankruptcy happened in a crisis – indeed in some ways it caused it. This meant that Lehman’s assets were liquidated under the worst possible conditions. The fact that they were sold for less than their holding value is unsurprising. A 20% discount to sell an illiquid asset in hurry would not be surprising – and Lehman had at least $300B of illiquid assets. So perhaps $60B here.
  • More to the point, while Lehman sailed fairly close to the wind on its valuations, what it did not do – what few firms do – was be honest about the uncertainty in those valuations. If you read the detail of the valuation section of the Valukas report, you will find that a lot of the time, the correct value of assets is simply impossible to determine. What Lehman did was not perhaps conservative, but it was not illegally aggressive according to Valukas. Given Lehman’s assets, a 5% uncertainty in valuation is not surprising. That’s another $15B.

The real point is leverage. If you have (in round numbers) $30B of capital supporting $600B of assets, then $30B of uncertainty in valuation wipes you out. If you were half as leveraged, you could tolerate twice as much uncertainty. No financial will ever be liquidated for anything close to its accounting value, particularly in a crisis. But if firms are less leveraged, then they are more likely to have higher recoveries. Given Lehman’s leverage, going from a going concern value of +$30B to a bankruptcy value of -$50B is not at all surprising.

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