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See Lehman’s balance sheet below, courtesy of Bloomberg. Just for emphasis, I added Bear Stearns’ balance sheet as of November 2007. Both of these companies will be reporting quarterly earnings in the next couple of weeks as their quarter ended in February.
If you were their auditor (and I have asked many CPA’s this question), would you sign their 10-Q knowing they have no idea how to price what they own? If they are forced to mark their assets to market (as if there actually is a market for many of their holdings) they might be forced into bankruptcy.

• Lehman Balance Sheet as of November 2007
• Bear Stearns Balance Sheet 

Desperate Moves by Desperate People

Ever since I saw Trading Places back in the 1980’s, the phrase ‘SELL, Mortimer, SELL!’ has stuck with me. The worst feeling an investor can have is to be leveraged and have prices go against you and be told you have to sell. This is otherwise known as a margin call. But what happens if you're told to sell and there's no market for what you have to sell? What do you do? What does your counterparty do? They expect you to sell but you can’t. In ‘Trading Places’, the Duke Brothers got ‘wrong-sided’ in orange juice futures and had to sell to Eddie Murphy and Dan Ackroyd. They were leveraged to the hilt, and of course had to sell at precisely the wrong time. Such is the case with Thornburg Mortgage (TMA) and many others. They are being told to sell, but cannot. Banks and brokers ‘have no balance sheets’ as they like to tell all of us. Others like my firm refuse to bid so the market goes into limbo and we're left to guess if these firms are actually solvent. There's just not enough liquidity left in the system to absorb the forced selling.

Thornburg Mortgage Bloomberg Headlines: Just how hard to price are these securities that many banks and brokers own? Back in November, when Citi (C) hired a new CFO, it was asked how it was pricing over $60 billion of Collateralized Debt Obligations (CDO’s). Usually, we hear about ‘mark to market’ or ‘mark to model’, or (and I laugh as I type this) ‘mark to management’s best guess’. But Citi went one step further. It said there was no market and was pricing these bonds to a ‘reasonable stab’. That’s a classic!

Citi at last count was down to $113 billion in shareholder equity and yet its balance sheet has exploded to more than $2.1 trillion, yes, trillion. It's taken hundreds of billions of dollars of Structured Investment Vehicles (SIV’s) onto its balance sheet, which coincidentally owns the same esoteric securities that firms like Bear and Lehman own. I fully expect Citi to write down as much as $50 billion more in coming months, further depleting capital.

Citi Headlines from November 2007: If you told Citi to liquidate what would happen? It could not. Yet it continues to pay out $6 billion per year in dividends. I guess I just don’t get it. Just the other day, Ambac (ABK) cut its dividend to a penny per share per year, just to keep institutions around that have a charter that says that they have to own dividend-paying stocks.

MBIA (MBI) and AMBAC are doomed for failure as well in my opinion. Why? They can’t sell anything that they need to sell and they're on the wrong side of the credit default swaps owned by many financial institutions. If you were a municipal issuer, would you ask them to insure your bond issue? Or would you call Warren Buffett and ask his company to insure them (interestingly, Buffett called credit derivatives ‘financial weapons of mass destruction’)? A rhetorical question if I ever asked one. This means they are doomed. Social Darwinism at its best. They took a perfectly good business model of insuring municipal bonds that rarely defaulted and opted for the world of derivatives instead to boost earnings. Yet another failed debt experiment.

Who else is desperate? Clearly the Fed. It's now panicked from the original goal of price stability to a new goal of supporting asset prices. I recall way back in August, Fed Governor William Poole said there was no way the Fed would panic into an intra-meeting cut. I saved the Bloomberg screen for posterity and you will see it below. Since then, the Fed has cut the Federal Funds Rate from 5.25% to 3.0% to what I believe will be close to 0% when it's all over. And, no, I don’t think it will help all that much except to deflate the already deflated dollar. What we need is a true blood-letting and forces the weak players out of business. A truly painful business cycle, but one that needs to be allowed to occur. (Fed Governor Poole Comments August 26, 2007)

Federal Funds Rate Probability Chart (courtesy of NDR)

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Comments from Fed on March 7, 2008: So it seems everyone's desperate these days. The solvency of the banking system is being questioned if one looks at the balance sheets closely and listens to the tune of the market. I'm asked all of the time how I think we should use history to guide us through this mess. The problem, in my opinion, is that the position we find ourselves in is so unprecedented and so leveraged that we'll look back 20 or even 100 years from now and use this as history, the ‘Great Debt Experiment Gone Bad’.

U.S. Trade Weighted Dollar Index since 1965 in Logarithmic Terms

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When I think about ‘What Have You Done Me Lately’, I can only answer it one way. That is, to pay particular attention to the macroeconomic environment, no matter how unpleasant it may be. My firm needs to help investors and friends get through the unpleasant credit unwind while opportunistically taking risk.

For example, there has been huge pressure on the Mortgage Backed Securities market of late as a result of forced selling by the likes of Thornburg, failed hedge funds and others that imprudently took risk. My firm purchased large amounts of Ginnie Mae Pools on Friday morning that carry the explicit (‘full faith and credit’) backing of the U.S. Government at yields nearly 300 basis points above corresponding Treasury notes. I believe that over the next couple of years, Fannie Mae (FNM) and Freddie Mac (FRE) will go from implicitly backed by Uncle Sam to explicitly backed (I know this rumor was floating around Wall Street Friday morning but was denounced by the Treasury Department). It seems clear that the mortgage market is slightly dysfunctional at this time, but I feel like we're being very well compensated for buying low risk securities. Sometimes it feels good to be ‘the only bid in a bid-less market’.

I may be early as usual (recall ‘The Bennet Factor’ that my friends came up with) but am pretty sure a year or two from now, my firm will be happy that we bought these securities and clipped the coupon for that period of time. We also feel fortunate to have avoided the train wreck now known as the municipal bond market and Auction Rate Securities (ARS) fiasco. I highly doubt that most folks involved in the closed end municipal ARS will get out at par ever (although a secondary market will likely develop over time at a huge discount to par) and hope that we helped others benefit as well. My firm is now getting interested in municipal bonds for client accounts but are treading carefully as I think most investors underestimate just how high yields can go as the credit unwind continues. After all, markets tend to overshoot in both directions as fear and greed take over. Finally, we sold all of our money market funds about six months ago that were invested in municipal notes of commercial paper and have been willing to sacrifice a little incremental yield and only hold U.S. Government money funds and expect to remain in this position for the foreseeable future.

My firm will continue to strive for positive absolute returns rather than trying to ‘beat the benchmark’. The benchmark we are most concerned with is capital preservation, an under-appreciated concept.