Lehman Brothers on the Verge of Liquidation

Geez. A guy can hardly leave Australia for two weeks without coming back to total chaos at the state government level. First, the Labour Government in New South Wales falls apart amid recriminations and salacious behaviour.

Meanwhile, Alan Carpenter's Labor government in Western Australia has been kicked to the curb. The Kingmaker Nationals party threw its weight behind Liberal Colin Barnett. Carpenter must feel like John Howard. One day, you're riding a resource boom. The next, you're fired!

The big question for investors is whether the change in government will kick off a boom on uranium production and exploration. We reckon it will, if the government can stick. We provide the table below from ABARE to give you an idea of which uranium projects in all of Australia are the closest to production.

By the way, if you think Colin Barnett's plan to build a canal from the Kimberley to Perth to solve WA's water problems is hallucinatory rather than visionary, you should check out China's $69 billion South-to-North water project.

Nearly two thirds of China's GDP is generated in the North. But there's not enough water to keep industrial activity humming, much less for growing things or keeping people hydrated. Fresh water may someday be more important a liquid than crude oil. Canada, incidentlly, has the world's largest fresh-water reserves. They don't call it the Frozen North for nothing.

By the time you read this, Lehman Brother's may have already been dismembered and sold into various parts and pieces. Merrill Lynch may have merged with Bank of America. What a spectacle.

There stands Henry Paulson like a paper wall. It appears that the best efforts of the U.S. Treasury Secretary to jawbone a deal to save Lehman brothers have failed. "Unable to find a savior," reports the New York Times, "the troubled investment bank Lehman Brothers appeared headed toward liquidation on Sunday, in what would be one of the biggest failures in Wall Street history."

Since the credit crisis broke in July of 2007 with the collapse of two Bear Stearns hedge funds, the markets have sent any investor who cares to listen a clear signal: it's a bear market in credit. The bad debts accumulated in the credit boom must be liquidated before the financial markets can recover.

But, to paraphrase a ten year old on a road trip, "are we there yet?" How many pundits are going to call the bottom with a Lehman liquidation? A lot, we'd guess. But they'll be early. There are still two big remaining bastions of funny money from the credit bubble. Three, actually.

One is in the Alt-A mortgage market. Bloomberg reports this weekend that Alt-A mortgages originated in 2006 an 2007 are already showing markedly higher delinquency rates than even submprime loans of the same vintage. Yet the Alt-A buyers were supposed to be lower credit risks (How this was established is a mystery, since many Alt-A loans were made without any documentation of the buyer's income, or, without right exaggeration in said incomes.)

Now, of course, the whammy has tripled. Home prices are falling. Payments on option ARM loans are increasing (as the interest is added to the principal, meaning the new loan value is anywhere from 110% to 120% of the original value). And that exaggerated income? It remains what it always was, a fiction.

So there are US$1 trillion in Alt-A loans on the books of companies like Wachovia (NYSE:WB), Washington Mutual, (NYSE:WM) Fannie Mae, and Freddie Mac. The best case scenario is that the market has already priced in this second wave of housing destruction. After all, both Wachovia and WaMu are down massively (WM down 92% in the last year and WB down 70%). We know what happened to the GSEs.

But after the sea of bad debts from collateralised mortgages is drained, there is a whole ocean of other debt-related assets just over the horizon. Securitised credit card receivables and auto loans come to mind. Then there is the massive credit default swap market. And of course, the huge bubble in Treasury bonds.

Here's a prediction: the liquidation of Lehman and merger of Merrill may very well produce a further rally in the U.S. dollar and a gold price under $700. And then gold will have bottomed. Investors will gradually realise that U.S. bonds are the last great refuge of the credit fraudsters.

What then? Bonds sell off and resource equities and precious metals begin to rally from their current battered state. That's what happens next. C'mon people! It's basic Austrian economics! Or, as Roger Garrison of Auburn University puts it, "The misallocation of resources during the period of artificially cheap credit has the feel of genuine growth, but the good feelings are followed by bad ones."

"The commitment of too many resources to projects that will yield output only in the remote future has as its counterpart an undue scarcity of resources for producing output in the near and intermediate future. With the passage of time, the misallocation becomes apparent, after which follows a period of liquidation and reallocation—in a word: a recession."

What a contrast. A recession in the paper economy of America looks like a dead certainty. This fact has pushed all stock prices down to near bear-market lows and made resource shares very cheap. Yet these shares retain the ability to grow earnings on the back of strong trends in the real economy of the developing world. What's not to like about that?

Dan Denning
for The Daily Reckoning Australia

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