Sunday, 14 September 2008

Lehmans, Darling & Financial Misregulation

Lehman Brothers, the 4th largest US Investment bank, stands on the edge of bankruptcy this weekend. In the last few months, the US Federal Reserve has bailed out Bear Stearns and then the mortgage companies, Fannie Mae and Freddie Mac.

Yet there appears to be no bail out for Lehmans. Structurally the threat to the CDS market (which is insurance bets from financial services companies against each other) is the same, if not worse than Bear Stearns. But after swallowing a $5,000 billion bail out of Fannie and Freddie the US Federal Reserve can't create the funds for another bail out.

So Lehamn's will be a new first for the credit crunch, a huge mega-bank that might actually fail. perhaps A large Private Equity house could risk taking on the bad debt, we will see this week. That HSBC and Barclay's are thinking of doing so should not re-assure UK residents as to the sanity of their respective managements in terms of understanding risks to their business. HSBC has a terrible record in the US and Barclay's has none at all.

However, the Left, in the form of Guardian Commentators, see the US as having had prescient and strong leadership, compared to our poor old Alistair Darling. How wrong they are, bailing out Fannie and Freddie is a very socialistic policy, I am not surprised the Left support this. Bailing out banks full stop is itself crazy. Northern Rock should have been left to die peacefully and order be restored. Markets are a harsh mistress and should be obeyed. Playing with them is likely to burn the surgeon, in this case governments armed with our children's money (i.e. future tax revenues).

This week will be crucial, if Lehmans goes without a world-wrenching destruction of the financial markets (which may NOT be the case) then many of the bail-outs we have seen will be shown to have been Government's panicking to save rich bankers. At the next ballot box opportunity we can decide if we want this sort of behaviour to continue.

UPDATE: Looks like this is going to happen. Barclay's have dodged a bullet; glad to see people reading this stuff at last and taking note.
Merrill's & Bank of America discussing merging too. We said there would be a third leg to the credit crunch, here we go...


Mark Wadsworth said...

I wouldn't worry too much.

If LB has overpaid for stuff in the past, then it has losses. Those losses have to be borne by shareholders, bondholders, creditors and depositors in whatever order US bankruptcy law says. Those are the rules. Simply acknowledging that there are losses doesn't create the loss, it's a bit late for that!

Anonymous said...

A lot of people don't know this, but Lehman is a pretty big player in that unsexy commercial paper market.

I don't understand why the government is balking on this one. Clearly, they are trying to send some kind of message, but after the Bear Stearns and GSE bailouts, I'm not sure what that message could be other than a conflicting one.

I'm still wondering how the government is going to pay for the Fannie and Freddie mess, to be honest. If they are going to buy over $100 billion in preferred shares, I wonder what kind of time frame they have in mind. The Treasury market WILL NOT LIKE IT if they try a couple of $40 billion issues. In addition to preferred shares, it sounds like they will be actively buying MBS. They already had some record size issues earlier in the year; with tax receipts shrinking, it looks like something that will continue. Add in bailouts and we might finally see the bubble in Treasuries pop.

Old BE said...

Just print some more money, there is no shortage of paper...

Anonymous said...

Perhaps it is time for the daring experiment of letting nature take its course.

CityUnslicker said...

MW - to back your point LB has $40 billion in cash at hand, so many creditors will actually be repaid. I think as usual it is the hard to gauge and astronomic CDS positions which could hurt the other banks

Matt - nice points, they have run out of cash in the fed perhaps? Or realised that hyperinflation will hit if they nationalise a bank a week?

BE - That is the danger before our eyes, as I am in NY this week I hope the market twig in time to sort out my exchange rate nicely...

Dearime - The right answer, but not one a politician would advocate for obvioous reasons.

Anonymous said...

Bailing out Freddie and Fannie was no more socialist then their very existence - the whole quasi-private setup was market distorting in itself, and they should've been broken into smaller parts a long time ago.

If they're re-privatized, and if it's done well - parceling them up into smaller companies to distribute future debts, as opposed to creating a centralized debt bomb capable of nuking the economy - the nationalization may very well cure a socialized ill. Lots of if's there though.

As for Lehmans, a big bank needs to fail, and Lehmans may very well be the one that takes the fall so it can be an example to the others.

Mark Wadsworth said...

CU, I'm not being flippant, but if you look at it sensibly, the losses boil down to good old fashioned unsecured lending* to people who can't repay. All these CDOs and stuff are just a way of spreading the risk around, but in theory they don't add to total loss.

It may well be that these losses are sufficient to wipe out capital of all banks, but so what? The banks' core businesses (customer base, computer systems, land and buildings etc) still has some value. And the economy needs banks to function.

Plan A is to force the banks to raise a bit of capital, write off a bit more of the loans, raise a bit more capital, write off a bit more etc, which is what they have been doing so far but I don't know how much longer they will get away with it.

Plan B must be (short of chaos) for Fed or Treasury or whoever to make banks come clean (in private at least) about losses (primary and secondary so that we can net off double counting) and ask solvent ones to buy up insolvent ones.

To the extent that losses exceed banks' shareholders' capital, you then lop the next slice of losses from bondholders, if they are wiped out as well, then you only repay depositors** pro rata and so on (so that a solvent bank doesn't get landed with another bank's losses, obviously).

You could fix the whole thing in a few weeks.

* Of course, legally, secured on a house but if the house has fallen in value to less than amount of loan etc.

** I realise that there is a blurred line between bondholders and depositors, but you get my drift, hopefully.

Nick Drew said...

Mark - do you know what % of the underlying (primary) losses stem from dumb mortgage lending ? Are there any other major (primary) categories of bank lending stupidity ?

Anonymous said...

Well I hate to say this but we are now looking at the start of Great Depression II. I hadn't wanted to believe this would happen, but there is no denying it now. Some are still in denial it seems, but it is time to face facts. We have never seen a banking crisis on this scale since 1928. The Savings and Loan collapse and Barings Bank collapse were isolated incidents. They sent shock waves around the world. Now we have seen the world's biggest investment banks failing one after the other. We have become a little complacent about this, because the fall-out of these massive bank failures has so far not consumed us. But the avalanche is heading this way and gaining momentum.

Companies need money from banks for their day to day operations, but they all need huge sums of finance before embarking on large new projects. This is because the end customer will not pay up-front and will only pay on completion of a project - so loan finance is required when starting new projects, whether it be building aircraft, building sky-scrapers or a plethora of other large-scale projects. This is where the real redundancies will come - when the money to finance big projects dries up because the banks are failing.

Before then we see the failures of companies that were already struggling with debt. Companies like XL can't get the finance they require to sort themselves out until the next holiday season when they could re-price their flights to take into account the extra cost of fuel. The weakest go to the wall first. But we are only at the beginning. Its going to get far, far worse. Huge numbers of people are going to be unemployed. In the UK large numbers of people are already being layed off, but so far they are not shown in the unemployment figures - the Poles are all going home, some UK employees made redundant have been quick to slot themselves into the jobs that were still being advertised before the crunch really started to bite. The government is desparately trying to expand the public sector to absorb the unemployed before they feature on the statistics. Over the next six months this will fail. The unemployment figures will climb rapidly and a huge percentage of the work-force will be lining up at soup kitchens. I mean this quite literally. Britain's economy will collapse to such an extent it will struggle to feed its own people.

At some point the global stock markets will fail. Maybe Lehman's collapse will be the trigger. If not, then there will be plenty of other big company failures over the next few months to give the markets the impetus they need for a crash.

AntiCitizenOne said...

I hear that Citibank is the biggest Lehman counterparty.

Anyone else know better?

Mark Wadsworth said...

Nick, I dunno. I'd guess nearly all. It's not like banks lend against tulip bulb futures any more.

I have explained this properly and come up with a bomb proof way of sorting it all out on my blog.

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