Four Questions About How We Got Here 11 comments
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What a weekend. I’m sure Wall St. feels a bit brutalized by the events. Now, here are my questions…
1. Doesn’t Lehman (LEH) have to be involved in moving trades that are facing it? I simply do not understand what the “Lehman Risk Reduction Trading Session” was all about. Indeed, if one looks at the I.S.D.A. Novation Protocol Guide, it’s the case that the “Transferor” (the “Stepping out party”) needs to agree on certain terms. For example:
Negotiating a proposed Novation Transaction:
The Transferor will contact the Transferee to agree a price [sic] for the Novation Transaction.
Seems like “negotiating” and “to agree” indicate the transferor has some decisions and veto power. Also, let’s be honest, all the banks sitting at the table for this situation showed that they aren’t willing to lend a helping hand to their competitors and are acting in self-interest while potentially risking the entire system’s stability (more on this in a bit). How do we know they will be candid with each other and the world regarding their exposures? If I were a bank, I would seek to novate all the in-the-money trades with Lehman and not the ones that are out-of-the-money, right?
And, now that Lehman is winding down, the trades that will be novated away could be hedges. So you have Lehman, sitting with assets it now needs to sell, as its hedges are being novated away and without the ability to put new hedges on. What does this mean? Lehman, in trying to recover maximum value for creditors, will now have to sell quicker or will be holding assets that are unhedged and much more exposed to further market deterioration. Something just doesn’t make sense with this whole thing…
To further complicate things, since the holding company is filing for chapter 11, not chapter 7, does that trigger this special session? Does it matter which entity it is? I suppose we’ll see. Oh, and then there’s this that seems to indicate there’s really no reduction of risk occurring at all, from the WSJ:
Some traders said it was difficult to find new counterparties for many of their outstanding trades with Lehman. The snags included different terms and maturity dates on derivatives contracts, and market prices changed rapidly Sunday afternoon. “People were screaming at each other over the phone, asking: How can this work?” one trader said.
William Gross, chief investment officer at bond-fund giant Pacific Investment Management Co., said very few Lehman trades were offset. “There’s an immediate risk related to the unwind of these positions,” he said.
(Emphasis mine.)
2. How is a solvent company with a recovery plan, on Wednesday, now insolvent? If you say it’s similar to Bear or you mutter the words “run on the bank” then you’re either making something up or you have insider information that has been reported nowhere in the media. Proof? From WSJ's Marketbeat Blog:
“Ongoing pressure and anxiety in the markets resulted in significant cash outflows toward the week’s end, leaving Bear with a significantly deteriorated liquidity position at end of business on Thursday,” the agency wrote.
Lehman’s prime-brokerage business is smaller than Bear’s relative to its more diverse portfolio, Mr. Sprinzen noted. And Lehman doesn’t depend on hedge-fund clients’ free credit balances to the same extent. In Bear’s case, the “run on the bank” by prime-brokerage clients was a major contributor to its fall.
(Emphasis theirs! [Again, wow!])
Lehman’s prime brokerage certainly isn’t anywhere near large enough to bring down the firm, as was Bear’s. So, did the Fed and Treasury cause this? By trying to set up a suitor did they make other firms unwilling to fund Lehman and thus cause its death?
Remember that there was consensus before that Lehman could survive.
3. The Treasury and the Fed have a lot of decisions to make. What will they do? Why did they choose this path?
First, it was earlier reported that the Merrill (MER) - Bank of America (BAC) tie-up would be under-capitalized and need regulatory approval. That reference, from the New York Times article, has since been removed.
Second, A.I.G. is now hunting for government loans to survive. How can the government provide those when it refused Lehman? How can it refuse those when it provided them for Bear? A.I.G. (AIG) is hardly at the center of the financial system. And, by the way, it went from selling units to not selling units and needing loans in a matter of hours!
Also, what of stability? First, Lehman is just as much at the center of credit derivative markets as Bear Stearns was, in corporate credit default swaps and interest rate derivatives probably more so. And what’s to stop people from asking questions and beginning to pummel Morgan Stanley (MS) or Goldman Sachs (GS)?
As Barry cites, perhaps the Fed has caused its own problems here:
To be eligible for a bailout, firms must also demonstrate a particular genius for screwing up. Before it went bust, Bear Stearns had a monstrous $33 of debt for every dollar of capital, and hedge funds it owned destroyed hundreds of millions of dollars of clients’ cash. It got a bailout. Lehman Brothers, which has taken painful measures to reduce its risk, is perversely less likely to get direct government help. “The worst Lehman can do is destroy the firm,” said Barry Ritholtz, CEO of Wall Street research firm FusionIQ and author of the forthcoming Bailout Nation. “Bear Stearns, on the other hand, set up the firm so that if they screwed up, they could threaten the entire financial system.” That may explain why Treasury Secretary Paulson has thus far resisted providing federal succor to Lehman.
(Italics theirs.)
4. As for Lehman’s assets, who gets them and what are the terms? I would claim that there should be an auction run. And, perhaps, when that auction is run, would there be enough capital to save Lehman? Well, Lehman owns those assets at a different leverage ratio so how would that play? Depends on the price. We have to see if investment banks, like Goldman, did the math and withheld capital from a rescue assuming they could buy the assets on the cheap later.
Okay…. more to come, but that’s what is initially sitting uneasily with me.
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This article has 11 comments:
The reason AIG became insolvant the instant the Fed let Lehman fail is AIG is the largest single writer of credit default swaps, and its book includes tons of guarantees on Lehman paper that Lehman clearing isn't going to pay. So did Merrill - it had many swaps with Lehman as the counterparty e.g., that is why it needed to merge with a strong counterparty the instant it became clear Lehman was going to fail.
As for how things can change so quickly for Lehman, um, does anyone here have the slightest idea what banking even is, anymore? Lehman has to roll over its debts continually. It was being asked to pay 15% and 20% on paper that a year ago cost 5%. You can't borrow at 20 and lend at 7 and make it up on volume.
As for how AIG is going to get money from the Fed without a bailout, it is simply calling the treasury's bluff. The Fed has a standing offer to allow any firm to borrow against decent securities collateral at affordable rates. It either means it or it doesn't.
Over the weekend, the Treasury secretary, listening to all the luddites baying for blood and the end of the west as a morality play, decided not to provide any guarantees on Lehman debts. If it had, they would not have cost anything in the end, and Barclay's would have bought the bank.
Now to save a headline about a bailout, instead the ECB just had to inject $43 billion, the Fed had to inject $25 billion, the Bank of England had to inject $9 billion, just to hold the line for today's close. Way to save money, brainiacs!
This will cost all of us an extra $500 billion easy, and probably more like an extra $2-3 trillion. It was world-historically stupid. Shrinking the money supply in 1932 stupid. It will be studied for generations as exactly the way *not* to run a lender of last resort operation.
The losses are already real, the issue is for the political system to rapidly and efficiently *allocate* them, so the financial system can get back to operating as normal. Instead we will have a mad scramble to get out of the way of losses that already exist, which will multiply those losses tenfold.
All the stupid ideologue moralizers saying "don't save him, he's not virtuous like me" are going to be buried in falling, burning timber. Earth to luddites - bankrupts don't pay their debts. Bankrupting your neighbors won't make you any richer - quite the contrary.
The entire lot of you should be ashamed of yourselves, and deserve whatever you get.
The very meaning of the phrase Seeking Alpha is an underlying belief that superior research, superior reasoning, and superior decision making results in superior returns. The flip side of that is that inferior decision making results in inferior returns.
Lehman Brothers made inferior decisions, choosing first to hide their assets and refrain from deleveraging in April, then continuing to try to hide their assets in "Level 3" in July. They chose to redouble their bets when they had a good base of capital (share price) that they could have deleveraged with instead. They chose to ask too much of a price of the Korean Development Bank in June. And in doing so, they totally forgot that they were a bank, a wholesaler of financial risk. The role of a bank is to *manage financial risk*.
Equity holders deserve nary a penny for holding to the end like this. Debt holders deserve, as dictated by insolvency law, that they will get priority recovery on those debts. Why should they get more, at your and my expense?
The 52 week low is precisely 1200.44.
In all probability it will be reported this evening that the S&P decline encountered "resistance" at the 1200 level.
Less than an hour to go, let's see.
To avoid a $15 billion bailout headline that would have enabled Barclays to liquidate Lehman, with the shareholders wiped out and all your precious incentives intact, the central banks had to lend the market, just today, $150 billion in fresh central bank credits. The markets actually sought $400 billion on the panic, to replace much of the $600 billion on Lehman's balance sheet as that was withdrawn from the market. They only got $150 billion of it and the Fed Funds rate closed at double the Fed's target. More huge loans will be required tomorrow.
Meanwhile, the Lehman bankruptcy means that guess what, its bankrupt, it isn't going to pay all its debts. Do its extra losses go away, therefore? Have you forced them to face up to them? Not at all. Instead they go careening around the rest of the system looking for a new home!
Merrill had to sell itself because Lehman was its counterparty on large portions of its swap book. AIG needs regulatory relief - endangering its policyholders - to the tune of $20 billion right off, to post enough collateral on its credit default swap book to stay in business another *day*, thanks to the huge spikes in loss rates due to the Lehman filing, and the direct losses on Lehman name CDSs.
Every company faces 1-2% higher funding costs which are the same as a huge Fed tightening in the middle of a deflation.
This was epic-ally stupid. 1932 deflate at the bottom stupid. And it is going to cost you 11 or 12 figures. Actually fixing Lehman might have cost 9 and it might have cost nothing.
Call it economy!
Ideological moralizing idiocy, is what I call it...
Given that the Bear Stearns, and then Fannie Mae/Freddie Mac bailouts created a reputation that the "Fed has your back," a collapse is definitely necessary. Systemwide, worldwide, maybe some sense can be put back into credit worthiness review, instead of letting the US Treasury subsidize every ailing company.