Why Lehman Wasn't Saved

If you're going to launch a new website devoted to business news, then doing so on the biggest day for business news in living memory is probably a good thing, on balance. Naturally, The Big Money leads today with a story about Lehman (LEH), taking the Slatishly contrarian stance that it should have been bailed out by the government.

Now, there is one big reason why the Fed or the Treasury should have stepped in with taxpayer money to backstop Lehman's losses and allow a sale of the bank. Banks are massively interconnected, with thousands of counterparties around the world, and if a major counterparty were to go bust, there's a risk of massive global contagion as failed trades cascade through the system and cause a legion of bank failures elsewhere. On this view, a Fed bailout is essentially an insurance policy against systemic meltdown.

But that's not the argument that Chadwick Matlin and James Ledbetter take.

Matlin and Ledbetter seem to be the last people on earth who still believe in what used to be called the Greenspan Put: the idea that if the markets are dropping, it's the Fed's job to prevent that. "We're writing this before U.S. markets open on Monday, but already the dollar is dropping and U.S. stock futures are sharply down," they write. "It is not unreasonable to think that tens of billions of dollars of capital will be wiped out across the globe on Monday as a result of Lehman's collapse."

Well, so what? Tens of billions of dollars is tiny compared to the total stock-market valuation which has been lost over the past year, not to mention losses on bonds. Markets go up and markets go down, it's hardly the Fed's job to cheer on the former and protect against the latter. Indeed, the more that happens, the worse the inevitable hangover becomes.

The article continues:

At the risk of oversimplifying things: Both Lehman and Bear were dogged by short sellers, the complications of toxic mortgages, and unconfident clients. Yet the Fed treated Bear and Lehman very differently.

Two things make the difference: Lehman Bros., it stands to reason, isn't as important to the economy as Bear was. And neither did Lehman have a suitor as willing to buy it as JP Morgan was to buy Bear.

A few points are worth making here. Firstly, enough with the guff about short sellers! The problem was sellers in general, not short sellers in particular. No one wanted to hold the stock, because no one else wanted to hold the stock, and banks by their very nature are a confidence game: Without the confidence of clients and shareholders, they're nothing.

Second, yes, the Fed treated Bear and Lehman very differently -- but that's the whole point. The last thing that the Fed wanted was for the Bear Stearns bailout to set a precedent, and for bond investors to have confidence lending to any US bank, safe in the knowledge that the Fed would always ensure they were paid back in full. The US government's contingent liabilities are quite big enough, thank you very much, without adding the entirety of US bank debt on top.

In any case, the Fed's concerns during the Bear blow-up weren't about the economy broadly so much as they were about the financial system more narrowly. Hank Paulson and Tim Geithner determined that the financial system, in Lehman's case, had had enough time to prepare for failure, so they allowed Lehman to fail, even though it did have a suitor, in Barclays (BCS), as willing to buy it as JP Morgan (JPM) was to buy Bear. (Remember that Jamie Dimon was adamant that he would walk away, just like Barclays did, if the government backstop didn't appear.)

Matlin and Ledbetter conclude:

By declining to offer the kind of guarantees that would have made Lehman an acceptable risk for the likes of Barclays or Bank of America, the U.S. government has forced Lehman into bankruptcy -- under which its assets will get bought for pennies on the dollar. It's hard to see how that is a better outcome than having Lehman bought for some low, $2-a-share price, as Bear initially was.

To the contrary, it's easy to see how Lehman's bankruptcy is a better outcome than yet another government bailout. Maybe not for Lehman's employees -- we'll see. But it's certainly good news for the robustness of the global financial system as a whole.

Lehman Brothers, like many other banks, levered up during the Great Moderation, in the seeming belief that there was no such thing as too much risk. Its lenders evidently agreed: Lehman's funding remained cheap, even as it was pouring tens of billions of dollars into hugely risky commercial real-estate transactions where the cashflow didn't come close to covering interest expenses. In other words, credit, both lent by and lent to Lehman, was massively mispriced.

Now in any market, mispricings happen. That's normal, and fine. The way that markets work is that when those mispricings happen, the lenders in question lose money. In asking for Lehman to be taken out with a positive value on its equity, Matlin and Ledbetter are saying not only that Lehman's creditors should lose nothing, but also that the holders of Lehman's preferred stock should get all their money back as well.

Matlin and Ledbetter seem to think that they are living in a world where there's a floor of $0 on how much a company can be worth. But in a world of leverage, a fair value for a financial stock might well be large and negative. According to CreditSights, Lehman's creditors are likely to end up with about 60 cents on the dollar -- and Lehman has at least $138 billion of debt outstanding. So as a first approximation, Lehman's creditors are likely to lose about $50 billion -- and on a mark-to-market basis, with the debt trading in the low 30s, the losses are substantially larger than that.

If Lehman had been bailed out, then, the government would have been on the hook for, let's say, $50 billion. I can think of much better uses for government funds than that -- and I'm sure that if Matlin and Ledbetter put their minds to it, they can, too.

Comments

[JasonC:]

"it's certainly good news for the robustness of the global financial system"

It is official - the moralizing ideologues have gone stark raving moonbat mad.

There is only one reason Lehman is bankrupt and it isn't your little morality play or market efficiency, it is your reckless ideology and the political pressure you and those like you have deliberately engineered.

And that will destroy AIG, Washington Mutual, Wachovia, and dozens of other companies before this ends. I dearly hope it ends with you on a soup line or living in a socialist republic.

The recklessness shown on this subject by the present financial press is exactly parallel to the recklessness shown by the left on security. It ends the same way - heads sawn off. We can hope only wealth in this instance, but that remains to be seen.

The level of untouchable complacency shown by the writer of this piece would be touching if it weren't obscene. You are fiddling as Rome burns.

2008 Sep 15 12:07 PM

[Gerry Sullivan:]

Felix Salmon is right. Lehman had to go bankrupt and take the preferred stock and part of the debt with it. Otherwise, how does this end?

When the Bear Stearns bailout was done, the Treasury and Fed was faced with a sudden surprise and shock. In the case of Lehman, Merrill Lynch and AIG and Wamu there can be shock, but no surprise.

The Fed told these institutions to do deals. Only Merrill did so, and Merrill was saved.

What happened to free market capitalism? Lever up too much and you are taking a risk. You might fail. Lehman did and AIG might fail this week.

Anyway, the employees made a lot of money. I hope they saved some of it.

2008 Sep 15 12:40 PM

[Outtanames999:]

Your post was a tad premature given what happened today with Merrill. Why don't you revisit this topic in light of that.

The most troubling point you make, namely, "Banks are massively interconnected, with thousands of counterparties around the world, and if a major counterparty were to go bust, there's a risk of massive global contagion as failed trades cascade through the system and cause a legion of bank failures elsewhere," is dead on and strikes at the heart of a vital issue.

That there are in effect so many potential single points of failure throughout the system is a critical flaw in any open market theory. If an open market is to thrive, the very existence of the market itself must not be something that is threatened by the failure of any one participant or even a few participants no matter how large. This is something that needs to be looked at more closely by the industry and regulators alike.

Systemic adjustments would seem to be called for to reduce the risk of massive failures. Whether that means better risk management, better asset pricing, better asset management, better reporting, better transaction flows, no matter what it takes to achieve, it must be done. We simply cannot have and will not stand for irresonsible risk management and concomitant daily volatility that is so great that it puts the very existence of the entire market at risk every day.

Spreading the risk around is a prudent strategy but clearly it didn't work this time. Where are the lessons here? Lloyd's perhaps? Ok let's just sell everything to Warrren Buffet right now before he dies. Who knows who will be running things after he goes? No? Ok, get ready for some changes then.

As to Lehman, and what may end up being a state of technical default based on FASB mark to market rules, those rules may need to be revised but there is one principle which must stand and that is, No more Enrons no matter what. If mark to market is what it takes to avoid another Enron, then unfortunately, so be it.

If there is one universal theme that plays itself out over and over, it would seem to be that there is a rule of thumb which says Wall St. will screw you no matter who you are, up to and including screwing Wall St. itself, and quite possibly even up to and including the very existence of Wall St. itself.

And while no one feels particularly sorry this time for what is happening to the financial sector because we know they have only brought it upon themselves, still there is something not right with an industry which lives by that rule of thumb and seems helpless to do anything about it.

There has to be a better answer than playing chicken with the federal government, and peek a boo and tag you're it with private equity.

2008 Sep 15 01:03 PM

[marine41:]

One word "GREED"

2008 Sep 15 03:26 PM

[Insiderman:]

I find it interesting that WM is even included in the discussion. Lehman bought and sold securities with underestimated or indeterminate risk, as the result of everything from GSE backing to originator misrepresentation. WM has loans that they made and better understand the risk of failure for these securities. They have reserved for the losses, have plenty of capital (almost 8% relative to a 6% "good" level), and in spite of blog postings to the contrary, don't appear to be seeking a buyer.

At the very worst, WaMu investors have a really good basis for lawsuits if new CEO Fishman's statements to date are just smoke. And he is no dummy, so I'm guessing he knows what he's talking about.

Most of WM's problem appears to be option ARMs, most of which have about two more years to reset, and many of which are in the process of renegotiation rather than going bad. About 6% of $52 billion in option ARMs appear to be non-performing.

One move that WOULD push non-performance is the prospect that the Federal government will bail out non-performing homeowners. Talk about moral hazard! (But, then, we take care of medical care for illegal aliens and drug abusers that can't pay their own freight.)

2008 Sep 15 07:44 PM