Lehman: Finally a Line in the Sand

Belatedly, the Fed and Treasury are drawing a line in the quicksand of moral hazard that has fuelled Wall Street's reckless mismanagement and overleveraged business model.

I warned last week amid the euphoria surrounding the GSE rescue that "a relief rally will prove short-lived...the next few weeks promise to be terrifyingly volatile, even by recent extreme standards."

This is now quite clearly an insolvency crisis for the financial sector, not just a liquidity one. An orderly bankruptcy process is the best outcome all around, particularly as it has forced Merrill Lynch (MER) into the fastest shotgun wedding since Bristol Palin, and AIG (AIG) to urgently recapitalise. The new mantra in investment bank boardrooms will be 'Don't be a Dick (Fuld)' and in many ways risks are receding fast in this corner of the shadow financial system; they are in Donald Rumsfeld's immortal analysis 'known unknowns'. The hit will be to bondholders and the CDS market rather than counterparties and customers.

The 'unknown unknowns' lie in the unregulated and financially opaque hedge fund industry, which has collectively suffered its worst trading period in at least a decade, as blatantly crowded momentum trades in currencies and commodities (and associated resource stocks) have blown up dramatically this summer. I made a lot of money betting against the consensus on the dollar, commodities and emerging markets, but now all those reversals are overextended and I'm sitting on cash and puts until this thing runs its course.

As many funds now try to tie shell shocked investors into extended redemption periods and even cut their outrageous fees as an 'incentive', there is no doubt that the collapse in previously 'hot' resource and materials stocks from Monsanto to Nucor has been exacerbated by hedge fund liquidation, which will accelerate this week as risk aversion spikes. There will be a great medium-term buying opportunity in this area soon (as indeed in selected emerging markets).

However, before this crisis period is over, I expect at least one major fund to collapse. A second huge risk is the crisis facing emerging market corporates in rolling over short term financing in coming months; $45bn is due in Russia alone in the next few months. Thirdly, we will have a truly momentous liquidity squeeze as banks square their books into this year-end, sending risk spreads to new highs.

Fourthly, the disastrous Bush administration is abandoning all remaining restraint in its final months, and is engaging in very dangerous (and illegal) incursions into Pakistani territory in a desperate attempt to nail Bin Laden by the election. They are more likely to stoke fast rising Islamic extremism in that very unstable and nuclear armed country. What next? Bomb Iran?

On the upside, the 50bp fall in mortgage rates since the GSE bailout, will at the margin help the natural healing process in US housing, although the bottom is still at least 6-12 mths away, particularly as Alt-A and Prime mortgage default rates are now climbing fast. Oil back below $100 is an effective tax cut for US consumers, which again will help housing at the bottom end where gas was eating up 10% plus of discretionary income a few months back. Inflationary pressures are abating fast, and global interest rates should fall sharply in coming months (even China is cutting now, NZ cut a half point last week).

Standing back from the Lehman debacle, overpaid and wildly reckless American executives have wrecked one of the few industries in which the US retained global leadership, and this period for banking will be seen in hindsight like the 1980s for Detroit, the era when leadership passed inexorably to better managed and capitalised foreign players. This is part of a larger trend where US economic leadership is being fatally undermined by a tectonic shift in power to Asia and the Middle East via SWFs, central banks, and aggressively expanding corporates. The role of China and Russia in hastening the GSE resolution by dumping US agency debt will prove to have been a watershed event, and an indication of just how vulnerable the US has become to margin calls from politically motivated foreign creditors.

Meanwhile, the US election campaign remains depressingly trivialized by inane discussions about lipstick rather than the historic loss of economic power and influence the country now faces. Like Lehman employees, US voters may pay dearly for their complacency.

Disclosure: Long SPY puts at 10500 and 10000

Comments

[JasonC:]

Fiddling while Rome burns, thinking a couple bearish bets will protect you when civilization crashes around your ears, humming your little morality-play ideological ditty. You and others like you have gone around the bend into barking moonbat land.

No, the Fed didn't draw any line in any sand, it caved to moralizing luddites like you, and we will all reap the whirlwind. Never ask for anything from the American people for the rest of your life, it won't be forthcoming.

This is world-historical stupidity...

2008 Sep 15 01:19 PM