Lehman's Collapse: Broader Economic Damage Unlikely 25 comments
J.D. Steinhilber
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The 14-month old credit crisis is clearly in its most dramatic phase. Last weekend, the U.S.government took over Fannie Mae (FNM) and Freddie Mac (FRE), in a transaction that essentially wiped out the common stockholders. The ultimate fate of these two entities has not been determined, and the cost to
The events of this past weekend, while not as momentous, are perhaps more startling. In the past 24 hours, Lehman Brothers (LEH), a major investment bank with a 158-year history, filed for bankruptcy after the U.S. government opted (thankfully!) to let a big institution fail rather than commit taxpayer funds to arrange another bailout of a fully private financial institution (as it did in the Bear Stearns (BSC) transaction).
Moreover, Merrill Lynch (MER) and AIG (AIG), the two other large financial firms in the eye of the financial hurricane, made major announcements yesterday. Merrill announced that it is being acquired by Bank of America (BAC) at a nice premium over Friday's depressed closing price. AIG announced that it is being forced to restructure and raise $40 billion of capital to shore up its balance sheet, which has been decimated as a resulted of insurance written against mortgage defaults. AIG's stock is down nearly 50% this morning to $6.50 (versus a 52-week high of $70.13) after tumbling 45% last week.
Going into the weekend, the outcome Wall Street was expecting was a buyout of Lehman Brothers. Instead, it got a Lehman bankruptcy, a buyout of Merrill and increased pressure on AIG. These developments have intensified fears of a financial panic. In early trading, the S&P 500 is down 30-50 points and is trading just above the major support level of 1200 reached in mid-July.
The yield on the 10-year Treasury bond is down 20 basis points to 3.5% on flight-to-safety buying. Oil prices are down another $5, and have broken below $100/barrel. The major volatility that we have seen in all asset markets in recent weeks appears to be accelerating in the short term.
This week we will witness the repercussions of Lehman's bankruptcy filing. Recall that when the Fed and the Treasury bailed out Bear Stearns in March, the action was justified as a necessary evil to avert major dislocations in the financial markets and the economy due to chain reactions in the derivatives markets and the potential for further destabilizing mark-downs in the prices of distressed assets.
While there may be a short-term panic in the financial markets, it is difficult to see how the broad economy will be damaged by the collapse of a highly leveraged investment bank. Lehman's balance sheet has assets with a stated value of $600 billion, against stockholders equity of $20 billion (30 to 1 leverage!). As one of the analysts we follow put it:
"Would Microsoft stop selling software if Lehman collapsed? Would Intel stop selling computer chips? Would Exxon Mobil stop selling oil? Would people stop shopping at Wal-Mart? Would farmers stop buying fertilizer from Potash Corp. and tractors from John Deere?"
Thankfully, the Fed and Treasury realized the enormous "moral hazard" involved in using taxpayer funds to bail out private financial institutions and decided to let Lehman Brothers fail. We are optimistic that Lehman's bankruptcy will not have any lasting negative effects on the economy or the markets for that matter. From our vantage point, the events we are witnessing are necessary, and ultimately healthy, steps to correct the excesses of the bubble in credit and Wall Street finance generally.
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This article has 25 comments:
Hmmm . . .
How about, huge sell offs in Asian markets due to further erosion of confidence in US financial markets, resulting in further huge sell offs the next day in American markets.
Worldwide economic slowdown appears to be exacerbated, leading to massive layoffs and rising unemployment rates. Consumers around the world see a depression coming, and stop spending money, especially here the US, which of course is the largest consuming nation.
Downward economic spiral continues and . . .
it's NOT too difficult to see how the broad economy will be damaged by the collapse of a highly leveraged investment bank. . . .
After all, LEH is only one domino in the string of financial dominoes . . .
Today, because it would not face a headline about a $20 billion backstop, which in the end probably wouldn't not have lost a dime, to allow Barclays to buy Lehman --- instead, "saving" you your precious principles of non-intervention, here is what happened instead.
The Fed funds rate hit 6% when the Fed's target was 2%. To keep the closing rate at 4.25%, the Fed injected $70 billion in new funds in 2 waves of $20 then $50 billion.
The Fed also filled $25 billion in weekly repos.
The Fed alone thus lent the market $95 billion, today, to "avoid" a bailout. Oh and buy the way, that was so accomodative that 2/3rds of the bidders went away empty handed - the $50 billion bit was oversubscribed 4 fold.
The ECB injected $43 billion - oversubscribed 3 fold. The Bank of England injected $9 billion - oversubscribed 4 fold.
In all, financial firms sought $400 billion in liquidity on the Lehman bankruptcy, and central banks provided $150 billion of it. What wizards, they managed to avoid a $20 billion bailout with - $150 billion in central bank credits that left the market wanting $250 billion more and unable to get it.
How stupid are you people?!
"Lend freely at a penalty rate". Bagehot. Works every time it is tried.
Moralizing ideology about "bailouts", multiplies losses 10-20 times as everyone scrambles to screw their neighbor. Then nobody pays, everyone welshes, and the 10-20 fold tab ends up right where the smaller one would have been, all along.
Braintrust idiots...
When people get scared, our basic fight or flight instincts kick in - it's a knee jerk reaction, but one that evolved for a reason - and right now I'll admit I feel a knot in my gut over the economy, and I'm seeing a downward trend in my own business which has got me looking for even more avenues to curb spending and increase liquid assets.
So I won't be upgrading office computer systems for the time being, sorry Intel, Microsoft. I'll also be auditing fleet logs and expense reports more closely, and restrict travel whenever possible, sorry Exxon.
Talk about putting lipstick on a pig...
At this point, the Fed and Treasury have shown they have little idea what is going on and even less ability to do anything about it. As far as economist and investors, many are still living in denial and continue to religiously put stock (pun intended) in the traditional economic indicators - most of which have been rendered useless by statistical meddling.
As to calling bottoms; if you keep calling them often enough, you will eventually be right. The only problem is by then your credibility will be completely shot and your portfolio (assuming you've been trading or investing on your own advice) in similar shape.
I outline the macro challenges that I see lie ahead in seekingalpha.com/artic... the greatest threat being that we are in a period of the unwinding of the greatest number and scope of asset bubbles in history... Such periods have ended neither happily or quickly.
How about a list of the banks, institutions, and companies that you think should be given taxpayer funds? How about regional banks? Mortgage originators? Automakers? BAC? C? NCB? Banks based in other countries? Is there any limit?
Also, what do you say to the debt hawks who worry about devaluation of our currency, which occurs every time a country takes on too much debt. Just run the presses and it'll be all right?
Lehman's junk investments won't be any more or less likely to default because they filed for bankruptcy. In the end, no one will likely miss the paper-shuffling function they served during a brief time when such paper-shuffling was profitable.
(1) they assume US economy has to be a consumer driven economy,
(2) they assume that the only way to prop up consumer demand is to re-inflate the housing bubble, and
(3) they assume that the only way to avoid another Great Depression is to bail out any bank that would otherwise fail.
We need to examine how these three faulty assumptions are really part of a larger picture. To see the larger picture one needs to understand the link between America's energy policy, its chronic trade deficit, and asset bubbles induced both by the Fed's easy money policy and America's need to borrow from abroad to finance its trade deficit.
America's energy policy has been entangled with our military policy for many years. Even Alan Greenspan admits that the war in Iraq was and is largely about oil.
Unfortunately, those opposed to the war have not insisted that American's must at least pay for the war by imposing a tax on oil consumption. Since the cost of the war is not included in the price of oil, America is subsidizing oil imports.
Taxing oil would help bring down the trade deficit and it would encourage investments in alternative energy. But instead, America borrows money from abroad to pay for the war.
The Chinese, Japanese, Germans, Saudis, and others have been all too willing to loan American money to help stimulate their trade surpluses. In fact, their surpluses are so large and America's deficit is so big that America is allowed to borrow still more to pay for "investments" in housing - hence the housing bubble.
If America could at least stop investing in housing and start investing in windmills (something Al Gore and T Boone Pickens could agree on) we could make a dent in our trade deficit. According to Pickens, we need to spend around one trillion dollars on windmills and another 200 billion dollars on the electric energy grid to bring electricity to the coastal states. In other words, we need to make a massive investment in alternative energy. Given that need for investment spending, a slowdown in consumer demand due to house price deflation may actually be a blessing in disguise for the country (if not homeowners with bad investments).
But politicians know they can't get elected by telling voters they'll need to take some bad tasting medicine for the country to regain its economic health.
So, instead, politicians (such as McCain and Clinton) propose only what they think voters will like - cuts in oil taxes - even though their economic advisers should know this is the opposite of what America really needs to bring down the trade deficit.
To make matters worse, both the Republicans and Democrats push for tax rebates to encourage consumption spending, which further exacerbates the trade deficit.
In an economic downturn, it does make sense to borrow money from abroad to stimulate aggregate demand. But, the government could and should do stimulate demand by spending money on alternative energy infrastructure.
Windmills help bring down the trade deficit, but increased consumer spending at WalMart only drives up imports.
Finally, to top it all off, politicians seeking to capture the home owner vote argue about who has the best plan to re-inflate the housing bubble.
Unfortunately, politicians, voters, and some economic journalists have come to believe that the US economy has to depend on consumer spending.
For some reason, they think the US has to focus on consumer demand and can't get our economy going again by making investments in projects that will reduce our trade deficit.
What's worse, some so called "free market" economists argue that the government shouldn't make or try to promote investments in alternative energy because this would be industrial policy, which they criticize as yet another futile attempt by to government to "pick winners."
Oddly, these same "free market" economists don't see the war in Iraq (a war Greenspan admits is largely about oil) as energy policy or industrial policy. They see war as "military policy" so therefore picking winners in this instance is OK according to the Ayn Rand and Milton Friedman guidebook on what governments should and should not try to do.
So, America borrows money from abroad and lets the Fed run the printing presses to send out tax rebates, bailout banks, and jack up home prices.
These policies may be "good tasting" but they're not good medicine, they're poison.
The medicine America needs to take won't taste good, but there may still be time to save the patient.
America needs to work off its trade deficit. And, to do so, we need to kick both our oil and our house-as-investment habits.
As for dealing with investment banks and other financial institutions that are thought to be too-big-to-fail - as I see it there are three options:
1) a free market approach that lets failing banks fail,
2) a socialism for the rich approach that bails banks out but eventually lets them go back to their high risk behavior that will lead to future bailouts, or
3) a plain old socialism approach that nationalizes institutions that are inherently too big to fail and turns them into highly regulated government agencies.
People keep arguing about whether option (1) or (2) above is better, but they don't give any serious thought to option (3).
The question is whether you want the CEO's and other high ranking executives of these firms to be highly paid, high rollers who earn their fat paychecks by taking big risks. If so, that's great but the taxpayers don't want to get left holding the bag.
Or, do you want the managers of these firms to be competent but rather boring bankers who are heavily regulated and are therefore obliged to follow a script. If so, that's great the taxpayers should be more willing to backup and bailout this kind of operations. But, don't expect much innovative behavior from banks if this is the way we want them to operate.
You can't really have it both ways.
So, if a majority of Americans really want an innovative, high risk banking system, then we need to be willing to let banks fail and suffer the consequences whatever they might be.
On the other hand, if the majority of Americans want a safe, reliable, but unexciting banking system, if we think banks are just too to fail, then great, I say we take banking out of the private sector and make it a function of the public sector.
Mohamed El-Arian suggested the liquidity crisis just got much worse with the events of the past 24 hours.
El-Arian 7AM Sept 15 - www.cnbc.com/id/158402...
Meredith Whitney of Oppenheimer said much the same thing this afternoon with a very dire warning of just how serious things are becoming and the need for major government intervention.
Whitney 3PM Sept 15 - www.cnbc.com/id/158402...
A generation of investors have beenacting as if they can't lose,
which means they will, badly.
Merrill didn't go up today.
UBS,, AIG etc etc all look like toast.
which means the system is at risk..
On average, there are typically 2 bear markets a decade.
This isn't your average bear market.
The entire banking system may need to be nationalized.
This huge debt deleveraging and its economic consequences will take years to resolve which means more economic pain ahead. The Japan economic bubble took all of a decade to resolve, the Asian financial crisis took a few years to resolve. America's debt problems was swept under the carpet by the markets for decades but the "dam has burst". Like past major crisis it will eventually be resolved but will it all likelihood take years. Talk of Dow 10k, 9k, 8k, 7k becoming more widespread- not likely from current perspective given the resilience of the economy and abundance of bulls but cannot be ruled out in planning for the worst case.
If you think that this is not a wake-up call on a global basis, which it most certainly is, you must be wearing a blindfold, not rose colored glasses.
If competitiveness was only about gearing up the most in bull markets, then intelligence would carry no premium and bots could replace bankers. However now, as always, the winners are those who emerge if not bigger and stronger, then at least leaner and meaner from the downturn and get a pole position for the new bull race.
- Thomas Jefferson, 1791 -