The Unwinding of the Moral Hazard Trade

Oct.10.08 | About: Lehman Brothers (LEH)

This is the Age of the Bailout. And everybody knows how bailouts work: The government steps in and makes whole any holders of fixed income instruments, be they bonds or deposits or even subordinated debt. That's what happened with Bear Stearns, after all: anybody who wrote credit protection on Bear while it was spiralling into insolvency wound up making a fortune.

Except, the moral hazard trade -- buying banks' bonds, basically -- hasn't worked this time. WaMu's bondholders suffered default, as did Lehman's. In Iceland, even depositors might end up losing money. And I think there's a fair chance that the stock market's action Thursday was related to precisely this effect.

When Bear Stearns went bust, CDS prices on all investment banks soared -- none more so than Lehman. Now Bear was unloved on Wall Street, and was particularly reckless when it came to residential mortgage-backed securities -- yet it still got its bailout. Lehman, by contrast, had a better reputation on the Street, and its main source of risk was commercial mortgages, all of which had gone through much more diligent underwriting than any of the dreck that Bear was securitizing.

It would have been perfectly reasonable to assume that if Bear was worthy of a bailout, Lehman was too. In which case all those CDS premiums were just free money, there for the taking.

Of course it didn't work out like that: Lehman went spectacularly bust, sold off all its operations for pennies, and has almost nothing with which to pay off its bondholders, who are likely to end up with maybe 15 cents on the dollar.

As it goes for bondholders, of course, so goes it for anybody who wrote credit protection on Lehman. And the day when they have to pay up is Friday.

No one has a clue how much money is going to change hands today in order to settle Lehman-related CDS contracts. But the most widely-cited estimate -- I have no idea where it comes from, or how reliable it is -- is $400 billion. That's a lot of money, and not the kind of scratch that speculators just have lying around in cash. So maybe Thursday afternoon they started selling off anything they had, including those defensive stocks which got crushed in late trade, in order to raise the money they're going to need to come up with.

On this view, the Lehman CDS auction is quite possibly the cause of Thursday's market action, but not in the systemically-damaging way that a lot of us fear most. The damage is largely behind us now, and it has basically taken place in the liquid confines of the stock market. The worst-case scenario, by contrast, is that the people who wrote CDS protection on Lehman simply can't come up with the money at all, setting off a chain of counterparty defaults which could lead in short order to systemic financial meltdown.

With any luck, we'll find out Friday afternoon which of these might be the case, in time for the assembled policymakers at the IMF/World Bank meetings in Washington to put a plan together over the weekend if it's the latter. Incidentally, if you want to follow news over the weekend, be sure to keep an eye on Emerging Markets -- the unofficial house newsletter of the meetings. There won't be any shortage of journalists in Washington this weekend, but the ones from Emerging Markets are really good at getting the big interviews and the big scoops.