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Sunday, September 14, 2008

Bankruptcy for Lehman

Okay, things are coming together in the Lehman situation, though there are worries about things coming apart more generally as financial markets continue to unravel. Let's start with John Jansen:

Bankruptcy, by John Jansen: The New York Times is reporting(via Deal Book) that Lehman will file for bankruptcy this evening.

The story notes that the Federal Reserve will take lower quality assets as collateral for loans and a consortium of banks will provide financing to assist an orderly liquidation of the company.

I am not sure that one can have an orderly liquidation of a company which has been around for a century and a half. This is confirmation, proof positive that we live in a most troubled time. One week ago we watched and cheered (I did) as the Treasury rescued FNMA and Freddie Mac.

That effort provided only the briefest interlude of calm in the markets. There is some historic climax to this series of crisis lurking just around the corner. At every twist and turn in this year long saga the result which has ensued has always been the worst case scenario. We are , I believe, headed for a very very ugly end to this story.

Government has not been able to hold bank the forces which have taken down financial giant after financial giant. Capitalism demands pain. Good risk is rewarded and imprudent risk is punished. We were engaged in an orgy of imprudent risk taking for nearly a decade and now a heavy price will be paid for the violation of so many simple and common sense precepts of trading.

I truly fear for our economy and our system the next several days.

He has thirty years of experience on Wall Street. That last sentence has my attention.

I'll add more as I find it. [Update: much more on the continuation page]

Naked Capitalism:

NY Times: Lehman Filing For Bankruptcy: ...update from the New York Times' Dealbook:

Lehman will seek to place its parent company, Lehman Brothers Holdings, into bankruptcy protection, while its subsidiaries will remain solvent while the firm liquidates its holdings, these people said. A consortium of banks will provide a financial backstop to help provide an orderly winding down of the 158-year-old investment bank. And the Federal Reserve has agreed to accept lower-quality assets in return for loans from the government.

But Lehman’s filing is unlikely to resemble those of other companies that seek bankruptcy protection. Because of the harsher treatment that federal bankruptcy law applies to financial-services firm, Lehman cannot hope to reorganize and survive as a going concern. It will instead liquidate its holdings.

It was not clear whether the government would appoint a trustee to supervise Lehman’s liquidation, or how big the financial backstop would be.

Lehman’s broker-deal subsidiaries would not be a part of the bankruptcy filing...bankruptcy lawyers say that customers are likely to receive their holdings back.

Moreover, changes to the bankruptcy code mean that counterparties to Lehman’s credit-default swaps can seize their collateral at any time, posing an enormous potential risk to the entire financial markets. Investment banks, hedge funds and other financial players labored throughout Sunday to offset their exposure to Lehman, moving their contracts to other firms.

Note we predicted that the authorities would lower collateral standards as a finesse for Lehman. This is a back-door bailout. Dow futures opened down 300 and S&P futures down 37, which would seem subdued ex the stealth provision of central bank support.

Update 6:55 PM Reader Jim Bianco e-mailed this observation on the futures trading:

It’s all about Merrill. They need to announce a deal with BAC before the open. If they do not, they plunge to $10 to $12 (from $17) on tomorrow’s open and no way does BAC pay $25 to $30. Then Merrill is at risk of blowing up and a crash becomes very possible.

More on Merrill and AIG: Merrill Said to Discuss Merger With Bank of America. Bloomberg. Also, Rush Is On to Prevent A.I.G. From Failing - NYT.]

Felix Salmon:

Lehman: All Fuld's Fault, by Felix Salmon: John Gapper has the first best Lehman post-mortem:

Fuld never changed, not really. He was still the same dark, obstinate Lehman loyalist that he had always been - a man who never wanted his firm to be sold. And, in the end, Mr Fuld's pride and obstinacy stood in the way of Lehman's desperate efforts in the past half year to right itself...
He had devoted so much of his life and his personality into moulding the bank he could not accept its decline. If he had sold out earlier, Lehman might have survived but he was too proud. It was hubris, followed by nemesis.

Gapper's right: the fate of 24,000 Lehman employees lies on Fuld's broad shoulders. This credit crunch is a category-4 hurricane, and Fuld is the idiot who decided to hold his ground rather than evacuating and living to fight another day. Now his 158-year-old house has been destroyed. It's sad, yes -- but it's also tragic.

Willem Buiter is optimistic that allowing Lehman to fail won't cause a chain reaction in financial markets:

What if Lehman files for bankruptcy and nothing much happens?, Willem Buiter: It now looks likely that, unless the US Treasury blinks and makes public resources available to support a private take-over of Lehman brothers, the investment bank will have to file for bankruptcy.

The argument for putting public money into the rescue/take-over by JP Morgan Chase of Bear Stearns was that Bear Stearns was ‘too interconnected to fail’. ...

Lehman Brothers is larger than Bear Stearns, so what’s different now?

One obvious difference is that since the demise of Bear Stearns in March, the Fed has created the Primary Dealer Credit Facility and the Term Securities Lending Facility. .... With these market support facilities in place, the threat of a fire-sale of illiquid assets is less daunting. ...

The second obvious difference is that since Bear Stearns crashed, the US Treasury has, through its de-facto nationalisation of Freddie and Fannie, taken an additional $1.7 trillion of debt on its balance sheet, as well as a $3.7 trillion exposure to mortgage- and MBS-guarantees, with a fair value of around $350 bn. ...

If the US Treasury, either directly or indirectly ... were to offer financial support for a rescue of Lehman or for any other investment bank (or commercial bank, for that matter), the floodgates could open and the fiscal-financial position of the US Federal government could be materially affected. Japan not that long ago shared a sovereign credit rating with Botswana. A trillion here, a trillion there and the US Federal debt could lose its triple-A rating.

Another explanation is that the argument in support of the Bear Stearns bail out is wrong, or at any rate is no longer considered true in the US Treasury. ... Or at any rate, no stronger argument than for the tax payer to support US automobile manufacturers, steel manufacturers or manufacturers of garden gnomes threatened with bankruptcy.

We may have a test as early as tomorrow morning ... of whether there are significant systemic externalities from the failure of a household-name investment bank. I am optimistic that investment banks will turn out to be more like normal businesses than like the negative-externalities-on-steroids painted by the Fed and the Treasury during the Bear Stearns rescue. The frantic attempts by the Fed and the Treasury to broker a private sector rescue/takeover of Lehman suggest that the monetary and fiscal authorities are not too confident that a household-name investment bank can fail without causing significant systemic damage. If that is indeed the case, one wonders why, six months after Bear Stearns went belly-up, there still is no special resolution regime (SRR) for investment banks, along the lines of the SRR for commercial banks administered by the FIDC and the SRR for Fannie and Freddie administered by the Federal Housing Finance Agency (FHFA, the regulator of the GSEs). The Treasury and the US Congress have much to answer for.

Arnold Kling:

Bryan Takes Over the Treasury, Econlog: My guess is that the government is not getting out of the bailout business. You have a session in which the folks being asked to take over Lehman say, "Give us X, Y, and Z, or we walk." The government negotiators think that's too generous. They let the folks walk. My guess is that the folks will come back to the table. Or someone else will come to the table. ... I predict that lots of folks pull all-nighters, and there will be more dramatic developments before the markets open tomorrow.

Paul Krugman:

When is not a bailout a bailout, by Paul Krugman: So the word seems to be that Lehman will be liquidated — hey, no more taxpayer takeover of risk, no more moral hazard; but to cushion the markets against the shock, the Fed will start accepting lower-quality assets, such as equities, as collateral for its credit lines — hence, more taxpayer takeover of risk, and more moral hazard. Oh, kay. By the way, I’m not sure this was the wrong thing to do. But it drives home the essential craziness of the situation.

Tyler Cowen:

I don't mean to overwhelm you with posts, but...: It's hard not to report this:

$$$ On CNBC they are saying that AIG has asked the Federal Reserve for some kind of emergency bridge loans. Can the Fed lend to an insurance company?

$$$ Federal Reserve is dramatically expanding its emergency lending program. It's now going to take all sorts of collateral, including equity.

$$$ "Take a very deep breath. It looks almost certain that this week will be the one where we see the financial implosion in U.S. banking and brokerage that many have been expecting for some time," Paul Kedrosky says.

With Merrill Lynch, Lehman Brothers and Bear Stearns gone, everyone is asking whether Morgan Stanley and Goldman Sachs will survive as independent investment banks.

The Fed's Press Release is here. There are comments from Angry Bear, and Naked Capitalism has Bank of America Buys Merrill For $29 a Share and AIG Asks Fed for Help. Also, Felix Salmon has one more, When Can We Start Breathing Again.

Brad DeLong, commenting on Krugman's statement (see above):

Lehman Bros. Goes Under, But the Fed Assumes the Role of Patient Capital. Brad DeLong: It seems to me that this is the right thing to do--as long as the Fed can borrow from the Treasury, that is, so that it can conduct its own operations on a properly-large scale. The Fed's portfolio is large. It is not infinite.

A few more from Paul Kedrosky: Why Would BofA Buy Merrill?, Curious Capitalist: The Day Wall Street Stood Still, and Felix Salmon: Lehman: The Media Meltdown.

I just realized I hadn't offered any of my own thoughts. Without the kind of detailed data available to regulators, it's hard to fully assess how likely this is to spread and create a larger, out of control, downward spiral.  But the first goal should be precisely that, to prevent a bigger problem from erupting and sending the economy into a tailspin. On that basis I've had no problems with the interventions to date.

But at some point the federal authorities have to let banks stand or fall on their own, even the big ones, and that point comes as soon as the system can withstand the shock without collapsing. Is that time now? I don't know for sure, I don't think anyone does, and this isn't a "you're on your own" moment for banks generally in any case, there are backup systems in place and steps to ease pressures, e.g. accepting lower quality assets as collateral, and the Fed would certainly step in if things start to go downhill fast. But one thing I do know is this. I hope political pressure on the Fed and Treasury, the type of grandstanding we'll see on this issue from politicians beginning tomorrow morning,  does not force policymakers to take a hands off stance prematurely. The politics of intervention are bad, but the economics of a major crash are much worse. So a cautious hands off - as seems to be the case right now - is fine, but if a more active role is needed now or in the future, there should be no hesitation about moving in that direction.

Dean Baker makes a point about press coverage:

The NYT Turns to the Arsonist to Analyze the Fire: Greenspan on Bank Bailouts: Alan Greenspan is certainly in a position to know about the problems the financial system is facing. After all, there is no one who bears greater responsibility for today's events.

But, it would be appropriate to remind readers that Greenspan was the arsonist here. He was the one who choose to ignore the abusive lending practices in the mortgage industry that became widespread under his tenure. He was the one who chose to ignore the growth of an $8 trillion housing bubble.

When he said that, "This is a once-in-a-half-century, probably once-in-a-century type of event," it might have been worth pointing out that he was the arsonist who created the conditions for the extraordinary set of events hitting Wall Street.

Brad Setser:

The world is changing, fast: After Argentina was — after a long, drawn out process — denied financial support from the IMF and left with no choice other than default and devaluation, the US Treasury encouraged the IMF to provide a large backstop to both Brazil and Uruguay. That strikes me as the right metaphor for tonight. But rather than worrying about the rest of the world, the US authorities now are worried about the health of the United States’ own financial system.

Lehman failed, at least in part because the Treasury and Fed were not willing to put taxpayer money on the line to help Lehman.

Merrill accepted Bank of America’s offer. And one assumes — based on Yves Smith’s analysis - that the Fed was quite happy that Bank of America was willing to bid for Merrill.

AIG is on the ropes and needs cash, which could imply that the type of institutions with access to the Fed’s liquidity window keeps expanding.

The Fed certainly is going to accept a broad range of collateral to try to avert John Jansen’s worst fears.

Felix is hoping that the deal for Merrill — together with the expansion of the Fed’s liquidity facility — saves the day. He defines short-term success as a fall in the equity market of less than 5%:

If AIG hasn’t collapsed after New York markets open and the broader stock market is down less than 5%, all that will mean is that there hasn’t been a systemic meltdown yet. It’s going to take a long time to liquidate Lehman and unwind all of its positions, and nobody has a clue how that’s going to play out.

I personally would pay more attention to the credit markets than the equity market. Partially that is because I understand credit markets better than equity markets. But that is also where it would seem, at least to me, the real shock may lie. ...

The US banks need to rollover a lot of debt over the next few months. Debt was was issued two years ago, back when the market was driven by greed rather than fear, is now coming due. The bankruptcy of Lehman could be more of a surprise to the debt market than the equity market; after Bear, the risks of holding equity in a major US bank were pretty clear. Up until now, though, unsecured creditors of large financial institutions generally have been protected from losses.

Back when the New York Times Magazine profile of my former boss/ co-author of “Bail-ins and Bailouts” came out, I said, more or less, that I would think the current crisis was over when it was clear that Nouriel Roubini was too pessimistic. Right now, though, things are still playing out far too close to his script for comfort.

Andrew Leonard:

Wall Street's nightmare goes nuclear: ...It is not an understatement to call the current crisis one of the most devastating challenges modern capitalism has faced in living memory. ...

There will be much more to say about all these things as the week wends on. ... But as we wait for Monday's opening bell at the New York Stock Exchange, let us remind ourselves, once again, of the most important lesson that economists, investors, and voters should be taking from this carnage.

Over the last three decades Wall Street sought, and received, a climate of deregulation and minimal oversight that allowed it to create new markets at will, permitted investment banks and commercial banks to commingle their activities, and exempted critical new innovative financial products from any meaningful government restraint.

Now, we are staring at the kind of mess you get when you give two-year-olds a few buckets of paint and tell the baby-sitter to take the day off. Clean-up is going to be a bitch.

Real Time Economics: 

The Government Stood Firm. Was It the Right Call?: The decision not to inject government funds stayed firm into the weekend, despite the threat that firms would walk without taxpayer support. Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke felt strongly about the need to resist a bailout... They faced continuing worries about moral hazard along with overarching concerns about distorting markets ...

Fed officials remain acutely aware of the system’s risks. ... Now they face another decision: Whether to support AIG with a lending lifeline.

More: Brad DeLong: It is Not About *You*, Paul Kedrosky: Blame the Short-Sellers, William J. Polley: Monday is going to be a rough day in the markets, and hilzoy: Donald Luskin Reclaims His Title.

Credit Slips:

Lehman 2007 Bonuses?, by Adam Levitin: Lehman paid out around $5.7 billion in bonuses in 2007. Are those bonuses safe? Maybe not.

The bonuses might be recoverable as fraudulent transfers---transfers made while insolvent...

Thus, the key question is whether Lehman was solvent when it paid out the bonuses?... On an equity basis, almost assuredly yes, but on a balance sheet basis, that might be a closer call...

If Lehman was not solvent when it paid the bonuses, then I think there's a fraudulent transfer. ...

Of course, it takes a challenge by a creditor whose claim arose before the bonuses were paid, but ... it only takes one of them, owed a single cent, in order to challenge all the bonuses. The lack of a creditor might protect the bonuses, but as creditors look to carve up what's left of Lehman, the thought of recovering a decent chunk of $5.7 billion is going to look very appealing.

    Posted by on Sunday, September 14, 2008 at 04:32 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (89)


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