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Lehman Brothers' Loss Is Nobody's Gain


Global plumbing now springing new leaks.


Financial crises like the one we are now experiencing increasingly result from the structure of modern capital markets. External shocks – such as declines in housing prices – are transmitted via connections between participants who are tied together by complex chains of dealings. Concentration of trading amongst a small group of large dealers exacerbates the risk.

The decision not to support Lehman Brothers, with the benefit of hindsight, was a major miscalculation and a significant factor in the subsequent problems at AIG (AIG) and other institutions as well as the complete failure of money markets.

Regulators and governments have shown limited appreciation of the detailed plumbing of the system for which they are responsible. In the present crisis, they have frequently appeared like Pritzker Prize-winning architects trying to deal with blocked plumbing. Central bankers and finance ministers have found themselves in the position of Woody Allen: " Not only is there no God, but try getting a plumber of weekends."

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In fairness, even experienced professionals have struggled to understand the structure of modern markets. Jeremy Grantham, Chairman of GMO, recently observed:

"I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don't. And I have no idea, really, how this will work out. I certainly wish it hadn't happened. It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect."

Increasingly it is difficult to analyze the solvency of financial institutions. The speed with which available liquidity and access to funding can evaporate (as seen in the case of Fortis, the European bank) renders financial statements out-of-date and inadequate.

Agreements, such as those governing derivative contracts, are also increasingly affecting solvency. For example, the downgrade of AIG below a "AA" rating triggered margin calls (in excess of $10 billion): The downgrade also gave counterparties to transactions with the firm the right to terminate certain contracts, triggering large losses ($4-5 billion). AIG did not have adequate resources to meet these commitments, ultimately requiring US government support.

The exact effect of financial distress depends on the form of any restructuring that takes place. In the case of bankruptcy, Chapter 11 filing or equivalent, the crucial issue is which legal entities are placed under protection. In the case of Lehman Brothers, only selected entities (primarily the holding companies) filed while other entities continued to operate. This means that the position of each institution dealing with Lehman may be different depending on which legal entity they contracted with.

In the case of Washington Mutual, the Office of Thrift Supervision closed the bank on concerns about its ability to meet its obligations. J.P. Morgan (JPM) subsequently paid $1.9 billion to the Federal Deposit Insurance Corporation (FDIC) in its capacity as receiver, for the assets and certain liabilities of Washington Mutual's banking operations. J.P.Morgan did not assume the senior unsecured debt, subordinated debt and preferred stock of WaMu resulting in losses for investors.

Predictable Losses

Financial distress inflicts predictable losses on creditors. In the case of Lehman, creditors included banks from every continent – US, Europe, Japan, Asia and Australia. Retail investors in Asia and Europe who had purchased structured products issued by Lehman also suffered losses.

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