Lehman Brothers' Loss Is Nobody's Gain
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and access to funding can evaporate (as seen in the case of Fortis, the European bank) renders financial statements out-of-date and inadequate.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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Two million open contracts with different jurisdictions and doubtless some rate of human error in preparing them? How many taxpayer dollars will be spent paying the judges, clerks, and what have you adjudicating all those contracts? Quoth the Sagan, "millions and millions ...".
You can reasonably regulate: leverage, capital, terms of trade, and possibly even counter-party risk as a percentage of the whole (in proprietary, non-cleared instruments). Those criteria are singular, measurable, and reasonable. (I'm not saying we SHOULD regulate - I'm saying I know some people WANT TO regulate, and here's what's sensible in that regard.)
why??? because now we can see under the hood.
besides NO ONE WANTED LEHMAN WITH IT'S SYSTEMIC RISK, not even helicoptor ben!!
this exposed a bigger problem lurky in the weeds.
One we don't even know about YET!
Time will tell and this one my friends may make lehman look puny indeed!
More de-leveraging will take place and needs to.
Will inocent people and companies get caught up in this??? YEP
We can not regulate business cycles, only delay and impeed them!!
So extent your dates by 1-2 years because of the bailout.
Like professor Depew says, until the spread between corp and treasuries come down significantly - be cautious!!!
Care would have to be taken against arrangements that allow an entity to extract disproportionate shares of profits or free cash flow.
Care would have to be taken against one person or entity owning a controlling stake in multiple similar companies. The goal is to not have multiple companies which are collectively too big to fail from sharing a common philosophy leading to near-simultaneous failure.
And, finally, some way would have to be found to enforce this idea in foreign companies. Breaking up Ford while Toyota is unmolested might be bad for competitiveness.
Cheers.
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