Roubini’s not wrong, but…

Let’s stipulate what “everybody knows”:

  1. There are some assets in the capital markets, many of which are mortgage-related, that were seriously overvalued over the past several years.

  2. Many of the others are Credit-related (CDS and CDOs and the like).
    1. Most of the two asset types listed above are reasonable concepts that, if they are commoditized, appear more liquid than they are. (Ask any homeseller in the current market.)
    2. Multiple sequences, while they don’t increase the total systemic risk (algebraically impossible), can have a distorting effect on risk, and
    3. Leveraging assets that are not so liquid can lead to cash flow mismatches in the best of circumstances.

  3. Attempting to arbitrage a perceived opportunity between a long-term obligation and a similar short-term obligation depends very much on funding, carry considerations, and liquidity. (Not certain if everyone knows that one—but everyone who does risk management should.)
  4. The Fed fears a “contagion effect” that will do more damage to the financial system than the “moral hazard” that accompanies “saving” any given firm.
  5. The Fed “saved” Bear Stearns (a.k.a., The Old Firm, or BS for short), to extent that they guaranteed the second through thirty-first billion dollars in losses that JPMC may (or may not) realise from having bought the firm.
  6. The Fed “saved” Fannie Mae and Freddie Mac in the stupidest way possible, ending their forty years in the desert as semi-private entities.
    1. The leaders who drove Fannie and Freddie into the Fed’s arms were rewarded handsomely for their not-so-creative destruction of their firms, most especially Daniel “acted-like-Harry” Mudd.

  7. On the surface, a Fed that saved BS should be likely to save LEH. (See rdan’s post below, citing Nouriel Roubini discussing the similarities.)

The center of Roubini’s argument seems to be this:

But then if on Monday no deal is done Lehman collapses and goes into Chapter 11 court and you have the beginning of a systemic financial meltdown as the run on the other broker dealers will start. Thus, what Fed and Treasury are trying to do this weekend is another 1998 LTCM bailin or Korea 1997 bailin, i.e. trying to convince all the major institutions to either support a purchase of Lehman or maintain their exposure to Lehman if no buyers is found.

The Chapter 11 filing appears to be what is about to happen. The rest is, perhaps, unfolding as it should.

What Roubini is talking about is, basically, the same thing as the “contagion effect” referenced in bullet (4) above. If Lehmann gets protection, many of its obligations will be reduced. So if LEH owes you $100 million, you may only get some fraction of that amount, or nothing, depending on the value of the assets and how secured a creditor you are. So if that $100 million exposure to LEH is essential to your operations, and you haven’t been able to take actions to mitigate it in the past six months, you may fail. Etc., as the Turtles once said.

So, yes, there will probably be some businesses that—despite almost six months of warning, since Bear and Lehmann were spoken of in the same breath, and had approximately the same leverage, when BS was purchased—who will suffer, and probably a few will go out of business.

But the effect of LEH going out of business would not be so severe as the effect of BS going out of business for one reason that Roubini, for some reason, appears not to have mentioned.

Lehmann has no clearing business.

Had Bear gone out of business, about 30% of the hedge funds in the country would not have been able to execute virtually any transaction for the following thirty days. Not a payment. Not a redemption. Not a trade on a listed exchange. Not a receipt. Not a de-leveraging. Not a swap payment, not a CDS payment, not fulfilling an option exercised against them.

There’s not just a “maybe” about financial collapse in such a scenario; P probably well in excess of 0.9944. $30 billion is a “bargain” in such a situation.

LEH has been on the ropes for at least six months, probably longer.* They were given a “word of confidence” by Goldman at the same time the Street was conspicuously silent about the prospects for BS.*** Anyone who has been looking at their risk positions without looking at their LEH exposure over the past six months doesn’t belong in the risk management business. As DealBook noted last Wednesday:

Financial institutions have been closely measuring their exposure to Lehman. On Tuesday, commercial and investment banks said they continued to do business with Lehman, and hedge funds did not appear to be pulling their accounts with the firm, events that helped precipitate the fall of Bear Stearns.

There’s a brilliant moment in Janet Tavakoli’s Credit Derivatives and Synthetic Structures:

[B]efore the fall 1997 [Korean banking] crisis, I took a call from a trader at a securities firm….The trader told me that several Korean banks were willing to offer credit default protection on other Korean names. In order to bolster up their own credit perception, they were willing to post 30 to 40 percent of the notional amount with G7…collateral….The trader then went on to tell me that Commercial Bank of Korea would sell credit default protection on bonds issued by the Commercial Bank of Korea.
“That’s very interesting,” I countered, “but the credit default option is worthless.”
“But people are doing it,” persisted the trader.
“That’s because they don’t know what they’re doing,” I affirmed. “The correlation between Commercial Bank of Korea and itself is 100 percent. I would pay nothing for that credit protection. It is worthless for this purpose.”
The trader mustered his best grammar, chilliest tone, and most authoritative voice: “There are those who would disagree with you.” (p. 85)

Several months later, those people were, presumably, downsized. Eleven years after that, no one in the market today would make the mistake of not considering the risk of the guarantor as well as the guaranteed.

LEH will file bankruptcy, but the market has largely priced that into its current market valuations. There will be failures, and there will be many stories about the suffering of former LEH employees, and the occasional counterparty without another option close at hand.

But its failure would not have a contagion effect, and any Fed support should be not to save the firm itself but, in the manner of the SBA’s efforts in NYC seven years ago, small loans to ensure that as few of those counterparties whose businesses are impaired by the LEH bankruptcy are unable to find other sources of capital.

As for the other firms—MER, AIG, etc.—those that can be saved are already taking action, if they still can.

After a necessary saving of BS, and an ill-timed, ill-considered deprivatization (h/t Brad DeLong) of Fannie and Freddie, letting LEH declare bankruptcy—assuming it remains necessary through the night—is the best choice.

Even if Alan Greenspan does agree with it.

*If you look at the debt market, they knew BS was a junk or near-junk credit in August of 2007 (5-yr notes at 245 over), when the stock was still trading at levels well north of 100.** LEH debt at the time was priced significantly higher (10-year notes in July 2007 ca. 140 over [same as Bear link]). “Lehman’s credit-default swaps [then] carr[ied] an implied rating of Ba1, according to Moody’s.” And no one believes things go better since then.
**There is a reason everyone agrees that fixed income is more difficult to price than equity. Accordingly, FI people dig a lot deeper in their evaluations. Or, at least, that appears to be the case here.
***LTCM memories, anyone?

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