Ladies and Gentlemen, I’ve been faithfully chronicling the global credit and financial crises for you since the first cracks started appearing in early summer of last year.
Tonight, with the almost-certain collapse of the investment bank Lehman Brothers, the crisis moves into a new and possibly very dangerous phase.
I’m going to keep you up-to-date on the key developments over the next few days, or longer if necessary, and give you as much analysis as there is time for.
The extraordinary events of this weekend will go down in history. To me, at this early point, I think there are instructive parallels to the financial crises of 1907 and 1987. Read on for a roundup of the events of the last two days.
UPDATE: Bank of America is expected to acquire Merrill Lynch, the third-largest Wall Street investment bank, for about $29/share, which is a large premium over MER's Friday close just above $17, and far below its 52-week high above $78.On Friday evening, Tim Geithner of the New York Fed called an extraordinary meeting of the CEOs of several Wall St. firms and large banks. Secretary Paulson attended some of the sessions.
The goal was to find a buyer for some or all of Lehman Brothers, a very well-respected firm that has been around for 158 years.
Lehman’s CEO Richard Fuld has been trying to sell off assets to raise capital for months now, for example the Neuberger-Berman investment-management business. But Fuld has been faulted for trying too hard to keep Lehman’s ownership structure intact and not working hard enough to raise new capital.
That’s the essence of Lehman’s problem. This is different from Bear Stearns, which was killed by liquidity problems as people suddenly started refusing to trade with them and clients started pulling their money out.
Lehman has large holdings (numbers like $50 billion are floating around) of debt securities that are backed by mortgages, including mortgages on commercial real-estate. (This is something of a twist, because residential mortgages have caused most of the problems to date.)
And Lehman’s mortgage paper is suffering the same reductions in valuation that everyone else is facing. If there is an expectation that mortgages may default or that cash flows may become less reliable, the value of the assets decline precipitously.
But it’s simply not an option for Lehman or anyone else to simply keep the paper in the bank and hold it to maturity, cashing the monthly payments. They’re required to mark the value of their portfolio to market on a regular basis (for some asset classes, several times a day, in fact). And when their marks reflect lower values, the difference comes out of the equity capital of the bank as a whole.
In short, Lehman ran out of capital. Their stock price has fallen nearly 90% over the past year. Obviously, this makes it hard for them to make money because they can’t take new positions. But when it gets really bad, they start looking too risky to the people they trade with and who invest with them.
That’s where Lehman is now. They need capital, or else they will be forced to liquidate their positions. And a liquidation, if done in a rapid and disorderly fashion, has the ability to depress the prices of similar securities all over the world, and possibly topple other institutions the same way.
Keep this point about destruction of capital in mind over the next few days. I’ll come back to it whenever I can. It’s really become the story in the ongoing financial crisis, which started as widespread liquidity impairment and has moved into a new phase.
The Treasury Steps In
The Treasury, Congress and the Fed have been criticized sharply for committing large amounts of public money in their attempts to quell various emergencies over the last year. Paulson and Geithner were absolutely determined to draw the line here.
After all, capitalism is supposed to punish risks taken imprudently, and to do so swiftly and severely. That’s what we free-market conservatives are all about, after all. If market participants form the impression that banks or Wall Street firms are “too big to fail,” meaning their mistakes will be made whole from taxpayer funds, then they have no incentive to avoid making mistakes.
So Paulson insisted throughout the weekend that no taxpayer or Federal Reserve funds would be committed to acquiring the “bad” (distressed) assets of Lehman Brothers.
One of the structures that was discussed throughout Saturday was the creation of a “bad bank,” which would acquire Lehman’s distressed assets, leaving behind a relatively healthy business consisting of investment-management, commercial-paper underwriting, and some proprietary trading.
The idea was that either Bank of America or Barclay’s would acquire the “good bank,” and a consortium of perhaps 10 other firms would pony up to buy the “bad bank.”
Do you remember the Long-Term Crisis of September 1998? Bill McDonough, then President of the New York Fed (the job Geithner has now), essentially ordered a group of Wall Street CEOs to sit in a room until they had a deal to acquire the assets of the Long-Term Capital Management hedge fund, and end the crisis. About 10 firms put in enough to buy Long Term’s assets for about 10 cents on the dollar. (Three months later, the assets were right back up to almost par, just as John Meriwether had long insisted would happen.)
This weekend, they didn’t make a deal.
With the moral-hazard precedents of Bear Stearns and Fannie Mae/Freddie Mac in the rear-view mirror, none of the firms in the conference were willing to undertake any acquisition of Lehman assets without government participation, or a taxpayer guarantee of some kind.
In essence, they called Paulson’s bluff. And first Bank of America, and then Barclay’s walked away from the table and there was no deal.
Paulson didn't blink. If he had, then moral hazard would have become permanently embedded in Wall Street's DNA, and Treasury would have lost most of its credibility. But by showing Paulson down, the CEOs of Wall Street put their self-interest (and possibly their desire to see the death of a capable rival) ahead of systemic stability.
An extraordinary thing happened then. This afternoon was hot, muggy, and brilliantly sunny in New York, but armies of traders were suddenly called off the beach and out of the Hamptons, and into work. On a Sunday. The International Swaps and Derivatives Association called a special trading session from 2pm to 4pm this afternoon, with a very unusual twist.
Traders were allowed to assume that Lehman Brothers would declare bankruptcy, and to make trades that would limit or offset their exposure to Lehman. These trades were permitted under the stipulation that they would be automatically “broken” (cancelled) in the event that Lehman did not execute a bankruptcy filing before midnight on Sunday.
As I write, that bankruptcy filing is reported to be imminent. Indications are for a very sharp drop in the stock market tomorrow (at least 300 points off the Dow, maybe more), and there has already been a large trade into short-dated US Treasury securities.
This is the nature of the risk that the financial world faces tomorrow morning when trading resumes in New York: a large amount of mortgage-backed securities may suddenly hit the market in a disorderly fashion. And if trading is messy and prices gyrate wildly, there is a strong possibility that other assets, like stocks, bonds, credit-default and interest-rate swaps, commodities, etc., may also be drawn into the maelstrom.
What would I be doing if I were in charge of the situation now?
Well, Secretary Paulson is a large, powerful and intimidating man, and he has a good handful of equally large, intimidating men working for him and in the Federal Reserve. These are the kind of guys that can make your ears bleed right through the telephone.
If I were them, I’d be burning up the phone lines all night tonight, and making the ears of CEOs bleed like never before. Their job is to persuade key people all over Wall St. not to panic in the morning. By brute force if necessary.
The fact that the stability of the system will once again depend on forceful personalities, rather than regulations or systems, is what makes me mindful of the crises of 1987 and 1907.
Stay tuned. I’ll be reporting here as necessary.