Sunday, 1 November 2009

Settling the "Was it Lehman?" Dust-up

Was the U.S. government's decision to let Lehman Brothers tumble into bankruptcy last fall a fatal miscalculation? By letting Lehman go, did we precipitate the brutal freeze-up in the credit markets?

Answering that question has become a hot niche topic for debate. The latest contribution by William Sterling is here: Looking Back at Lehman. It's a rather tedious read, so I'll just cut to the chase:
In contrast to the analysis of Lehman skeptics such as John Taylor (2008, 2009) and John Cochrane and Luigi Zingales (2009), the evidence we present supports the view of many practitioners that the decision not to rescue Lehman represented an immediate and massive shock to the financial system that was larger by an order of magnitude than anything seen over nearly two decades.
First, if you examine the day-by-day, blow-by-blow data, I think it's obvious that the Lehman bankruptcy did matter hugely. But if you look at the larger picture, I don't think Lehman mattered much at all. The long historical view: we were poised on the tip of a teetering Seussian-type credit edifice, creaking with hidden risk and towering with high leverage. It was bound to collapse in an ugly way sooner or later.

The "micro" analyses that focus on how the credit markets reacted in the immediate aftermath of Lehman's collapse largely miss the point. Which is: Lehman's failure revealed the Seussian-type credit edifice in all its terrifying precariousness for the first time. There were at least two big problems that came to the forefront with Lehman:

1. The shadow banking system was shown to be extremely fragile.

First, check out this primer on shadow banking; it's what I consider a great introduction to the subject. It's an interview between Mike Konczal (the creator of the always-smart Rortybomb blog) and a Barnard College professor, Perry Mehrling.

Shadow banking was (still is, I imagine) HUGE. This MarketWatch story claims that the shadow banking system had $10 TRILLION in assets in early 2007, making it the same size as the traditional banking system. Just ponder that for a second. That's a tremendous amount of money sloshing about that's meeting demand for funds in the economy, while doing so outside of the reach of regulators.

Big brokers such as -- ta da -- Lehman Brothers were supposedly the largest players in the shadow bank network. How does shadow banking work? An investment bank such as Lehman arranges to sell some securities to what we'll call a "pseudo-bank", then buy them back say a day later for more money (that extra bit of money providing an interest rate on funds, if you will, for the lender). James Kwak at Baseline Scenario breaks it down well here.

Those securities may be AAA-rated, making them appear pretty safe. That's important because the pseudo-bank has to juggle two risks here: (1) That it will get stuck with the securities (2) That, if it is stuck with them, it will have to make enough money selling them to be made whole. Who are the pseudo-banks? Largely, it appears, money market mutual funds swimming in cash, looking for better yields.

So Lehman gets to de facto borrow against high-rated securities (that serve as collateral). Once this collateral looks suspect, or Lehman begins to falter financially, the mutual fund may refuse to "roll over" the buy-resell contract. Then, since these are very short-term agreements, Lehman can very quickly find itself pretty much screwed, unable to raise money that it desperately needs.

Which is what happened when Lehman stumbled. Its financial footing was rapidly whisked away and, because this is a "shadow" banking system, there was nowhere to turn for emergency liquidity (see Mike at Rortybomb for a longer discussion of this gaping weakness).

Now, if you're a pseudo-bank providing funds to this shadow banking system, and you observe Lehman staggering about, badly wounded, what do you think? It's not, "Well, that must be a problem isolated to Lehman." No, it's more like, "Holy crap, almost any of these investment banks could be in similarly rough shape, and how do I know these 'AAA' securities are really worth as much as anyone says."

Meanwhile, the U.S. government begins to realize that it can't let all the investment banks go belly up, en masse, because the Lehmans and Morgan Stanleys have got a million tentacles reaching into many corners of the global financial system, such as through their derivative operations. These guys have been at ground zero in the efforts to launder risk.

So Lehman's failure was about more than Lehman. I think we could've rushed in and bailed out Lehman, sure, but eventually the sprawling, frail shadow banking system would have blown up somewhere else.

2. Lehman was shown to be worth a lot less than it claimed, further scaring the hell out of everyone. Everyone starts to wonder, "How solid are the counterparties I'm doing business with?"; nervousness sets in; credit flow ices over.

September 15, Lehman Brothers Holdings says it will file for bankruptcy. It cites bank debt of $613 billion, $155 billion in bond debt, and assets worth $639 billion. Doesn't sound too bad huh? Assets of $639 billion, liabilities of $768 billion?

Now take a guess how much Lehman's bondholders recovered on the dollar. 50 cents? 40 cents?

Recovery rates for defaulted bonds have declined in the U.S., true. Moody's said they fell, on average, from 61.8 percent on senior unsecured bonds in 2007 to 33 percent in 2008. But Lehman bonds crapped out spectacularly. They fetched less than 10 cents on the dollar. That's pretty awful.

So there you have it.

Here's my takeaway point: Lehman's bankruptcy was a proximate cause of the credit freeze, but that doesn't necessarily mean rescuing Lehman would have been the wise thing to do. Perhaps if we had saved Lehman, that would have only delayed the breakdown of the financial markets to the fall of 2009, and it would have been twice as bad.

I worry about the "No More Lehmans" crowd because they're the ideological heirs of "Bailout Nation," the hopeless model of propping up Too Big To Fail banks. And I'm concerned they don't even seem to realize it.