Tuesday, September 14, 2010

Doomsday for Lehman; September 15, 2008

Fear gripped Wall Street on the morning of September 15, 2008, as investment giant Lehman Brothers Holdings Inc. filed for Chapter 11 bankruptcy protection following weeks of stock market losses and the steady downgrading of its assets. Traders hoped that the century-old warhorse would be saved in an 11th hour reprieve. But when last minute negotiations with Barclays broke down, Lehman had no choice but to call it quits. The news sparked a frenzied selloff as millions of shares were dumped at firesale prices. As fear turned to panic, turbulence spread across the markets and the grim predictions of a systemwide meltdown became a reality.

From the Wall Street Journal: "We have never seen anything like this," said analyst Glenn Schorr, who covers the investment banks for UBS AG. "There have been tough situations like Long-Term Capital Management and the crash of 1987, but the problem here is there is leverage in the securities under the microscope and in the banks that own them. And to try and unwind it all at once creates a one-way market where there are only sellers, and no buyers." ("Crisis on Wall Street as Lehman Totters, Merrill Is Sold, AIG Seeks to Raise Cash", Wall Street Journal)

The problems that originated with subprime mortgages quickly spread to the secondary market where shadow banks exchanged short-term loans for complex securities. As trading slowed to a crawl, the so-called wholesale credit system heaved a mighty groan, and the banking system began to teeter. Lehman's collapse had ignited a full-blown market crash.

Officials from the New York Fed tried to allay investors fears by promising an orderly liquidation of Lehman's positions to prevent their pool of assets from flooding the market. But no one knew who the counterparties were or whether they could withstand the humongous losses ahead. Thus, the prospect of contagion grew while markets seesawed and the selloff accelerated. Many believed that Lehman's default would domino through Wall Street taking down everything in its path. In fact, economist Nouriel Roubini predicted that very scenario on his blog just days earlier. He summed it up in the bleakest terms:

"All of the independent broker dealers are going to disappear. In March it was Bear Stearns. Tonight it was Lehman and Merrill Lynch. Morgan Stanley and Goldman Sachs should go find a buyer tomorrow. The business model of broker dealers is fundamentally flawed. They cannot survive."

The markets were already on edge from the government bailout of Fannie Mae and Freddie Mac a week earlier as well as the sudden sale of Bear Stearns to JP Morgan. Now Lehman's woes were sending shockwaves through the global system; credit spreads continued to widen, the VIX "fear gauge" spiked to record highs, and stock indexes plunged. Under-capitalized investment banks and hedge funds were overwhelmed by withdrawals from investors fleeing the market for the safety of US Treasuries.

Late Monday night, an ashen-faced Harry Reid (Senate Majority Leader) emerged from an emergency meeting with Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke where he'd been told in stark terms that the system was at the edge of the abyss. Reid--who was visibly shaken--dismissed questions from the media with a sweep of the hand saying somberly, "We are in new territory, this is a different game...No one knows what to do."

Even before Lehman had failed, Bernanke started slashing rates and setting up lending facilities to provide assistance to ailing financial institutions. But now, the Fed chairman began to drain billions of dollars of liquidity from the system to increase the stress in interbank lending and push Libor higher. Bernanke and Paulson were deliberately exacerbating the crisis to force congress into passing Paulson's $700 billion bailout package, the Troubled Asset Rescue Plan, aka--TARP. Economist Dean Baker sums up Bernanke's role like this in an article titled "Ben Bernanke; Wall Street's Servant":

"This is not the first time that Bernanke has done Wall Street’s bidding. When Goldman, Citigroup and the rest were on the edge of bankruptcy, Bernanke deliberately misled Congress to help pass the Troubled Asset Relief Program (TARP). He told them that the commercial paper market was shutting down, raising the prospect that most of corporate America would be unable to get the short-term credit needed to meet its payroll and pay other bills. Bernanke neglected to mention that he could singlehandedly keep the commercial paper market operating by setting up a special Fed lending facility for this purpose. He announced the establishment of a lending facility to buy commercial paper the weekend after Congress approved TARP. Of course, the whole crisis stems directly from the Fed and Bernanke’s fealty to Wall Street." ("Ben Bernanke; Wall Street's Servant", Dean Baker, Industry News.org)

While it's clear that Bernanke allowed credit conditions to deteriorate, the larger question remains: Did Lehman jump or was it pushed? Keep in mind, that Bear Stearns was stripped of its toxic assets and bundled off to JP Morgan with a clean bill of health. That same precedent should have applied to Lehman as well. So, when the bankruptcy was announced on the morning of the 15th--and the Fed did not intervene--all hell broke loose. But, then, Bernanke and Paulson really had no other choice. Either they take advantage of the crisis to wrangle the $700 billion out of congress or they walk away empty-handed. And, if they walked away empty-handed, the rest of the big 5 investment banks--including Paulson's former employer, Goldman Sachs--would have folded overnight. It was "do or die".

The causes of Lehman's troubles are generally misunderstood. Prior to the meltdown, depository "regulated" banks were funded through repurchase agreements (repo) with institutional investors. (aka---"shadow banks"; investment banks, hedge funds, insurers) The banks would post collateral, in the form of bundled "securitized" bonds, and use the short-term loans to maintain operations. Estimates of the size of the repo market vary, but experts believe that it is somewhere in the range of $10 to 12 trillion, which is to say, it's equal to the size of the traditional banking system. When the banks collateral became suspect (because no one knew which bundles held the toxic subprime mortgages) then intermediaries (primary dealers) demanded more collateral for the loans. In essence, the banks were taking a haircut on the value of their assets. Suddenly the banks were losing money hand-over-fist as the downgrades continued. Financial institutions were forced to sell their higher-rated liquid assets to maintain cash-flow. Distress sales pushed prices down further and the system began to crumble. That's when Bernanke stepped in and offered emergency funding and blanket government guarantees on deposits (and securities) for underwater financial institutions.

The total amount of subprime loans was not enough to trigger a financial system meltdown. The real source of the problem was the new architecture of the markets, and in particular, the shadow banking system. The Wall Street Journal provides this explanation in an article titled "Senate's Goldman Probe Shows Toxic Magnification". Here's an excerpt:

"Documents released by Senate investigators last week provide clues as to why the losses were so severe. The documents show how Wall Street banks packaged and repackaged the same risky bonds into securities that ultimately helped magnify the impact of defaulting subprime mortgages on the financial system.

“In one case, a $38 million subprime-mortgage bond created in June 2006 ended up in more than 30 debt pools and ultimately caused roughly $280 million in losses to investors by the time the bond's principal was wiped out in 2008, according to data reviewed by The Wall Street Journal.....("Senate's Goldman Probe Shows Toxic Magnification", Carrick Mollenkamp and Serena Ng, Wall Street Journal)

The staggering amount of leverage that had built up in the system via opaque derivatives and asset-backed securities had amplified the value of the subprime by many orders of magnitude. Now that the air was whooshing from the bubble, the process began to reverse itself exposing a humongous capital hole that precipitated a collapse in asset prices. Here's how author and ex-Goldman employee Nomi Prins explains it in The American Prospect in an article titled "Shadow Banking":

"Between 2002 and early 2008, roughly $1.4 trillion worth of sub-prime loans were originated by now-fallen lenders like New Century Financial. If such loans were our only problem, the theoretical solution would have involved the government subsidizing these mortgages for the maximum cost of $1.4 trillion. However, according to Thomson Reuters, nearly $14 trillion worth of complex-securitized products were created, predominantly on top of them, precisely because leveraged funds abetted every step of their production and dispersion. Thus, at the height of federal payouts in July 2009, the government had put up $17.5 trillion to support Wall Street's pyramid Ponzi system, not $1.4 trillion. The destruction in the commercial lending market could spur the next implosion." ("Shadow Banking", Nomi Prins, The American Prospect)

This is a point that bears repeating: "...nearly $14 trillion worth of complex-securitized products were created" on top of just "$1.4 trillion" of subprime loans." The Fed and Treasury committed the nation's wealth to support a shadow system which most Americans don't even know exists.

Lehman was merely the fuse that lit the powder keg. Given the sheer magnitude of the bubble, any sharp downward move in asset prices could have triggered a similar correction. Simply put, the mortgage-backed securities and other complex bonds traded in the repo market were not worth what people had thought they were. Now, everyone knew that, which made deleveraging inevitable. The downgrades sent markets reeling while the massive repricing incident pushed the financial system to the brink.

On Tuesday, September 16, the turmoil grew as the government took over American International Group (AIG) a private insurer that had been selling credit default swaps without sufficient capital to pay off claims. The Fed invoked an obscure clause in its charter ("unusual and exigent") in order to lend to a nonbank. AIG was propped up with a $85 billion loan which was used to pay off counterparties in a massive derivatives scam that is still being investigated. Bernanke and Paulson assured the public that the bailout was needed to stabilize the financial system when, in fact, the money largely went to the same group of speculators who were responsible for the crash.

Also, on Tuesday, a New York money-market firm, the Primary Fund from the Reserve, said it "broke the buck", which intensified to the selloff. Bernanke could have easily remedied the situation by providing support for the money markets, but held back to ensure the TARP would pass congress.

Here's a clip from the Wall Street Journal which captures the mood of the time:

"The financial crisis that began 13 months ago has entered a new, far more serious phase.....Lingering hopes that the damage could be contained to a handful of financial institutions that made bad bets on mortgages have evaporated. New fault lines are emerging beyond the original problem -- troubled subprime mortgages -- in areas like credit-default swaps, the credit insurance contracts sold by American International Group Inc. and others. There's also a growing sense of wariness about the health of trading partners....The consequences for companies and chief executives who tarry -- hoping for better times in which to raise capital, sell assets or acknowledge losses -- are now clear and brutal, as falling share prices and fearful lenders send troubled companies into ever-deeper holes." ("Worst Crisis Since '30s, With No End Yet in Sight", Wall Street Journal)

On September 29, 2008, the House of Representatives defeated Paulson's $700 billion TARP bailout sending stocks into freefall. Traders watched anxiously from the floor of the New York Stock Exchange as the votes were counted on big screens overhead. As the "No" votes were tallied, the market plunged and a full-blown rout ensued. By day's end, the Dow had lost 777 points, its biggest point drop in history and the "biggest closing decline since the day the markets re-opened after the Sept. 11, 2001, terrorist attacks." Nouriel Roubini provided this chilling analysis of the mounting troubles:

"The US and advanced economies’ financial system is now headed towards a near-term systemic financial meltdown as day after day stock markets are in free fall, money markets have shut down while their spreads are skyrocketing, and credit spreads are surging through the roof. There is now the beginning of a generalized run on the banking system of these economies; a collapse of the shadow banking system... and now a roll-off of the short term liabilities of the corporate sectors that may lead to widespread bankruptcies of solvent but illiquid financial and non-financial firms.

“On the real economic side all the advanced economies...entered a recession even before the massive financial shocks that started in the late summer made the liquidity and credit crunch even more virulent and will thus cause an even more severe recession than the one that started in the spring. So we have a severe recession, a severe financial crisis and a severe banking crisis in advanced economies.

“At this point the risk of an imminent stock market crash – like the one-day collapse of 20 per cent plus in US stock prices in 1987 – cannot be ruled out as the financial system is breaking down, panic and lack of confidence in any counterparty is sharply rising and the investors have totally lost faith in the ability of policy authorities to control this meltdown." (Nouriel Roubini's Global EconoMonitor)

The TARP bailout was modified and eventually steamrolled through congress despite valiant resistance from grassroots groups of all stripes. It's likely to be remembered as the most despised piece of legislation ever passed into law, and for good reason. Even so, the markets continued their downward slide for the next 6 months until they hit bottom on March 9, 2009. The S&P 500 had dipped from 1,293 in early March 2008, to an abysmal 676 on March 9, 2009, a 47 percent drop. The Dow had fallen 54 percent from its all-time high in October, 2007. On March 10, Bernanke gave a speech to the Council of Foreign Relations where he said:

“In the near term, governments around the world must continue to take forceful and, when appropriate, coordinated actions to restore financial market functioning and the flow of credit...…Until we stabilize the financial system, a sustainable economic recovery will remain out of reach. In particular, the continued viability of systemically important financial institutions is vital to this effort. In that regard, the Federal Reserve, other federal regulators, and the Treasury Department have stated that they will take any necessary and appropriate steps to ensure that our banking institutions have the capital and liquidity necessary to function well in even a severe economic downturn. Moreover, we have reiterated the U.S. government’s determination to ensure that systemically important financial institutions continue to be able to meet their commitments.”

Thus, Bernanke enshrined the principle of Too Big To Fail (TBTF) and vowed to continue to usurp congressional authority whenever he thought the financial system was in danger. The implications of the Bernanke Doctrine are not yet known, but economists Ian Bremmer and Nouriel Roubini believe that the Fed's response to the crisis foreshadows a fundamental change to the system itself.

"An era of state-driven capitalism has dawned, one in which governments inject political calculation into the performance of markets," Bremmer and Roubini write." ("Roubini and Bremmer: Financial crisis ended the era of free Market Capitalism", Matthew Scott, Daily Finance)

The Fed and Treasury have done an impressive job of bandaging the financial system together, but stability is still largely an illusion created by zero rates, a massively expanded Fed balance sheet, and Enron-style accounting at the banks. True, the panic phase of the crisis may be over, but the Depression is ongoing. Credit remains constrained, economic activity is weak, and unemployment is much too high. Most sectors of the economy are still in deep distress. The Fed's emergency programs have done nothing to reduce foreclosures or lower unemployment.

Many expected that Lehman's default would lead to greater oversight and tougher regulations. But that hasn't been the case. Depository and investment banks have not been separated, the credit rating agencies have not been cleaned up, Too Big To Fail financial institutions still enjoy implicit government guarantees, and (many) derivatives are still traded beyond government supervision. Congress's attempts to reign in Wall Street have failed. When the economy eventually recovers, banks and shadow banks will increase their leverage, inflate another gigantic credit bubble, and precipitate another crisis. The lessons of Lehman have not yet been learned.

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