Sunday, September 14, 2008

Game of Economic chicken: Fed hanging tough, Bankers not bailing out Lehman Brothers on their own.

Palin who? There's real ECONOMIC news happening today.

Lehman Brothers is essentially bankrupt. The other bankers together with the Fed's Ben Bernanke andthe Treasury's Henry Paulson are trying to save the banking industry and the economy. The weekend is not going well.

Summarized from Nouriel Roubini: Lehman brothers financial bank is essentially bankrupt. They have operated on a business model like regulated banks in which they borrow short term money and relend it long term in investments that cannot easily be sold on short notice. Unlike regulated banks, they have no government insurance for the short term money they borrow.

Bear Stearns was in a similar situation last Spring. When no one would buy the essentially bankrupt BS, the Federal Reserve swapped solid government securities for BS's nearly valueless securities which made BS a financially going concern that J.P. Morgan was glad to buy. Of course, the taxpayers will take the losses on the junk assets that BS traded in.

After the Federal Government took flack over paying out taxpayer money to save multibillionaires who invested badly, the Fed has not wanted to repeat the deal. Yet recently it simply took over Fannie Mae and Freddie Mac, essentially doing much the same thing. So the Fed and the Treasury have been hanging tough demanding that Lehman Brothers find their own buyers with no government subsidy.

The problem is, Lehman Brothers is bankrupt if they properly report all their bad investments at true value (Mark to Market.) No sensible buyer is going to buy LB at even a price of zero, since it will require so much more investment to save. The potential buyers are waiting for the Federal Reserve to sweeten the pot and take off the garbage investments before they buy LB.

The Fed and the Treasury Department are hanging tough, unwilling to spend more taxpayer money to bail out the ultra wealthy. Krugman reports today "Uh oh, black smoke

They still haven’t chosen a Pope found a way to rescue Lehman."

Nouriel Roubini writes:
If Lehman does not find a buyer over the weekend and the counterparties of Lehman withdraw their credit lines on Monday (as they all will in the absence of a deal) you will have not only a collapse of Lehman but also the beginning of a run on the other independent broker dealers (Merrill Lynch first but also in sequence Goldman Sachs and Morgan Stanley and possibly even those broker dealers that are part of a larger commercial bank, I.e. JP Morgan and Citigroup). Then this run would lead to a massive systemic meltdown of the financial system. That is the reason why the Fed has convened in emergency meetings the heads of all major Wall Street firms on Friday and again today to convince them not to pull the plug on Lehman and maintain their exposure to this distressed broker dealer.[Snip]

The Fed may delude itself in thinking – as its stress models suggest – that the systemic risk of a collapse of Lehman are less serious than those of Bear Stearns: after all Lehman is less involved into CDSs [Credit Default Swaps] than Bear was and now both Lehman and the other major broker dealers have access to the discount window with the PDCF [Primary Dealer Credit Facility of the Federal Reserve]. A collapse of Lehman instead will have as much of a systemic effect as the collapse of Bear for many reasons: Lehman is larger than Bear was; Lehman is a major player in a variety of key financial markets; all the other major Wall Street institutions are interconnected with Lehman in dozens of different types of counterparty activities; the PDCF support of the Fed is neither unlimited nor unconditional, i.e. investors cannot assume that Lehman or any other broker dealer can borrow unlimited amounts with no conditions from the discount window. Thus, a collapse of Lehman would trigger a panic and a potential run on all sort of other broker dealers and also on other distressed financial institutions like banks (WaMu) and insurance companies (AIG) and smaller member of the shadow financial system (distressed and highly leveraged hedge funds, etc.). [Snip]

What we are facing now if the beginning of the unraveling and collapse of the entire shadow financial system, a system of institutions (broker dealers, hedge funds, private equity funds, SIVs, conduits, etc.) that look like banks (as they borrow short, are highly leveraged and lend and invest long and in illiquid ways) and thus are highly vulnerable to bank like runs; but unlike banks they are not properly regulated and supervised, they don’t have access to deposit insurance and don’t have access to the lender of last resort support of the central bank (with now only a small group of them having access to the limited and conditional and thus fragile support of the Fed). So no wonder that this shadow banking system is now collapsing. The entire conduits/SIV system has already collapsed with the roll-off of their ABCP financing; next is the collapse of the broker dealers (Bear, Lehman and soon enough the other ones) that rely mostly on unstable overnight repos and other very short term funding for their financing; next will be hundreds of poorly managed hedge funds that will face a tsunami of redemptions; and finally runs on money market funds that are not supported by a large financial institutions or other smaller member of the shadow banking system as well as highly leveraged and distressed private equity funds cannot be ruled out either.

This is indeed the most severe financial crisis since the Great Depression and occurring at a time when the US is falling in a now severe consumer led recession. The vicious interaction between a systemic financial and banking crisis and a severe economic contraction will get much worse before there is any bottom to it. We are only in the third inning of a nine innings economic and financial crisis. And the only light at the end of the tunnel is the one of the incoming train wreck.
The question for today and tonight is who is going to blink? And if no one blinks, how bad are the results, because there are no good possibilities.

Addendum 5:01 pm CDT
Bank of America, the most likely purchaser of Lehman Brothers has been reported to have pulled out of the talks and begun talks to merge with Merrill Lynch instead. Barclay's Bank PLC, Britain's third largest bank and another bank considered very likely to buy Lehman Brother's assets has similarly left the talks. A spokesman for Barclay's stated "Lehman was attractive but did not meet what he described as Barclay's stringent requirements."

Treasury Secretary Paulson is reported to be adamant that no government money was going to be used to bail out Lehman Brothers.

The prospect of a Lehman Brothers bankruptcy filing grows larger. "[But] there was also an emergency trading session being held at the International Swaps and Derviatives Association to 'reduce risk associated with a potential Lehman Brothers Holdings Inc. bankruptcy.' The ISDA, which arranges trades for derivatives, said it was allowing customers to make trades and unwind positions linked to Lehman _ but that those trades would be voided if no filing occurs before midnight."

That's what Greenspan meant when he said "'Oh, by far,' Greenspan said, when asked if the situation was the worst he had seen in his career. 'There's no question that this is in the process of outstripping anything I've seen and it still is not resolved and still has a way to go and, indeed, it will continue to be a corrosive force until the price of homes in the United States stabilizes. That will induce a series of events around the globe which will stabilize the system.'"

The financial world we wake up to Monday morning will be very different from the one we thought we went to sleep with Friday night, and it's going to be economic Terra Incognito.

Addendum p:40 pm CDT

From Paul Krugman's blog
September 14, 2008, 9:21 pm
When is not a bailout a bailout

So the word seems to be that Lehman will be liquidated — hey, no more taxpayer takeover of risk, no more moral hazard; but to cushion the markets against the shock, the Fed will start accepting lower-quality assets, such as equities, as collateral for its credit lines — hence, more taxpayer takeover of risk, and more moral hazard. Oh, kay.

By the way, I’m not sure this was the wrong thing to do. But it drives home the essential craziness of the situation.

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