Letting Lehman fail did much more than create an unwillingness to lend (though it certainly did that, and we’ve seen how drastic that can be).

Tomorrow, 10/10/08 at 9:45 A.M. the CDS on Lehman debt will be settled. Current estimates are for (possibly via an auction) recovery rates of $.10 on the dollar from Lehman assets. If correct, that means the “insurers” of that debt – the companies (JP Morgan, Morgan Stanley, AIG) that have been making money taking payments to backstop Lehman leverage – would have to pay $.90 on the dollar.

This means they would have to produce $360 billion IN CASH TOMORROW. What are the chances of that being possible? What is going to happen when they can’t pay up (there’s another $50 trillion or so in CDS out there holding its breath)?

Secretary Paulson annouced today that he is going to interpret the “spirit” of the TARP (it sure ain’t in the language) to authorize him to give “around $300 billion” of the money that was supposedly for MBS purchases directly to banks (in exchange for equity warrants or preferred stock or something – he wasn’t specfic). There are only so many possible outcomes:

1. The estimates are wrong, and Lehman assets are going to cover much of the debt that will be settled. This determines the “degree of ugliness” we are about to experience.

2. The CDS settlement will be manipulated so that “30-year payment plans” or some other (increasingly common) Rube Goldberg evasion of immediate payment postpones the potential catastrophe. If I were King of the Forest, I’d declare a CDS Holiday; no settlements until we’ve stopped the panic and figured out how who wins and who loses (now, how do we do that?).

3. Treasury writes up to $360 billion in checks tomorrow to “re-capitalize” those banks and insurance companies that would be thrown into instant bankruptcy if they had to make good on their CDS. This one gets my money, because it follows the “squeaky wheel gets the grease” thought process that our genius Treasury Secretary and Fed Chairman have been employing up to now.

4. Complete nationalization of the existing U.S. financial system a la Fannie Mae and Freddie Mac – private ownership, but all the current liabilities are guaranteed until a sorting out process in the very distant future with promises of superior government control of all such financial transactions henceforth.

5. Armageddon. There will be no “financial system” left to save.

primordial dwarf

The financial sector was whopping 20% of the S&P 500 by market cap. We fixed the market cap problem, but the companies are still here.

In the early stages of the banking crisis during the Great Depression banks did band together on a voluntary basis and pledge to support each other. But this quickly fell apart due to mounting pressures of deflating assets (due to too much systematic leverage in the first place) and eventual bank runs once the public figured it out.

So guaranteeing deposits may calm the public, and now it looks like TARP could be used for cash for equity deals with banks. Of course the success of it depends on the implementation.

They have been inconsistent with the treatment of IBs. Bear – yes, Lehman – no..and AIG ???? Haven’t even heard of the mortgage insurance guys lately.

Sensible. Shrinking the financial system in the U.S. is necessary. However, letting Lehman fail created the unwillingness to lend.

I would like to seen Paulson face his real problem – which is, how to create the conditions that will make sound banks want to lend to each other.

I think everyone now knows the theater IS on fire. So policy action is to send the fire trucks, or at least make siren noises if you don’t have dollars or euros, and turn on the sprinkler system.

The powers of the world do this all at the same time so there is no side exit. Then they think they can quench deflation, but sow the seeds for eventual inflation. Same as they did in 2002.

So the only questions left are by 2011 will commercial banks be offering structured mortgage backed savings accounts(CDS Squared), will home equity growth be the biggest wage earner in the household, are $2 trillion federal deficits OK, where does China get $2 trillion for our current account deficit, why is oil only $35 a bbl, and will we be talking about a national health care plan, better wages and working conditions for illegal immigrants, and finally doing something about the public school system?

We can only wait and see what the answers to these questions are. (I hope that Italy is the 51st state of the Union, but we should buy as much of Europe as we can afford.)

Of course, carry trade. And hence musical chairs. If the dummies do not find a seat they do not deserve one.

Still, I love the politics and yes of course some russians must have had a bit of an exposure plus either plenty of collateral or good friends in Moskva. But I do like the fairytale that Russians came to the rescue (for selfish reasons hopefully- where would we be if even the Russians became irrational?) and hence the parallel with US/Georgia. These are times that you will be able to tell your grandchildrend about, cherish them!

http://www.nakedcapitalism.com/2008/10/wolfgang-munchau-policy-errors-risk.html

Wolfgang Munchau in EuroIntelligence argues against conventional wisdom, which is that modern policy tools and institutional arrangements will keep the credit crisis from morphing into a depression. He contends that the policy errors, the result of political considerations, have been substantial. He also says that Treasury Secretary Henry Paulson devised the badly-flawed Troubled Assets Repurchase Program to benefit Goldman Sachs. Although this is a widely-held view, few financial commentators have been willing to say so in writing. He also discusses how EU member nations are wasting firepower rescuing institutions for competitive reasons when they should have been allowed to fail.

http://en.rian.ru/analysis/20080924/117072937.html

In the light of the recent financial crisis in the USA, could the same thing happen now to the bonds issued by the American government, and could the country which has dominated the world for the last half century now enter history as a bankrupt state? And what can Russia do in the circumstances?

In America, this basic culture of debt is aggravated by the fact that other countries use the dollar itself as a reserve. This means that the United States can export dollars in order to pay for its imports without the dollar losing value. Other states also need dollars to buy key commodities like oil. The USA can therefore export paper currency almost indefinitely – the famous “deficit without tears” analysed by the great French economist, Jacques Rueff. Naturally, if the state itself encourages such a culture of debt by issuing unredeemable paper currency to pay for imports, and by accumulating such mountains of debt, then it is no surprise if the American financial markets themselves operate on the same basis. But the collapse of those markets is only a symptom of a much deeper problem, the basic insolvency of the American state itself.

What can Russia do about this? At first sight, Russia’s role in the international financial system does not seem very large. However, as a major exporter of hydrocarbons, her role in the world economy is actually very important. As the age of the dollar draws to a close, Russia will have to consider selling her oil and gas not in the devalued American currency, but instead in the euro used by most of her customers. It is surely unnatural for two geographical neighbours to do such large volumes of business using the currency of a distant and now ailing nation.

2 never say ” don’t worry, here comes the fire engine” in a crowded theatre.

3 if you are in a theatre and the play gets drowned out by the arrival of all of the fire fighting helicopters from america, canada, britain, france, germany, italy, sweden, switzerland, and china, accompanied by cheering japanese – leave quietly by a side door saying as little as possible.