On the precipice
Words no Managing Director of the International Monetary Fund ever wants to utter:
“Intensifying solvency concerns about a number of the largest US-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.”
(source: FT)
Lehman’s default – and the resulting $400 billion run on money market and “prime” funds – precipitated the current, intense crisis. Van Duyn, Brewster and Tett of the FT report:
As word of the Reserve Fund’s predicament spread, investors fled. By that weekend, more than $200bn had been pulled from money market funds, by both retail and institutional investors. When other short-term funds, such as prime funds, are included, the amount that was taken out of short-term investments quickly reached $400bn. That shift brought the funds under heavy pressure to sell into an illiquid market, simply to ensure they had enough cash to pay investors withdrawing their money. For banks, heavily reliant on these investors for their funding needs, it created a spiral of liquidity crises. “It was the straw that broke the camel’s back,” says Joe Lynagh, a portfolio manager at T. Rowe Price, an investment company. …
The run on money markets created problems for a host of institutions that relied on the money markets rather than deposits for dollar financing. Think European banks – and the large former investment banks. It turns out that American money market funds were financing the large European purchases of US corporate debt. That explains why less risk was dispersed than the regulators thought – and why Europe was providing less financing to the US than the TIC data indicated. Van Duyn, Brewster and Tett:
The impact of the investor pullback is borne most heavily by banks that are predominantly reliant on wholesale funding, a group that includes many European banks,” says Alex Roever, analyst at JPMorgan. “This investor pullback from the secured dollar bank commercial paper market is a contributing factor in the recent wave of liquidity issues at European banks.”
Lehman’s default clearly triggered the run. But the ultimate cause of the crisis is more troubling: a large number of large commercial and investment banks seem to have been borrowing not on the strength of their own balance sheets but rather on the expectation that they were too big and too systematically important to fail.
“Prior to Lehman, there was an almost unshakable faith that the senior creditors and counterparties of large, systemically important financial institutions would not face the risk of outright default,” notes Neil McLeish, analyst at Morgan Stanley.”
Much of the infrastructure of modern finance in effect rested on an expectation of a government backstop for the creditors of large financial institutions – a backstop that allowed a broad set of institutions to borrow short-term at low rates despite holding large quantities opaque and hard to value assets on their balance sheets.
That observation has a number of implications, not the least that the leverage – and resulting capacity for outsized profits — of some parts of the financial sector was made possible by the expectation that the government would protect the key creditors of the financial system from losses.
Lehman’s default shattered this implicit guarantee. The end result likely will be a series of explicit guarantees – and a rather significant government recapitalization of the financial sector.
The G-7 didn’t agree on a detailed action plan, only general principles. But by tomorrow morning, national governments will likely have extended guarantees to an enormous share of the liabilities of the world’s “private” financial system. And other parts of the “private” financial system will no longer be in private hands.
Stunning.
It really is stunning. People normally underestimate the amount of mania markets are subject to. But the level to which those that thought they deserved tens of millions a year in pay misjudged the markets they were paid so well to work within in amazing. And the rapid disintegration of companies built over more than a century is amazing. The power of leverage plus greed and feat is vast.
I suppose it is stunning that these large banks were operating on the basis that the investors felt there was an implicit government backstop. The impairments of their balance sheets by the bursting of the housing bubble (which they engineered by the use of fanciful models, inflating the market) have been guessed at by many and are not so stunning. Lehman had a very large hole in their balance sheet and I suspect there are a number of other large banks worldwide with similar impairments.
The cat was let out of the bag when Lehman went bankrupt and there is no way to get it back in. Now the governments of the world have to nationalize or otherwise explicitly guarantee these banks or investors will flee all of them because they don’t know which is broke and which is sound.
Lesson: Don’t abuse leverage to inflate markets. Should have been learned in 1873.
Brad,
Watching Dik Fuld tell Congress that he “will wonder until the day they put me in the ground” why Lehman was allowed to fail, I am sure I was not alone pondering “what kind of thing is that for the CEO of a private company to say or even think?”.
Your excellent article puts it in context. Dick Fuld never in his wildest imagination thought Lehman would be allowed to default.
In light of what you have pointed out, the exaggerated earnings and bonuses (over recent years were basically expropriated from future taxpayers. And, knowingly so.
Stunning, yes.
The idea that the Fed/Treasury or the equity markets are the ultimate determinant of the stability (willingness of business participants to continue to do business with each other as they have been) of an economy is blind to the primary role that credit markets play.
During the 1970’s inflation run-up, bondholders were demanding higher returns – and driving up the cost of credit, which produced recession/minimal growth – well before Volcker finally brought the Fed Funds rate in line (though he got all the historical credit).
The credit markets failed to demand sufficient return for risk during the last 6 years, probably because bondholders also bought the “I can’t imagine no bailout” model (LTCM set the example). Once Lehman proved them wrong, the over-reaction set in. And once the credit markets say it’s too dangerous to lend, there will be no lending.
Now that the bondholders have awaked from their slumber, unless there are ironclad government guarantees for debt (the “policy by implication” model has clearly failed), the debt is going to have to pay much better rates of return to get anyone to loan. Using government action to push rates of return down (to try to stimulate borrowing) has exactly the wrong effect (it discourages lending).
I find it amazing there are institutions considered “too big to fail”. Why?????
I am of the opinion there is considerable pain coming to this Country as a result of this period drawing to a quick close. No matter what is done from a bailout perspective, the damage is done and the results are inevitible. It may, and probably will, lead to a depression.
With that said, why preserve the institutions who made bad bets (that is what it was, not sound investing)? Let the institutions who made bad bets fail. Will it be painful, yes. But consider that allowing failure, rather than a huge scale LTCM bailout, will send a signal for the long term this behavior will have consequences. I run my own busness and if I screw up, I go out. There is no backstop so I always make sound decisions.
Heading full steam into socalism…….
Bruce
isn’t it nice to know tho that the world’s financial leaders are uniting?
…to form voltron!
> Using government action to push rates of return
> down (to try to stimulate borrowing) has exactly
> the wrong effect (it discourages lending).
Very good point.
If the US government wants to overpay, they will find they are all alone in that desire. If they want the market to resume, they have to get their foot off the credit hose, even if they don’t like the subsequent rate of interest.
This cannot be socialism, for the simple reason that it paid too few too well.
[...] Director, IMF — Excellent summary of the situation, plus the IMF’s mild forecast. As Brad Setser said, these are “Words no managing director of the IMF ever wants to [...]
It’s interesting – it has become common knowledge among academic economists (or at least Paul Krugman, who I have a lot of respect for) that the failure to rescue Lehman was a big mistake.
Apparently not so. If investors and financial institution management teams are operating on the assumption that banks are too big to fail, then obviously moral hazard has gone too far. There is clearly pain in the short term as a result, but hopefully the lesson has been leaned.
One of the regulatory developments that should arise out of this crisis, should be a formal plan for dealing with banking crises in the future – even though they may only occur every 80 years or so in any given developed country. Part of the plan should be to make it explicit that a certain number of failures will be tolerated (and that deposits will be guaranteed).
I’m guaranteeing all deposits, btw. If anything bad happens – anywhere – just give me a call. Day or night, np. I there for ya baby.
John – you think deposits shouldn’t be guaranteed?
Vindication On Implicit Assumptions
Vindicated again. From the Financial Times:
“The pledge reflects the belief that the collapse of Lehman Brothers unleashed the latest devastating wave of financial panic. ..
Many creditors who suffered losses with Lehman did so in part because they believed that the Bear Stearns rescue in March meant that Lehman enjoyed an implicit guarantee – a guarantee that never materialised. A former senior policymaker said the market would press the authorities to provide more clarity and turn their implicit guarantees into explicit guarantees.”
Excuse me, but this is exactly what I’ve been saying.
And more:
“The world’s leading industrialised nations have pledged to do everything in their power to prevent any more Lehman Brothers-style failures of systemically important financial institutions.
Experts said this remarkable commitment was the most concrete and far-reaching promise made in a weekend of international efforts to contain the escalating global financial crisis.
They said it came close to a G7-wide temporary implicit guarantee for many or all of the liabilities of systemically important financial firms.”
Here’s me:
The market’s reaction after the Lehman refusal showed that the markets and investors were expecting a bailout. In other words, there was an implicit government guarantee to intervene in a crisis such as this. In this instance, to try and go against the expectations of the market would be very hard and complicated. On the other hand, going forward, it will be clear that this implicit guarantee, which will now be explicit, was partly responsible for this crisis. I believe that this will come to be widely understood. Contrary to what you are saying, the moral hazards of this arrangement are more widely understood and accepted, and will finally have to be addressed.
I know that you’re not going to like hearing this, but the uncertainty was caused by the government not bailing out Lehman. The reaction of the credit markets showed that people were expecting a bailout, and when they didn’t get one, they started to panic. believing that they might be on their own. I’m not defending this belief or the bailout here, but simply calling attention to the real conditions under which the market and investors were operating. Sadly, a lot of people, including you, it seems, didn’t realize how far we’ve already gone done the road of government guaranteeing bailouts such as this one in a crisis. I’ve always been in this for the long run, so, although I agree we’re going to have to answer some hard questions about government intervention in the future, maybe this time will begin with a realistic assessment.
Now, again, Chapman is making great points going forward. But we need to settle this crisis with the cards that we have been dealt, i.e., the government had implicitly, for sure, and obviously, I think, guaranteed that it would intervene in a crisis such as this. So, for this time, game over.
The head of the Council on Foreign Relations is on the board of Fortress Investments — has he gotten any insights on this from the folks at Fortress?
Wasn’t the favourite soundbite provided by some ECB or German minister- that we were essentially staring at the abyss – lotsa papers and posts headlined with that quote.
Borrowing on assumption is never quite absent from our financial system – leverage is the simplest form of that assumption- obviously, no one would be lending if they thought no one had a reasonable buffer or protection against being busted…
which might be part of the problem right now, there seems to be no fiat guarantee – whihc is presumably what the brits are trying to arrange. In other words, the brits’ rescue package is a temporary life support system -duration currently undetermined, but with a guarantee that there are fewer DNR if at all.
Which is why the icelanders are so pissed that Kaupthing wasn’t one of those on the rescue list.
It appears the impetus for the huge market sell off in global equities, bonds and commodities was an orchestrated margin call on hedge funds by JPM, GS and MS occurring on 2nd and 3rd October as the EESA was enacted. That will withdraw an estimated $500 billion to $900 billion or so in highly leveraged liquidity from hedge funds – spurring the massive liquidations of quality markets.
Just to record it somewhere, let me predict here a continued surge in the dollar this week as the proceeds are repatriated to the US-based prime brokerage accounts. Any defaults will be orchestrated so that assets are inside the US ring fence and losses fall on foreign banks and investors. Then we can expect a nice fluffing of the US markets in advance of the US election (as usual).
Heads the US wins, tails the world loses.
If this is Paulson’s plan, it is elegant and possibly even successful. It is very reminescent of the rigging of options expiries in illiquid markets.
I wish you would set up your site so that if one forgets to do the addition one’s post is not wiped out when one backs up to do it.
US Investment Banks defraud thousands of Hong Kong pensioner retirees
HONG KONG, Oct 12 (AFP) Oct 12, 2008
http://www.sinodaily.com/2006/081012045137.jaqdlxu0.html
Retired security guard Tam Kai-biu does not like to take risks.
The 74-year-old never gambles on the horses or the lottery. When his banks tried to sell him an investment product, he would say: “Please, I don’t need any funds or stocks.”
Now he fears he may have lost the two million Hong Kong dollars (260,000 US dollars) of savings and pension he and his wife had built up since he arrived here penniless from the southern Chinese city of Guangzhou in 1955.
Tam and his wife had saved the money over almost four decades from what was left after raising four sons. He worked as a wood craftsman during the day and a security guard at night, while his wife was a cleaner.
He said he was now having trouble sleeping and eating, and his wife was suicidal.
They are among the more than 8,000 angry Hong Kong investors who claim that various local banks mis-sold them the “mini-bonds” and other complex financial products backed by Lehmans, which are now potentially worthless.
Their combined loss could be around 12.7 billion Hong Kong dollars.
It’s not just in Hong Kong. In Singapore, about 600 investors who have lost savings rallied Saturday urging the city-state’s central bank to help recover their money.
Like Tam, many of those who gathered were retirees who invested their life savings in financial products linked to Lehmans and other institutions.
DJC writes: “US Investment Banks defraud thousands of Hong Kong pensioner retirees…”
Then we read: “various local banks mis-sold them the “mini-bonds” and other complex financial products backed by Lehmans”
So methinks it was the local banks who defrauded. But, you know, never let facts get in the way.
a,
It’s all a bogus system to defraud the average person of his hard earned money. Lehman’s AA rating by S&P and Moody’s was really worthless. Lehman bonds weren’t downgraded until the firm declared bankruptcy. Anyway it’s fiat US dollar money made of thin air. Sooner or later, the rest the world will rise and dump the US Dollar hegemony system for good. It’s designed by financial architects who are thieves and loansharks to the core, baby !! One good example , ie , World Bank and IMF that pillaged the Indonesian economy under the direct authority of former US Treasury Secretary Robert Rubin.
What Lehman was involved in was another name for a sophisticated Ponzi scheme.
=========================
Lehman: One Big Derivatives Mess
Enron may look tame compared with this: a fight over billions of dollars posted as collateral, then used in a tangled web of deals
http://www.businessweek.com/magazine/content/08_42/b4104000160047.htm
It turns out that Lehman, like other big dealers, was running a perfectly legal but highly risky game moving money from firm to firm. It used the collateral from one trading partner to fund more deals with other firms. The same $100 million collected in one deal can be used for many other transactions. “Firms basically can use [the money] as their own collateral for anything they want,” says Kenneth Kettering, a former derivatives lawyer and currently a professor at New York Law School. But when the contracts terminate as the result of bankruptcy, the extra collateral is supposed to be returned.
Off-topic: Paul Krugman wins Nobel economics prize for his analysis of how economies of scale can affect trade patterns and the location of economic activity. For the record, no nation in the world can beat the massive industrial economies of scale in China today. LOL.
Monday October 13, 7:47 am ET
Associated Press Writers
http://biz.yahoo.com/ap/081013/eu_sweden_nobel_economics.html
STOCKHOLM, Sweden (AP) — Princeton economist and New York Times columnist Paul Krugman won the Nobel economics prize on Monday for his analysis of how economies of scale can affect trade patterns and the location of economic activity.
Hal — i hear you; hopefully the upgraded site will have a second chance function. one way of saving yourself is to copy the post (ctrl-c) before submitting it.
London banker — I am dense this morning. EESA = ?. i don’t doubt there there has been a margin call — as banks demanded more collateral and b/c hedge funds saw redemptions at the end of q3 and anticipated more …
Brad – “Emergency Economic Stabilization Act” is TARP’s new name. We need more letters for our financial Scrabble boards.. I lost count at TSLF, TAF, etc., etc…
Why did the TARP produce a global margin call? Doesn’t that confuse cause and effect? The absence of capital + falling markets led to both the TARP and margin calls?
LEH’s bankruptcy may also have had an impact, as some hedge funds found their funds in LEH frozen and they consequently shifted out of other stand alone brokers …
@ Brad
I guess I’m asserting a coordinated manipulation of global markets to crash them by the big prime brokers. They know better than anyone how tight capital is, and how fragile market confidence. By doubling the average margin required from hedge funds from 15 percent to 30-35 percent in parallel with a period of high redemptions, they knew they would crash global markets in equities, bonds and commodities. Then they use the cash which is given to them as margin, along with whatever they get from TARP, to buy a lot of quality assets at deep discount.
We can expect to see equities shoot up in a nice bear rally over the next two weeks into the election, and then oil and gold will shoot up again after the election.
I think we are witnessing coordinated market manipulation on a grander scale than Goldman Sachs ever dreamed before it had access to the US Treasury’s limitless leverage.
Forgive the dumb question, but could anyone help me understand the fx swaps announced today?
I get the part about (eg) the fed swapping USD for EUR and an agreement to unwind at term (eg. 28 days hence). A couple of questions though:
1. Does the ECB actually deposit EUR at the fed, or is it really a USD loan collateralized by ECB EUR holdings?
2. Is the net effect of the operation an increase in the supply of USD for the term? In other words, is there an offset (sterilization) needed to mop up USD, and if so, how can we tell if and to what extent it’s actually being done.
Thanks in advance.
Re: “Watching Dik Fuld tell Congress that he “will wonder until the day they put me in the ground” why Lehman was allowed to fail”
>> Fuld also will wonder on that great day, why he was unable to make more dough.
London Banker: 2 LB’s think alike…
though it’s hard to not to think this way when it’s staring us right in the face.
notice who went up in the late-hour rally on friday — the usual suspects.
re: LEH — if we agree that LEH was the straw, that begs the questions…
why was LEH allowed to fall in the 1st place?
why did JPM freeze their cash accounts on a Friday night?
was this just an climax of a longrunning BSD contest between the IB big boys in the sandbox or was there something deeper going on there?
and after the bankruptcy filing, why did LEH request to the court that special creditor status be given to the company (JPM) who pulled their plug?
Estagon — I had to learn about the mechanics a couple of weeks ago myself. The Fed receives foreign currency as collateral, and the market value of that collateral is what is reported as an asset on the Fed’s balance sheet. If there are large exchange rate moves, i think the ECB has to supply more collateral.
I am still thinking through the issue of sterilization — if the Fed lends dollars to a european central banks that lends the money to a european bank that then pays cash to an American money market fund, there would be an effective increase in the money supply. But if the funds in the money market are invested back into Treasuries, nothing much happens. And i think the latter is the best way of thinking about this.
But i am not sure …
I though fairly confident in the analysis of Dr. Hamilton — namely that in the face of a huge collapse of confidence and the hoarding of dollar liquidity, this isn’t likely to be inflationary. The money the fed is lending out isn’t being spent …
@ LB
With respect to Lehman, I understand the following to be the case. The SEC has been sitting inside of Lehman since March, getting things in order so that SIPC wouldn’t take a hit if it failed (e.g., replacing anything missing from nominee holdings or client funds). Then in the run up to the Chapter 11, Lehman liquidated huge holdings globally, preciptating the collapse of Asian, Russian and Eastern European markets. Lehman repatriated over $22 billion in cash proceeds to its New York operations. Lehman also looted the prime brokerage custody accounts of all the hedge funds serviced in London, using repo and lending agreements to stream all the assets to third party creditors or the New York operation. The management team paid themselves huge remuneration.
Then and only then did they file Chapter 11. And the timimg was a bit of a Reichstag Fire as it set up the Congressmen keen to get home to campaign for a quick panic passage of the biggest appropriation with the least oversight in US history.
Go figure. Sounds like looting to me.
I suggested on Brad’s thread some two or so years ago that the Fed would export inflation, then export deflation. You want to see what exported deflation looks like, examine Lehman or the massive margin call liquidation of the past ten trading days.
@LBnkr
re: LEH — ok, now it’s beginning to make more sense, especially in light of the HK post above.
if this is true, then:
it would make proper sense that UST decided not to bail them out, as that would be rewarding possibly soon-to-be explicit criminal behavior
(Mr. Fuld and pals weren’t too good in covering their tracks were they? perhaps we should start a new acronym — TSNTF — Too Sloppy Not To Fail?)
and JPM would have been acting properly in their fiduciary capacity as LEH’s clearing agent to freeze their liquid accounts of $17B, the straw that broke LEH to file chap 11 3 days later.
okay, but ‘properly’ also importantly depends on WHEN DID JPM discover what LEH was doing and how long it did it take them after their discovery to alert the UST, and then how long it took the UST to act.
everyone will have their own personal opinion of what constitutes a ‘proper’ duration but given the gravity of the situation and the eventual repercussions would it be proper to say that Monday of LEH’s last week would be construed as proper, giving them a comfortable 5 days for everyone to decide how to act?
(perhaps i’m being too generous given the time Congress was allowed to pass TARP/EESA/PWFU, but i’m in a generous mood today)
it would be interesting to see a timeline of those events you outlined above.
it will also be interesting to see how far this lawsuit goes, because that seems to be the only way to ever answer the above question:
http://www.nakedcapitalism.com/2008/10/lehman-creditors-allege-jp-morgan-role.html
London Banker: By doubling the average margin required from hedge funds from 15 percent to 30-35 percent in parallel with a period of high redemptions, they knew they would crash global markets in equities, bonds and commodities. Then they use the cash which is given to them as margin, along with whatever they get from TARP, to buy a lot of quality assets at deep discount.
I don’t think so. The big prime brokers tend to have positions that are market neutral so that whether the market rises or falls doesn’t affect their valuation. I don’t think this would have been possible without my having hear about it, and I didn’t get a “let’s crash global markets” memo. I did get a “given that things are falling apart, let’s be conservative who we lend to” memo.
The big banks *did* increase margin requirements on hedge funds last week, but that was because a lot of cash is going to change hands this and next week to cover the fallout of the Lehman bankruptcy, and no one wanted to be in a situation where they ended up losing lots of money if a hedge fund goes under because of this.