Monday, September 15, 2008

Lehman Brothers Bankruptcy

We all know how markets can move like lightning, but for the general public it must be unnerving and incomprehensible how it is that the fate of such a large investment bank like Lehmans had to be decided one way or another in just 72 hours. For this reason alone the financial system authorities have much to answer for. Why is there is still no special resolution regime (SRR) for investment banks, along the lines of the SRR for commercial banks admininstered by the FIDC. This begs the question of whether such a convenient solution is feasible and could have been conceived in time given the scale involved here, what Greenspan calls a “once in a century event” when the regulators were working (based on Basel II risk management laws) on a “once in 25 years” scale of adverse shock events?
Lehmans was not the first and will not be the last major bank to crash at such speed. Today is the most exceptional of many exceptional days in the year or more since the credit crunch began.Ironically, Lehmans had a valid claim before the credit crunch hit of having the most advanced analysis, valuation and monitoring of the structured products and securitisation markets, and prided itself in its property market analysis, yet these totally failed the bank’s economics, and must stand as a warning to all.
Over the past year, to be perceived as a credit cunch winner not a loser, depended on achieving partnership with the regulators. Not even Barclays could win this for Lehmans. But, this tactic may have run out of steam since the nationalisation of Fannie and Freddie and hitherto safe bets such as even JP Morgan or Goldman Sachs or HSBC may now stand more exposed.
Realised and unrealised losses are a factor of time, of how much time can be won to manage and work out bad positions, best of all to be able to do so over the whole of the credit cycle. There is no doubt that Lehmans & Merrils were both victims of short selling as well as their own proprietary trading hubris. But, when the toxicity of MBS, CDO and CDS are dictated more by market sentiment (panic) than fundamentals, it is surely a role, if not the duty, of central banks and other financial regulators to step in and seek to halt trading in dysfunctional markets?Lessons that occur to me from this include the following:
1. when commentators and regulators blamed the Ratings Agencies, they underestimated the Agencies’ power, failed to think through the extent that banks’ internal ratings continued necessarily to be wholly dependant on the ratings agencies’ ratings to calculate fair value fundamentals. The speed of Lehmans and Merrils melt-downs were triggered by the ratings agencies pre-announcements of possible ratings downgrades, which alone can set the dominos tumbling. Such advance warnings can become self-fulfilling prophecies, especially in panic-driven markets. The future possibility of upgrades and downgrades, however imminent, should not be heralded in advance (the watch-list culture)
2. For similar reasons CDS (tens of $trillions in nominal size) should be illegal because they put a haze over the markets’ price discovery allowing toxic bubbles to amplify and build up to become “financial weapons of mass destruction” (Warren Buffet’s term). Foolishly, CDS were overtraded as if solid assets to such an extent that the spaghetti chains have become almost impossible to unravel, making ‘access audits’ a Herculean task.
(Note: ’Access audits’ is a medical term relating to physical incapacity. With the banks we have to consider ‘dysfunctional behaviour’ in proprietary trading, the silo mentality that meant one part of a bank did not care about the impact of its activities on other parts.)
3. When Merrils sold supersenior tranche assets in July for only 23% of face, this undermined all central banks’ liquidity lifelines an banks’ lifeboat plans that would accept ABS as collateral. This was a massive irresponsible blunder, worse than when Citigroup demanded more collateral (margin call) from Bear Stearns and when Bear objected grabbed Bear’s existing ABS collateral to sell instantly for whatever little it could fetch, thus triggering Bear’s collapse and at a stroke devaluing Citi’s own similar assets, much worse than when Goldmans auctioned off a $7bn SIV for 40% of face!
4. The $50bn super-SIV proposed of a lifeboat for toxic assets (similar to the scheme that years ago saved Lloyds of London) should not have been allowed to fail to get launched. Today, the next attempt to launch something similar at $70bn plus an emergency fund of $30bn plus should this time not be allowed to fail.
5. banks’ writedowns of MBS before today was about $500bn (much or most of this in Europe)as a result of which (plus banks’ share price falls) caused $350bn in new capital raising (much of it negated by short-sellers) to shore up (replace) reserves. Banks, we now hear, will have to raise at least as much new capital again! We need to re-think the whole system of trading book writedowns compared to the softer banking book loan loss provisions system.
If these toxic assets were in the banks’ banking books, not held for trading, the time available to work out the unrealised losses over time would be much greater. Additionally, we may need some rules or prudential principles to provide risk caps on banks’ proprietary trading.
Note that one reason credit crunch losses are less embarrassing for European banks is that they passed the positions on to their customers’ investment funds, including pension funds, who therefore had to bear such losses!

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