Could Lehman's Failure Cause a Systemic Meltdown?

by: Felix Salmon September 11, 2008 | about stocks: BAC / LEH    
Felix Salmon

Felix Salmon

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What are the risks of a systemic crash if Lehman Brothers (LEH) is allowed to fail? As Sudeep Reddy says, Lehman is just as big and interconnected as Bear Stearns was:

Mr. Bernanke, testifying before Congress in July, outlined his three reasons for stepping in with Bear Stearns: One was the size of the firm and its implications for broader financial markets. Another was that financial infrastructure was not strong enough to protect against a failure in derivatives markets. The third was "extremely fragile" financial conditions.

Supporting the case for Fed action with Lehman: Most of those issues aren't resolved today.

Yet the situation with Lehman is clearly not a re-run of Bear. Why not? That's harder to answer. The main reason is that the Lehman unravelling has taken so long that everybody pretty much expects it to fail, at this point -- and in the markets, if something is expected (a/k/a priced in), there's generally little likelihood much chaos when it actually happens.

On the other hand, I suspect that although a bank failure might be priced in to the LEH share price, the same expectations have yet to percolate fully through the rest of the financial system. It's easy for a stock market investor to anticipate a Lehman collapse: you just sell the shares. But what if you're a widget manufacturer in Iowa whose treasurer has been doing a lot of business with Lehman's derivative desk? Those positions are much harder to unwind. If you're expecting a big payment next month on the interest-rate swap which Lehman wrote for you, what are you meant to do?

I would hope and expect that the New York Fed will somehow manage to backstop most of Lehman's obligations to its counterparties, but given that nobody knows anything, it's impossible to say for sure. There should be some way to keep the pure trading book functioning smoothly even if people who lent money directly to Lehman are forced to take a haircut. But it would be much easier for a big commercial bank to take over the entire Lehman Brothers operation -- Bank of America (BAC) seems to be the most likely contender, according to the WSJ.

Remember that when BofA took over Countrywide (CFC), it was careful not to guarantee Countrywide's debt. It might be able to do something similar with Lehman: buy the bank, absorb its employees and traders, but then allow the subsidiary to default if it turns out to be insolvent.

That might be a desirable outcome from the point of view of the New York Fed, but I can't see Ken Lewis being particularly keen on taking the reputation risk associated with such a move: No banker wants to default on his obligations, ever. It'll be interesting to see whether Tim Geithner comes up with a clever way of twisting his arm.

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This article has 22 comments:

  •  
    Sep 11 06:03 PM
    The answer, obviously, is yes. Does no one read? JPM looked at what would happen if BSC was just allowed to fail and it concluded, with I think a 90% certainty, that the major IBs would ALL FAIL, including GS.

    Think about that for a second, the exposures are so great that it would bring down GS.

    If you think the government is going to allow that to happen, think again. However, equity holders will likely be wiped out since the Fed./Treasury is rumored to be involved. Sad case.
    Reply | Link to Comment
  •  
    Sep 11 06:14 PM
    What will happen is there will be further devaluing of the dollar. Unless the Fed is stripped of it's power, then we will slowly become more and more controlled and devalued by them.
    Reply | Link to Comment
  •  
    Sep 11 06:25 PM
    Give Lehman to Nomura or another Japanese bank. They never have to mark-to-market. They can hide all of those assets (liabilities) under a rug for years!
    Reply | Link to Comment
  •  
    Sep 11 06:50 PM
    With LEH trading below $3.60 in the after-market, this is an incredible set-up for the greatest trade ever.
    LEH is a great franchise and Wall Street will not let it fail for obvious systemic reasons, nor will it let it go the way of BSC. If it did, when will this run on the bank end? Who will the shorts crush next? MER? MS? GS?!?
    I am convinced that LEH will be snapped up by a large financial institutions for $20-25/share by Sunday. When this deal is announced LEH shares will run up to $35 in a massive short covering wave. This will send a clear signal that the financial sector isn’t fair game.
    Reply | Link to Comment
  •  
    Sep 11 07:04 PM
    LDT, put down your crack pipe man. LEH has liabilities well in excess of its assets. They can not pay their debts in full, what makes you think someone is willing to buy them for $35 billion? To me that seems like $34.9 billion too much.

    I would like this to just end the way it should, let the bank wind down and the chips fall where they must. I could not disagree with Felix more that the Fed should take any actions. How much more of my money does the government have to steal? I am already in the mortgage business thanks to these clowns, I don't want to be in the Investment Banking one right now.

    These criminals create a bubble for five years, steal our money and then expect us to "backstop/cover up" their theft. I have no problem working out the counterparty issues but debt should get exactly what is left over after asset sales, not a penny more.
    Reply | Link to Comment
  •  
    Sep 11 07:07 PM
    Actually, the criminals are guys like Einhorn who created a 'run' on Lehman.
    Reply | Link to Comment
  •  
    Sep 11 07:45 PM
    User 243313 has just nailed it. Meanwhile, the SEC keeps trying to cure the disease by treating the symptoms. One wonders just how many more major IBs will go belly up before naked shorting in our markets is eliminated.
    Reply | Link to Comment
  •  
    Sep 11 08:31 PM
    the criminals are the bankers who leveraged themselves to buy ABS backed by guys working at the 7-11 making payments on a macmansion.
    Reply | Link to Comment
  •  
    Sep 11 09:17 PM
    LDT: This will send a clear signal that the financial sector isn’t fair game.

    We already know that. Fair game implies no government manipulation and in a free market we just can't have that kind of non sense
    Reply | Link to Comment
  •  
    Sep 11 09:17 PM
    My concern would be with the amount of credit default swaps Lehman may be a party to. This is a huge unregulated business of insurance, nobody knows how it all adds up or if it does. Lehman's MBS assets could simply be held until their value becomes clear.

    Treasury and the SEC need to clean up the CDS business and make it open and transparent. Because it is insurance, insurable interest should be required to eliminate gambling or the moral hazard associated with short-sellers attempting to create CDS losses.

    If Lehman can't find a buyer or protector in the private sector the government should prop it up and then clean up the market - both the CDS mess and the short and distort manipulation, the rumor-mongering and the attack publicity.

    Reply | Link to Comment
  •  
    Sep 11 09:43 PM
    Why is Einhorn the problem??? I guess all lie detectors are evil and should be trashed as well. Each time he's raised a problem with fraud, he's been right. The man is a hero. He didn't create the toxic sludge and he did not pay himself handsomely for years out of imaginary earnings. He saved people like me who took his warnings seriously and got out.

    Let's burn books while we're at it. Darn those inconvenient truths
    Reply | Link to Comment
  •  
    Sep 11 09:46 PM
    You put if perfectly The Realist.
    The thing I hate most about short selling is that it allows all of these apologists to blame the practice, which I don't like by the way,
    for bringing the whole financial system to the edge of the abyss. Even cheerleader number one, Mr Cramer has admitted ( I heard him say it) that he was deceived by Lehman into believing that short selling was at the seat of their problems. Reading a lot of these posts, it is little wonder America is heading down the gurgler at light speed. I just wonder how long the PPT can keep this teetering sham on two legs.
    Reply | Link to Comment
  •  
    Sep 11 10:07 PM
    What a mess! It's clear that shareholders and creditors of these failing financial institutions are being punished as the stock/bond prices go to zero, but what about the executives who are largely responsible for letting this happen? Are they appropriately losing their jobs/equity/financial parachutes? Also isn't this the clearest example of the failure of rubber stamp boards of directors? Is anyone doing a study of the implications for reform in all of this so that we might not be "doomed to repeat history because we didn't learn from it" ?
    Reply | Link to Comment
  •  
    Sep 11 10:56 PM
    hey felix, i added you in my watchlist.

    can you tell me how to make that sketch picture of yours. i want to make mine also. thanks!
    Reply | Link to Comment
  •  
    Sep 11 11:01 PM
    RP,

    He most likely didn't sketch that picture. He probably just took a regular photo and used a photo editor (there are many available) to apply that effect.
    Reply | Link to Comment
  •  
    Sep 12 01:53 AM
    You geniuses still haven't figured why they gave up the crap about naked short selling rules without a sound?

    Who do you think has been benefiting most from naked short selling?
    Reply | Link to Comment
  •  
    Sep 12 02:17 AM
    i certainly have no qualms about seeing a failing mismanaged business fail unrescued by government props, etc. unfortunately lehman bros. investments for better or worse are tied into economies world wide. wall st. is easily shaken, often rising and falling on rumors, unfounded aphorisms, sentiment or plain lies. such has overwhelmed reality as the street interprets it. witness the precipitous fall of united air due to a false report mistakenly printed.

    concur or not, sometimes the safety of the lehmans of the world is a priority if for no other reason than keeping it afloat keeps us all floating; the so-called big picture. it may serve and even amuse the merrills of the world to see one of its competitors die but it may not serve the efficient and profitable running of the economy. lest the other
    finance-titans lose touch, basking in the cozy warmth of their schadenfreude, someone may rudely remind them that they may be next.
    Reply | Link to Comment
  •  
    Sep 12 02:32 AM
    To blame Lehmans mess on the short sellers is like blaming your account balance on your bank. Fuld had plenty of opportunities to clean up the mess, but didn't take them. The Koreans came out and said Fuld wanted twice the book value for a 50% stake. When you factor out the losses, a $10 p/s offer from the Koreans was actually very realistic.

    SpinCo is nothing more than spin. How does Dick plan to capitalize this new company? Stock offerings? Who would buy into a business that everyone knows is losing a billion a month? Not me. Use the money they get for selling a stake in Neuberger Berman? Lets say they get 5 Billion for a 50% stake, that wouldn't cover 6 months of losses, and they would be giving up 50% of what they have as profits now.

    The dogs are now on MER, WB, and WM because they have exactly the same issues with bad paper. Once again not a short sale problem, it's a risk and greed issue created by management.
    Reply | Link to Comment
  •  
    Sep 12 11:20 AM
    Why isnt PIMCO and Bill Gross a target here? He is the one who gains from this bailout. He bet 62% of his money on a bailout then begged on Cramer for it. He's a PIG!

    As for the biggest criminal in the mess ? It is congress, they encouraged the mortgage people to lend to Mr 7/11 and took kickbacks, (er I mean political contributions) from the Wall Street types who made millions in bonuses.

    The US has the most dishonest, corrupt government in the world. That includes both parties.
    Reply | Link to Comment
  •  
    Sep 14 03:27 PM
    in the past we have seen bank failure or failures of some financial instituion right at market bottoms letting lehman fail is not such a bad thing
    www.tradersaffiliates....
    Reply | Link to Comment
  •  
    Sep 15 12:45 AM
    Good call LDT.
    Reply | Link to Comment
  •  
    Sep 15 02:07 AM
    so much chatter about LEH, this issue is far far bigger than LEH it is the end of credit based capitalism , LEH is one tiny symptom of the end of a seventy year bubble which started at the end of the first depression , it took a world war , gold confiscation and massive credit provision to get us out of that mess but the dye was cast and J.M. Keynes provided the intellectual cover for banksters and their political puppets to squeeze every last drop of juice they could out of an exponentially growing economy based on exponentially greater resource utilization , the resources are now limited in supply (peak oil) and the financial ponzi scheme that LEH played a significant role in perpetuating has now come to an end. Gold/itellectual capital and means of production will be the only resources worth a dime when all the cards are being raked over. America and GB have dumbed down their populations , handed away their means of production and allowed their gold to be loaned/sold/stolen at give away prices for the benefit of the banksters and their minions . buy gold Monday morning and hold it in your safe custody.....if you can find any because i hear that physical gold hardly exists in the US at the moment ..... you will be grateful if you have some under your bed in the next few months/years.
    Reply | Link to Comment
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