Archive for the ‘lehman’ Tag
In yesterday’s post, I posited that the credit crunch which crushed Lehman has a lot to do with the adverse turnaround in US public finances as a result of the Iraq war, and I am sure that it is a factor, but it was not the thing that actually did for Lehman. The US fiscal account has been in substantial deficit before; the country only finished paying for the Vietnam war during the 1990s Clinton-era boom. Nevertheless, I think that we must always look at the fundamentals when trying to understand what is going on in an economy, and the combination of fiscal surplus/current account deficit produces surplus dollar capital and a boom in dollar-denominated asset prices, whereas twin deficits (as we have at the moment) will tend to depress dollar-denominated assets as the US Treasury absorbs the surplus dollar capital from the current account deficit. There is a substantial lag in this process, particularly around the downturn, because no one likes to sell an asset at a loss so notional asset values stay high until forced sales really make the fundamentals bite. I’m over-simplifying the process and there are other factors at play, including a change in international sentiment towards holding the dollar as a reserve currency, but asset prices are driven by capital flows. The burgeoning US current-account deficit helps explain how the proportion of US public debt in foreign hands is now at an all-time high.
But, macroeconomics 101 over, it’s time to talk about trust, which is what this blog is about, and if you read all the commentators, they are saying that the loss of trust between bankers is what really did for Lehman.
Up to a point, Lord Copper.
Lehman went to the wall because its finances were shot to pieces. It lost the trust of fellow bankers (to whom it is massively indebted) because its underlying positions were no longer trustworthy. It had borrowed from them to buy dollar-denominated property assets, by underwriting mortgage backed securities and buying commercial property. If these assets had continued to rise in price, the borrowing would have been easily repaid, and Lehman would have made a substantial profit, as it had done before. This is the genius of leveraging; the problem is, when assets fall in price, the loss is leveraged as well. Had it been smart, it would have seen the change in sentiment coming; but it didn’t – because the analysis of the fundamentals didn’t seem to match with experience on the ground in the early years of the decade when property prices were still booming. This usually means a bubble is building, but in the euphoria of a commission-driven sales culture, no one likes to admit that the bubble is about to burst. And the longer the bubble keeps growing, the more spectacular the burst. The fundamentals have been adverse for most of the decade, so the burst of the US property bubble has been spectacular.
What we now find is that no one actually knows whether Lehman is solvent or not. The realisable value of its commercial property and subprime mortgage books is not clear; if it’s more than the total that Lehman owes in bond and bank debt liabilities, Lehman could even emerge from chapter 11. This, however, is now highly unlikely. Like any major investment bank, Lehman is financed by a small amount of equity and large amount of bond and bank debt, which turns over as instruments mature and debt becomes repayable. Normally, it would just issue more debt to repay the maturing instruments; but since no one trusts it, that is no longer possible. So it has to realise its other assets, and their disposal becomes even more of a fire-sale. This is what the administrators are doing, who are now struggling to raise the cash to pay the current month’s salaries.
So could greater transparency have helped Lehman? Again, the answer is moot. Almost certainly, it would have precipitated the current crisis much earlier: lenders would have seen the dire state of the bank’s finances, and stopped lending long ago. But it might have been in time to stop Lehman racking up most of its excesses.
A good friend of mine from university went to work for Lehman Bros; I haven’t seen him for a while, but the last time I heard he was still working there. Very wealthy too he was; he lived in a lovely old manor house outside Beaconsfield; lucky chap.
Like most people working in financial services, he’d done very well since the 1980s deregulation. Although he’ll probably have to tighten his belt a bit now, he won’t be destitute. Losing a job is one thing; losing everything is another.
There will be many people picking over the bones of Lehman to try to work out why it collapsed, and more importantly, to try to prevent its collapse bringing down the rest of the industry. Is financial services really just a house of cards? It will be very bad for both the UK and the US economy if – as I somewhat suspect – the whole edifice is broken. So what has been happening with Lehman – and Fannie Mae and Freddie Mac? Superficially, the root of the problem is the sub-prime mortgage market. Lenders lent money to people who couldn’t afford the repayments; these deals were often pushed by brokers on commission. These dodgy loans were backed by mortgages on the properties bought with them, and in a rising property market they looked like a one-way bet. If the borrowers managed to keep up the repayments, all well and good; if they didn’t, just evict them, reclaim the property and sell for more than the outstanding debt. The key is, “in a rising property market”. The problem is that the property market was rising only because of the availability of these inappropriate loans.
To get money to continue lending, retail banks in the US, advised by the big boys on Wall St, “securitised” their mortgage books. Wholesale investors would buy the securities, and the retail banks would have more money to continue lending. But, as it became apparent that sub-prime borrowers were defaulting on their loans, the mortgage-backed securities became harder to sell. The banks who had underwritten the deals were left with lots of unsold securities on their books. With no new money to lend, the retail banks stopped issuing mortgages, and the US property market collapsed. As it did, the value of the properties backing the mortgage-backed securites did too.
This is the main story as to why Bear Stearns, Lehman Bros and Merrill Lynch have now collapsed. Fannie Mae and Freddie Mac are casualties of the collapse of the US property market; they were not directly involved in the market for sub-prime, mortgage-backed debt.
But there is another story, and it concerns wholesale money. Eight years ago, the Bush administration took over a thriving US economy, with a fiscal surplus measured in trillions. Even so, its trade balance was negative; a thriving US economy sucks in imports of oil from OPEC countries and manufactured goods from the Far East. This trade imbalance means that Arab oil exporters and Chinese manufacturers have lots of surplus dollars. They need to put those dollars somewhere safe, and Wall Street had just such a place: the mortgage-backed securities market. Not, by any means, the only place it offered, but a pretty good alternative to their preferred place: US Treasury bonds. With the fiscal account in surplus, the US Treasury had no need to issue quite so many bonds; but then came 9/11 and the Iraq war. Spending on the war rapidly tipped the fiscal account into deficit, so the Treasury needed to issue bonds, and these bonds absorbed a lot of the wholesale money which had been used to buy sub-prime debt. Ergo, the collapse of Lehman Brothers is the consequence of the war in Iraq. And of stupidly lending money to people who can’t afford to repay it.