Lehman and the loss of trust

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.

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