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Lehman talks extend to third day

user profile picture Chris Martenson Sep 14, 2008
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The Lehman Bros. talks have not yet resulted in a solution.  A rabbit had better be pulled out of the hat prior to the open of the Asian markets or there’s going to be some additional management problems inserted into the mix.

Here’s my read on this fast-developing situation.

[quote]

"The big concern here is, that the system is short on capital in a
big way," said Dan Alpert, banker at Westwood Capital in New York.

"That’s a problem — there could be another half a trillion dollars in writedowns, and you have to find that somewhere."[/quote]

 

Link to article  

The basic problem here is that none of the banks have the capital lying around to take over Lehman.  Worse, Lehman consists of both good assets and a big pile of toxic junk so convoluted that nobody is really sure how negative it really is.  So the banks that are possibly interested (Barclay’s and Bank of America) are only interested in the good parts.

What’s going to happen to the bad parts?  The banks want the US government to pick those up ,which means that they want (expect?) this deal to  be structured just like the Bear Stearns deal.  The good bits get absorbed by another bank and the bad bits get shunted off to the side into a government (or Federal Reserve) account.

But this next quote tells us exactly what is happening.

[quote]

Although the bank has reduced its leverage, or debt relative to
assets, it still has about $600 billion of assets supported by some $30
billion of equity, meaning the value of its assets need only decline by
5 percent to make the company worthless.

In a world where financial institutions are reducing their leverage globally, many different asset prices are falling.[/quote]

5% is not a lot.  This tells us that even at the relatively modest (by recent standards) of 20:1 leverage, Lehmans is insolvent.  And this tells us that the government has leverage to twist the arms of the banks to get them to pick up both the good bits and the bad bits.  There was a lot of negative press and hostile inquiries about the manner in which the Federal Reserve overstepped its bounds in the Bear Stearns deal.  Politically, it would be highly preferable to not have to do that again.

The problem for the banks here is that if the break-up deal falls through and Lehmans goes into a straight-up bankruptcy process, everybody’s assets will get re-valued in the process.  This would set a ‘market price’ on all the toxic debt, and this would force every bank to  adjust their portfolios in accordance with the now-established price for this junk.

In a single blow, hundreds of billions of dollars would get wiped off the books, many financial institutions would be revealed as utterly insolvent (which everybody already knows, but we are keeping up appearances, and that seems to be holding things together at the moment), and many more would all enter the bankruptcy process.  These falling dominoes would crash into other dominoes, and nobody is quite certain how that would all end.

Especially considering the derivative bombs that would go off as a result.

All of this means that  the government has the banks over a barrel, but the banks have the government backed into a corner. I am sure these meetings are very tense, and very strained.  On the one hand there’s the entire system to consider (altruism), and on the other hand there is fiduciary responsibility to one’s organization to consider.  If you were one of the few remaining banks with sufficient capital, would you want to risk it on a pile of toxic junk that you’ve only had 48 hours to review without some sort of explicit government guarantee?

And then what happens next week, when Washington Mutual goes under?  And then AIG?  And then CITI?

If I were a well-capitalized bank, I’d want to keep all of my powder dry in the interest of survival, and because there are going to be some incredible bargains down the road.

This means that the only banks that the government can likely strong-arm (without an explicit guarantee) would be banks at the margin, without much to lose and everything to gain.  In other words, the more desperate ones, who really only have one hail-Mary left before the clock runs out.