Lehman’s bankruptcy: putting the cart before the horse?

Update Mar 2009: There is a pernicious little piece of historical revisionism going around that the Lehman bankuptcy did not matter. I am reposting this as a retort.

Note the piece by James Suriowiecki which induced me to re-post:

In the past few days, though, a new meme has started circulating through the economics blogosphere, suggesting that Lehman’s failure actually did not wreak the havoc that everyone who lived through last September thought it did. This argument, which was floated by the well-respected macroeconomist Willem Buiter on Friday, is based on a paper from last November by the Stanford economist John Taylor, which purports to show (pdf) that the credit markets actually did not react all that badly to Lehman going under and that the crisis was really the product of market uncertainty about the effects of government action.

Below is the original post from 16 Sep 2008.

Yesterday was a volatile day in the global financial markets. With the Nikkei down 5% and European bourses down 2% in overnight trading, we should understand that more volatility awaits us in the coming days and weeks.

As I survey this situation in serene tranquility away from market turmoil, I realize that I am very troubled by how the Lehman Brothers bankruptcy was handled. In my estimation, it was like putting the cart before the horse – allowing a financial institution to fail before you have worked out a mechanism of how to deal with that failure.

This one action will expose the global financial system to enormous additional risk.

Hank Paulson at the U.S. Treasury and Ben Bernanke at the U.S. Federal Reserve wanted to avoid the moral hazard of supporting the acquisition of a failed institution with government funds as it had done when JP Morgan Chase bought Bear Stearns. Therefore, Paulson and Bernanke were both fairly adamant about not offering any backstops for a Lehman Brothers takeover.

This is the principal reason both Bank of America and Barclays decided not to pursue a takeover of the firm. And this is also the reason Lehman Brothers failed. Had the U.S. government offered guarantees on Lehman’s debt, Barclays or Bank of America would have bought Lehman Brothers. In fact, I reckon BofA would have preferred to buy Lehman Brothers over Merrill Lynch as the price tag was much lower.

Were Paulson and Bernanke correct? After some time to digest events, I must answer no. They were wrong.

They were wrong for three principal reasons:

1. The U.S. government has failed to provide a framework and process for dealing with failed institutions of this size and the impending wave of future bankruptcies it should expect.
2. Failure will lead to asset liquidation, depressing asset prices further and putting further pressure on the remaining solvent financial services firms to writedown asset values.
3. This will potentially result in a Great Depression-like chain of failures, credit contraction and asset liquidation.

Rather than learning from the Great Depression, we are likely to repeat it.

Why we need a framework and process
It is clear from the difficulties facing AIG and Washington Mutual right now that further large failures are likely to occur.

In the case of AIG, we are presented with a potential derivatives nightmare as this $1 trillion firm has its tentacles in all manner of Credit Default Swaps, Collateralized Debt Obligations and insurance products generally. AIG represents a much more ominous case of potential systemic risk than either Bear Stearns or Lehman Brothers.

Washington Mutual is a large bank with $300 billion in assets. It is very leveraged to Alt-A and pay-option mortgages. Unlike subprime mortgages, which have seen the maximum number of interest rate resets, the majority of these products are resetting to higher interest rates now and in the future. This means a significant number of defaults in the sector will occur and that Washington Mutual will be stressed by these events. That may create liquidity or capital concerns which would force WaMu into insolvency. Were WaMu to be declared insolvent, the FDIC would need to be bailed out as it does not have adequate funds to deal with the likes of Washington Mutual.

These two institutions are suffering even more as a result of the uncertainty that allowing Lehman Brothers to fail has created. Due to investor and counterparty jitters, AIG and WaMu are now more likely to fail than had Lehman Brothers been rescued. This fact and the systemic risk that AIG represents and the threat to the FDIC’s adequacy that WaMu represents makes the need for a government bankruptcy framework and process more evident.

Lehman’s failure will lead to asset liquidation
By allowing Lehman to fail and subjecting the likes of WaMu and AIG to greater risk of failure, Paulson and Bernanke are unleashing a tidal wave of assets into the markets. In bankruptcy, Lehman Brothers will need to liquidate positions in Residential Mortgage Backed Securities (RMBSs), in Commercial Mortgage Backed Securities (CMBSs), in Credit Default Swaps (CDSs), and in a panoply of other asset classes.

Needless to say, Lehman is a forced seller and a price taker. That means these assets will go onto the market at distressed prices, depressing the price in the market generally. For the remaining solvent securities firms, this is a nightmare because it means they must write down their holdings of these tradeable assets to the new lower distressed prices. It is analogous to foreclosed homes being dumped on the market at super-low prices. Those foreclosure sales compete with regular home sales and, thus, depress the overall price of houses — one major reason people want to stop or slow-walk foreclosures.

What this means is that Lehman’s bankruptcy will lead directly to distressed asset sales at low prices which will compel other firms to take further writedowns. These remaining firms will therefore be forced to de-leverage, creating more distressed sales and a vicious cycle of asset deflation and potential bankruptcy.

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Update 10 Mar 2009:

My contention that forced sales by Lehman would cause asset writedowns is false. I have since wriiten about provisions in the mark-to-market rules which exclude writedowns in the event of distressed sales. See my comments on this here and here.

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The process I just described is a modern-day Depression and must be either stopped at all costs or managed effectively through a systematic and well-conceived framework and
process.

A good process and framework
I am a proponent of the free market solution: controlled liquidation through a managed process.

As we have heard nothing from the U.S. government about how they intend to deal with the impending wave of bankruptcies in the financial services sector, we should look to other models for guidance. In August, I wrote that the Swedish Banking Crisis was a model for the United States. Here is an overview:

1. Maintenance of the banking system’s liquidity through a general government guarantee of the entire system protecting all creditor losses except shareholders. (Whether subordinated debt and preferred shares should be protected is debatable).
   

   One way of limiting moral hazard problems was to engage in tough negotiations with the banks that needed support and to enforce the principle that losses were to be covered in the first place with the capital provided by shareholders.

2. The provision of a separate authorities — uninfluenced by political considerations — for the administration of bank guarantees on the one side and of liquidating assets on the other side.
   

   Banks applying for support had their assets valued by the Bank Support Authority, using uniform criteria. The banks were then divided into categories, depending on whether they were judged to have only temporary problems as opposed to no prospect of becoming viable. Knowledge of the appropriate procedures was built up by degrees, not least with the assistance of people with experience of banking problems in other countries.

3. Decision whether
   1. (a) to defer reporting losses for as long as possible, using current income for a gradual writedown of any loss making assets. This is what low short-term rates and a steep yield curve help do.
      

      One advantage of this method is that it helps to avoid the bank being forced to massive sales of assets at prices below long run market values. A serious disadvantage is that the method presupposes that the bank problems can be resolved relatively quickly; otherwise the difficulties compound, leading to much greater problems when they ultimately materialise. The handling of problems among savings and loan institution in the United States in the 1980s is a case in point.

      or

   2. (b) to have the government supervising authority take account of all expected losses and writedowns early, clarifying the extent of problems and support needed
      

      It entails a risk of creating an exaggerated perception of the magnitude of the problems, for instance if real estate that has been taken over at unduly cautiously estimated values in a market that is temporarily depressed. This can lead, for instance, to borrowers in temporary difficulties being forced to accept harsher terms, which in turn can result in payments being suspended.

The Swedes went with Plan 3b.

I concluded my post in August saying:

This is an immense task that the Swedes took on. There entire banking system was effectively insolvent. Yet, they were able to fashion a workout scheme that had bi-partisan political support, did not unfairly reward shareholders, dealt with moral hazard, separated regulatory and workout roles so as to reduce conflicts of interest, and that quickly wrote down valuations and liquidated the bad debts as opposed to dragging the process out. The Swedish authorities should be especially commended for dealing with the liquidity and solvency concerns simultaneously, while keeping moral hazard to a minimum.

The United States needs this plan now, not tomorrow. Allowing more firms to fail without a comprehensive workout plan in place is another sign of the laissez-faire regulatory attitude that got us in this predicament and is the height of irresponsibility. Congress, the President, the U.S. Treasury, the SEC and the Federal Reserve need to do their jobs and act now or the United States may suffer a very nasty case of debt deflation.

Source
The Swedish Experience, Riksbankschef Urban Bäckström, Federal Reserve Symposium, 27 Aug 1997