14 September 2008

Shadow Banking Collapse

It is now clear that we are again – as we were in mid- March at the time of the Bear Stearns collapse – an epsilon away from a generalized run on most of the shadow banking system, especially the other major independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley, Goldman Sachs). If Lehman does not find a buyer over the weekend and the counterparties of Lehman withdraw their credit lines on Monday (as they all will in the absence of a deal) you will have not only a collapse of Lehman but also the beginning of a run on the other independent broker dealers (Merrill Lynch first but also in sequence Goldman Sachs and Morgan Stanley and possibly even those broker dealers that are part of a larger commercial bank, I.e. JP Morgan and Citigroup). Then this run would lead to a massive systemic meltdown of the financial system. That is the reason why the Fed has convened in emergency meetings the heads of all major Wall Street firms on Friday and again today to convince them not to pull the plug on Lehman and maintain their exposure to this distressed broker dealer.

Let me elaborate in much detail on these issues…

This bail-in of investors is the opposite of a bailout of investors like the one that was done in the case of Bear Stearns and Fannie and Freddie. It is thus akin to the bail-in of investors that was done in the case of LTCM in the summer of 1998 and the bail-in of the interbank creditors of Korean banks in the winter of 1997. I wrote in 2004 with Brad Setser an entire book titled “Bailouts versus Bailins: Responding to Financial Crises in Emerging Markets” that discusses these policy tradeoffs in financial crises where you have runs on the liquid liabilities of either illiquid and/or insolvent countries. Those were the international equivalent of the banks runs and financial crises that we are now seeing in the cases of Bear Stearns, Lehman and Fannie and Freddie.

Since government bailouts put at risk public money and create moral hazard Treasury and the Fed decided that they need to draw a line somewhere after the bailouts of Bear Stearns creditors, of Fannie and Freddie and all the other actions aimed at backstopping the financial system. These actions have included the creation of the TAF, TSLF, PDCF, the use of the FHLBs to provide liquidity to distressed mortgage lenders, the provision of Treasury liquidity to the FHLBs, the outright purchase of agency MBS by the Treasury, the swapping of two thirds of the safe Treasuries of the Fed for toxic illiquid securities of banks and non banks, etc. So after having created the mother of all moral hazard with their actions (including the biggest bailout of all, i.e. the rescue of Fannie and Freddie) the Fed and Treasury are playing a chicken game with the financial system. Tim Geithner told clearly to the heads of all the major Wall Street firms that if they pull the plug on Lehman and Lehman collapses they are next in line for a run on their institutions. So if a buyer for Lehman is not found (or even if it is found and the counterparty lines are still pulled) not only Lehman will collapse but the run will extend to all of the other major broker dealers and banks that are the counterparties of Lehman.

The Fed may delude itself in thinking – as its stress models suggest – that the systemic risk of a collapse of Lehman are less serious than those of Bear Stearns: afterall Lehman is less involved into CDSs than Bear was and now both Lehman and the other major broker dealers have access to the discount window with the PDCF. A collapse of Lehman instead will have as much of a systemic effect as the collapse of Bear for many reasons: Lehman is larger than Bear was; Lehman is a major player in a variety of key financial markets; all the other major Wall Street institutions are interconnected with Lehman in dozens of different types of counterparty activities; the PDCF support of the Fed is neither unlimited nor unconditional, i.e. investors cannot assume that Lehman or any other broker dealer can borrow unlimited amounts with no conditions from the discount window. Thus, a collapse of Lehman would trigger a panic and a potential run on all sort of other broker dealers and also on other distressed financial institutions like banks (WaMu) and insurance companies (AIG) and smaller member of the shadow financial system (distressed and highly leveraged hedge funds, etc.).

The reason why Lehman is having a hard time to find a buyer is that it is most likely insolvent. If you had to mark to market the value of it illiquid and toxic assets (the $40 billion of commercial real estate assets, its remaining residential MBS and CDOs, its holdings of real estate private equity funds) Lehman is most likely insolvent (i.e. has negative net worth with liabilities well above its impaired assets). So leaving aside the potential and now dubious value of its franchise (an option to the value of a much slimmed down financial institution) no financial institution should be paying even a single penny to buy an insolvent firm. That is why all the potential suitors of Lehman (such as Bank of America and others) are waiting for the government to provide another sleazy Bear Stearns deal where the government would buy at higher than market value the toxic assets of Lehman (the commercial real estate assets for example) so as to make the net worth of the remaining institution positive and worth buying. But such action – borderline illegal in the case of Bear as pointed out by Paul Volcker – would be a scandal in the case of Lehman and severely exacerbate the moral hazard problem.

But here lies the conundrum of this Lehman crisis: no one seems to want to buy for a positive price Lehman unless there is a public subsidy (taking off their toxic assets off the firms' balance sheet). The government cannot afford to provide the subsidy as the moral hazard problems are becoming severe. But then if on Monday no deal is done Lehman collapses and goes into Chapter 11 court and you have the beginning of a systemic financial meltdown as the run on the other broker dealers will start. Thus, what Fed and Treasury are trying to do this weekend is another 1998 LTCM bailin or Korea 1997 bailin, i.e. trying to convince all the major institutions to either support a purchase of Lehman or maintain their exposure to Lehman if no buyers is found. Can this bail-in work? It is not clear as there is a major collective action problem: you can't only convince half a dozen major Wall Street firms to maintain their exposure to Lehman. You need also to convince all the other counterparties of Lehman (including the hedge funds and the other broker dealers and banks) not to roll off their claims and credit to Lehman. This is a much more messy collective action problem and coordination game than in the case of LTCM and Korea where the number of involved counterparties was more limited (less than 20 in each case).

Paulson and Bernanke and Geithner (the troika managing this financial crisis) have all made public statements in the last few month to the necessity of finding an orderly way to close down – rather than bailout – a major and systemically important non bank financial institutions: the embarrassment and losses for the Fed that the bailout of the creditors of Bear led made it paramount to avoid another Bear like bailout. That is why they are now playing tough with Lehman and its creditors. But in this game of chicken the Fed and the Treasury may end up being the ones to blink. Faced with the risk of a generalized run on the other broker dealers they may decide that greasing again a deal for the purchase of Lehman may be less costly and less risky than testing whether the system can orderly work out a collapse of Lehman (something that is highly uncertain). Even in the case of the Bank of America purchase of Countrywide such public subsidy was significant (the FHLB of Atlanta lent to Countrywide over $50 billion and Bank of America has most likely received plenty of tacit forbearance from the Fed to support its takeover of an insolvent Countrywide). So implicitly or explicitly the Fed and the Treasury may decide – however reckless and moral hazard laden that choice may be – to provide some explicit or implicit subsidy to a private purchase of Lehman.

The trouble is that, in spite of all public statements regarding the need to provide an orderly demise of large broker dealers, the Fed and the Treasury have done nothing to create such insolvency regime for such broker dealers. So the only option for Lehman – if a buyer is not found - will be the one of ending up in Chapter 11 and trigger massive losses on its counterparties that will in turn trigger a run on such counterparties.

In February of 2008 I predicted – in my “12 Steps to a Financial Disaster” – that one or two major broker dealers would go bankrupt. A month later Bear Stearns went bust and the collapse of the other ones was avoided for a time by the most radical change in monetary policy since the Great Depression, i.e. the creation of the PDCF that extended the lender of last resort (LOLR) role of the Fed to non-bank systemically important broker dealers (i.e. all of the bank and non bank primary dealers of the Fed).

I next argued in June that such action would not prevent a run on other broker dealers such Lehman as to avoid a run you need both deposit insurance and unlimited and unconditional access to the Fed LOLR support. I also discussed why Lehman was next in line for a collapse and why the PDCF would not prevent a run on Lehman.

I also argued in follow-up pieces that, in a matter of two years, no one of the remaining independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley and Goldman Sachs) would survive as: 1. their business model is now impaired (securitization is semi-dead); 2. they will need to be regulated like banks given the PDCF support and thus have lower leverage, higher liquidity and more capital that will erode their profitability; 3. Their severe maturity mismatch – borrowing very short term and liquid, leveraging a lot and lending and investing in more long term and illiquid ways – makes them very fragile – in the absence of deposit insurance and in the presence of only limited LOLR support by a central bank – to bank like run that are destructive even of illiquid but otherwise solvent institutions. Thus all such broker dealers need to merge with larger financial institutions that have a commercial banking arm and thus access to stable and insured deposits and to true LOLR Fed support. That process of unraveling of independent broker dealers started with Bear Stearns; now it is moved to Lehman; tomorrow Merrill Lynch will be on line; and Morgan Stanley and Goldman Sachs will be next. No one of them can and will survive as independent entities. So, the Fed and Treasury should advise them all to start finding a large international partner (international as almost no domestic partner is now sound to take them over) and merge with such partner before we get another Bear or Lehman disaster.

The step by step, ad hoc and non-holistic approach of Fed and Treasury to crisis management has been a failure so far as plugging and filling one hole at the time is useless when the entire system of levies is collapsing in the perfect financial storm of the century. A much more radical, holistic and systemic approach to crisis management is now necessary.

What we are facing now if the beginning of the unraveling and collapse of the entire shadow financial system, a system of institutions (broker dealers, hedge funds, private equity funds, SIVs, conduits, etc.) that look like banks (as they borrow short, are highly leveraged and lend and invest long and in illiquid ways) and thus are highly vulnerable to bank like runs; but unlike banks they are not properly regulated and supervised, they don't have access to deposit insurance and don't have access to the lender of last resort support of the central bank (with now only a small group of them having access to the limited and conditional and thus fragile support of the Fed). So no wonder that this shadow banking system is now collapsing. The entire conduits/SIV system has already collapsed with the roll-off of their ABCP financing; next is the collapse of the broker dealers (Bear, Lehman and soon enough the other ones) that rely mostly on unstable overnight repos and other very short term funding for their financing; next will be hundreds of poorly managed hedge funds that will face a tsunami of redemptions; and finally runs on money market funds that are not supported by a large financial institutions or other smaller member of the shadow banking system as well as highly leveraged and distressed private equity funds cannot be ruled out either.

This is indeed the most severe financial crisis since the Great Depression and occurring at a time when the US is falling in a now severe consumer led recession. The vicious interaction between a systemic financial and banking crisis and a severe economic contraction will get much worse before there is any bottom to it. We are only in the third inning of a nine innings economic and financial crisis. And the only light at the end of the tunnel is the one of the incoming train wreck.

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