Friday, October 17, 2008

Why Lehman mattered

Read my post on the 1934 Act first… this will not mean much to you unless you have done so… and after that get ready for some seriously wonky stuff…

I was chit-chatting with a very prominent NYC financial journalist the other day and gave him the accepted view – which is that the decision to let Lehman fail was a big mistake. 

He asked quickly and fairly why it was a big mistake. 

I had to confess that I did not know.  Just the facts on the ground since that decision have confirmed that it was a mistake.  That hardly seemed satisfactory to me or to him.

At the time of the decision I thought that whilst the decision was risky Paulson had made the correct call.  Lehman was – he thought and I thought – just not important enough.  I blogged about constructive uncertainty and unfortunately I was wrong.

Krugman (who I admire almost to the point of idol worship even though I think he wrong often) had an editorial in the New York Times which said that Paulson was playing with a loaded gun – but Krugman was not then prepared to call it a mistake (though he has since).   (Score Krugman 1, me 0).

But I now I think I know why letting Lehman fail was a mistake.  It was the absence of suitable broker-dealer regulation in the UK. 

The 1934 Securities Act was written with recent memory of what it means for a major broker-dealer to fail.  Indeed legislators were so scared of this they enacted two pieces of legislation – the first ring fenced the broker deal from all the other business of the broker (the 1934 Act) and the second (Glass Steagall) prohibited combining any of it with a conventional bank. 

It turns out I think that the Great Depression double-separation was overkill – and you could do without the Glass Steagall legislation.  But you could not do without the 1934 Act. 

Anyway Lehman had lots of assets pledged to its European broker dealer which they could in turn repledge to finance client business (as would be possible in the US) and to finance their own business (which would not be possible in the US).  As Lehman’s own business became stretched the UK broker dealer repledged more and more client assets to keep Lehman alive.  This eventually made the UK hedge funds (and the European operations of many US hedge funds) unsecured creditors of Lehman.

Now it turns out that many of the most levered books were resident in the UK.  Why?  Because the UK had eschewed many capital controls of the type favoured in Great Depression legislation.  Lehman’s own UK book was similarly levered.

Lehman UK behaved appallingly pledging pretty well the entire UK client asset base and sending big cheques back to NYC. 

Several hedge funds (notably led by Harbinger) are trying to investigate these transactions and have made requests to the US bankruptcy judge to force Lehman to hand over the details.  I guess the issue is fraudulent conveyance.  Lehman has asked the bankruptcy judge to deny the request for administrative reasons.  The bankruptcy judge should force Lehman to hand over the documents, but being Southern District of NY (the most creditor friendly bankruptcy jurisdiction in the world) Lehman will probably get its way.  A prosecutor looking for indictments should probably look here too…

But let’s see it as it now is.  The assets and liabilities of these highly levered hedge funds became assets and liabilities of Lehman in bankruptcy.  [The entire books effectively were hocked to Lehman creditors…]  The leverage had to come off – and fast.

And so what the Lehman bankruptcy did was trigger waves of delivering – and it did it through the mechanism of UK broker-dealer.

The European trade de-jour – run at high leverage through the UK Broker Dealer was long Porsche, short Volkswagen.  Porsche (a very fine company indeed) owns a very large amount of Volkswagen (read General Motors for Europe).  Indeed Porsche owns several times its market cap in VW stock.   It was a trade everyone had on.  And the more leveraged a player the more they had on – and they had it on in London because it was (a) European, and (b) favoured by people with leverage.

And so – after the Lehman bankruptcy – this trade exploded.  VW went up every day – Porsche went down and the ratios became totally absurd.  Go look – either Porsche is absurdly cheap or VW is absurdly expensive or both.  Anyone that believes in the rational market hypothesis (and there are plenty of them out there) would have a real problem with this data as there is no way the movement is explained by rational valuation… 

Anyway Porsche Volkswagen example of massive deleveraging – but it was perhaps the most spectacular.  It happened across the board – and anyone who was levered to anything that looked like an obvious position had their backsides thrashed following Lehman.  It did not matter if they were housed at Goldman Sachs because enough people would have had the position on at Lehman London to get market prices to administer the thrashing. 

There was a day when high short interest stocks started rising in a falling market for no reason.  Almost all high short interest stocks.  Why?  My guess is because someone at Lehman London was short them and Lehman started covering the positions in bankruptcy.  The move was big enough to destroy some levered players.  But it also happened to stocks into which people were levered long. 

Soon delivering took on its own dynamic because people who were housed way-away from Lehman but were still over-levered got themselves in the vortex. 

Finally the redemptions are coming – and if you were not over-levered before the redemptions you can be over-levered after them.  Redemptions have their own dynamic.

The leverage of course was not only in equity markets – leverage is much more pronounced in debt markets because debt markets typically only have a couple of points of spread and you need to lever that seven to twenty times to get a reasonable ROE.  Moreover Lehman was always primarily a debt house, not an equity house – and the debt-arb funds were far-more-likely to be housed at Lehman than the equity guys…

The deleveraging of debt markets following the Lehman failure left everyone (maybe except Uncle Warren) hoarding cash.  [It also ran the Federal Reserve out of balance sheet in a single day – something that I will come back to in a later post…]

Lehman’s failure cracked this market – and it did so because the UK lacked the basic depression era legislation (the 1934 Act) and had encouraged reckless leverage by reducing capital requirements to low levels. 

It was the failures of London that made Paulson’s decision wrong.  I didn’t see it at the time – and nor did he.  However I have never been CEO of a broker-dealer – and Paulson has.  So one bad mark for me and three for him.  I keep score…

 

 

John

PS.  I should tell you what the German take is on Volkswagen and Porsche… a surprising number think it is reasonable that Porsche trades so cheap because the arb is between a voting stock and a non-voting stock – and being Germans they have seen non-voters ripped off shamelessly in the past – so it is reasonable to discount Porsche massively.  They do think that Volkswagen is over-priced but as there are already so many people on the trade it is an expensive stock to borrow and hence hard to short.  The problem with this argument is that it was just as true when the spreads were a third as attractive as now.  The market remains irrational – but it might be irrational for rational reasons.  

PPS.  This is a good summary of the legal issues as they are now...   http://www.iht.com/articles/ap/2008/10/16/business/NA-US-Lehman-Brothers-Bankruptcy.php

27 comments:

Anonymous said...

Tangential to your post, but your comment on leverage increasing strikes a chord. We're not really seeing leverage decreasing anywhere, are we?

Blank Xavier said...

> Lehman’s failure cracked this
> market – and it did so because the
> UK lacked the basic depression era
> legislation (the 1934 Act) and had
> encouraged reckless leverage by
> reducing capital requirements to
> low levels.

From the free market/small Government POV, it happened because Lehmen wrote a contract which permitted them to repledge to their own business and clients read that contract and accepted it.

RC said...

Another outstanding post. Keep it up!

Anonymous said...

Sorry, John, just to be clear. You are saying that if a Fund in New York has Lehman Brothers Inc. (New York) as its prime broker, then the prime brokerage agreement allows Lehman New York not just to repledge those securities to Lehman London against intercompany exposure, but that London can then repo them out on its own account? Why on earth would anyone sign a prime brokerage agreement like that?

Anonymous said...

I'd have to say the best action so far has been letting Lehman fail.

As an observer of the historic credit bubble (valiant non-conformists like Doug Noland opened some our eyes early), I felt the number one priority was to expose the ponzi scheme. Only if everyone knows the problem can it be fixed. Without the Lehman blowup, most of us would still be living in a fantasy world.

MW said...

It was a bad idea to let LEH fail because: money markets held $bns of LEH debt; the default led to them breaking the buck; that in turn led to massive outflows from prime funds into govy funds and a broader flight-to-quality.

That said, your points are excellent and much less obvious.

John Hempton said...

"Sorry, John, just to be clear. You are saying that if a Fund in New York has Lehman Brothers Inc. (New York) as its prime broker, then the prime brokerage agreement allows Lehman New York not just to repledge those securities to Lehman London against intercompany exposure, but that London can then repo them out on its own account?"

No - you were alright ONLY if your relationship was with America. If your relationship was with Lodnon you were stuffed.

But if you held the same positions someone who had a big relationship with London held you had a very rough time because the London positions became forced covers for Lehman in bankruptcy.

John Hempton said...

It was a bad idea to let LEH fail because: money markets held $bns of LEH debt; the default led to them breaking the buck; that in turn led to massive outflows from prime funds into govy funds and a broader flight-to-quality.

[--

That has to be wrong. If it was a few money market funds going to 97c (which is what happened in the worst case) it would not have caused this sort of meltdown.

---

To the market fundamentalists who think that letting Lehman fail was the best thing to happen so far - then - well you got ideology ahead of common sense.

Since then the US Government has taken on trillions in conditional liabilities. The facts on the ground simply do not support your view.

I would put this up there with the creationists. Fossil rabbits in the precambrian and all that...

Roger Bigod said...

You are of course correct that letting Lehman fail was a big mistake. They had the example of Bear Stearns, in which the system recovered fairly quickly after a going wobbly on us for a few days.

The irony here is that the Depression Era legislation in the US was ostensibly to protect small savers and investers. Hedge funds were later exempted on the theory that the rich understand the risks, or can pay for advisers who do. It's a mystery why the hedgies walked off this cliff, given the rumors about Lehman's shakiness. People who run billions in assets are supposed to read the fine print.

John Haskell said...

John-

I'm very sorry to learn that so many "sophisticated investors" signed agreements with a 30 to 1 levered entity that would result in their implosion if that 30 to 1 levered entity were to fail.

I agree with you that the US taxpayer should pay up $135 billion (difference between LEH's assets and liabilities) so that these sophisticated, levered, unregulated investors do not suffer any negative consequences.

I understand that $135 billion would probably provide health care for 12 months for every uninsured American, but I guess you gotta make priorities, right?

John Hempton said...

John Haskell's comment bears notice.

I do not give a stuff about the losses of hedge funds. I do give a very big stuff about what the consequences of a world where banks will not lend ANY money are. They are a great depression.

Iceland is about to experience mass prostitution for hard currency. That offends people when I say it - but their offense does not make it any less true.

If you stuff up your macro-economics them is the consequence. This matters.

---

135 billion would be a small amount to pay to stop it. If that were it.

As for health care. Its more expensive than that. Look in percent of GDP spent on medicine now...

J

Blank Xavier said...

John wrote:
> If you stuff up your macro-
> economics them is the consequence.
> This matters.

Amen to that. This is why I'm so devoutly passionate about free markets. We avoid starvation and poverty because we have a functioning economy. It is the source of our wealth. It's so absolutely vitally important to run the economy efficiency and that's why I hate Governments so much. Tax, tax, tax, tax, tax and more tax. Tax is to the economy what kryptonite is to superman.

Don said...

Surely the problem was that investors were expecting a bailout? After all, it was the government's not taking action that caused the panic, not the underlying conditions. They were there the day before.

Don the libertarian Democrat

Anonymous said...

The porsche price is crazy. Do you own the company?

David Einhorn mentions in his latest letter that greenlight holds porsche stock and that its current market cap is less than the price of its volkswagen holdings.

Anonymous said...

"I do not give a stuff about the losses of hedge funds."

If it's not obvious to you, it is obvious to others that many IBs and hedging funds were trading on -- and profiting from -- the guarantee of a government bailout. We would never have gotten to where we are today without the "Lehman is too big to fail" dynamic.

The truth is that what needs to be protected is the commercial banking system. All of high finance can fail -- with firms going back to pleading with banks for loans. As long as we don't have runs on deposits, the world will not end.

Yes, the economy will suffer for several years due to deleveraging, but this is inevitable no matter what the government does because the "too big to fail" guarantee generated too much leverage.

You need to explain how propping up bankrupt firms like Lehman (paying only 10% on its bonds!)could possibly work to heal the financial system -- instead of prolonging its misery.

(Iceland is a sorry case, but the solution is surely government to government support, not efforts to prop up a defunct financial system.)

MW said...

"Surely the problem was that investors were expecting a bailout?"

I believe that was PIMCO's rationale for selling protection on LEH.

williambanzai7 said...

As painful as all of this is, we will all be better off in the long term. The financial services industry completely lost touch with reality. I don't know how you can explain this otherwise.

The problem with the bailouts is that many or if not most of the people responsible for this are still employed in the industry.

As for the 34 Act. I am sure there was plenty of pressure to avoid tightened regulation in London in order to induce Lehman et al to bulk up in Canary Wharf. You reap what you sow.

As for Bernanke and Paulson, they are riding a tiger.

Nice Post

CrocodileChuck said...

Paul Dirac said that the mark of an intelligent mind was holding two contradictory ideas of something in one's mind-at once.

The data in terms of cost:benefit makes John's point inarguable

But Anon of 7:22 pm has a point-how CAN we be frightened of these massive financial structures and their attendant risks if we can't see into 'Extremistan', as Taleb would put it?

CrocodileChuck

Dirac:
http://en.wikipedia.org/wiki/Paul_Dirac

anon 9:19 said...

"The data in terms of cost:benefit makes John's point inarguable"

This attitude really irritates me. Of course, letting Lehman fail has huge costs. The problem is that there no evidence whatsoever that bailing Lehman out would do anything but delay these costs -- and possibly make them even bigger.

YOu guys need to put together a coherent argument to defend your point of view. Are you imagining that it is possible for our governments to manage a one-by-one bailout of the entire financial system without dropping the whole structure with a huge crash at some point.

The government tried to implement your sequential bailout strategy for a full year -- and the situation only go worse and worse. It seems to me that you folks are living in Never-never land.

Anonymous said...

> From the free market/small Government POV, it happened because Lehmen wrote a contract which permitted them to repledge to their own business and clients read that contract and accepted it.

Except even those clients who had segregated accounts without rehypothecation (presumably paying extra for this) find themselves facing a best-case scenario of waiting several months before they can hope to retrieve their assets (see FT for instance), because of the incredible complexity of untangling Lehman's affairs. It's not clear that they could have anticipated this situation from reading their contract.

Anonymous said...

Porsche/ VW relationship explained on FT Alphaville:

http://ftalphaville.ft.com/blog/2008/10/17/17150/porsche-llc-the-vw-fruit-machine-explained/

fredw said...

John , I disagree with your premise that the decision to allow LEH to fail was a "mistake." Prior to LEH was allowed to go into BK by the Treasury Department and the FED , Paulson was explicitly warned by Christine LaGarde ( French Finance Minister - per 10/17/08 Telegraph article ) , to bailout LEH or face global collapse. That warning was ignored. As a former Head of Goldman , Paulson had to aware of the consequences for the CDS markets , interbank market and credit markets in general , as well as counterparty risks inherent in letting LEH fall. One must consider ( in light of the TARP plan which had already been prepared months beforehand ) , that the decision to let LEH fall was intentional malfeasance , not mere nonfeasance or an ill-informed mistake. If we consider LEH tragic fall as an intentional act , a financial 911 , then we must look at the recent events since LEH's collapse differently.

Blank Xavier said...

> Except even those clients who
> had segregated accounts without
> rehypothecation (presumably
> paying extra for this)

Or to put it in a better way,
paying the normal price for sane
behaviour, as opposed to receiving
a discount for taking crazy risks.

> find themselves facing a
> best-case scenario of waiting
> several months before they can
> hope to retrieve their assets
> (see FT for instance), because
> of the incredible complexity of
> untangling Lehman's affairs.

True enough, I have no doubt,
but this is an entirely different
matter to that of whether or not
clients accepted crazy terms in
their contract.

Clients I'm sure had an
expectation of reasonably
prompt return of their
assets. However, I get the
feeling from what has been
written that this was not
present in the contract.

If it was not present, then
Lehman acted within the bounds
of the signed contract. What
they did - permitting their
internal arrangements to become
so complex that timely return
was impossible - was bad,
bordering perhaps unethical,
but they didn't break their
contract.

If OTOH the contract specified
timely return and this has
turned out to be imposible,
the people responsible for this
need to be prosecuted.

A problem I suspect is that
people signing those contracts
didn't really believe Lehmen
could ever fail, so they were
not diligent. This was their
mistake and they - rightfully -
bear the consequences.

> It's not clear that they could
> have anticipated this situation
> from reading their contract.

They could have, by inserting
a clause specifying timely return
and what timely means.

They perhaps didn't think it
would be necessary. They were
wrong. Lehmen ought to have
behaved anyway in a decent
fashion and ensured return
would be possible in a timely
manner, but Lehmen as we know
behaved in questionable ways
towards the end. However, they
do not appear to have broken
their contractual agreements.

Main conclusion from all this?
take contracts seriously. Make
sure they're simple enough that
you really can understand them
and that they cover your assets
in straightforward, unambigious
terms.

3rdWorldThinker said...

Great post. Thx for the perspective on Britain’s flawed regulatory system.

I also felt strongly that the FED needed to support Lehman and prevent the Firm's collapse. The fact that they allowed LEH to implode in a heap of financial dust is mind-boggling. In my less complicated writing/blog [ www.tbmw.blogspot.com ] I hinted at the fact that it was probably something more sinister, more devious, more “Wall St like”, that led Paulson & Co to K.O. "The Brothers", and prop up his G-Men. All this theoretical, Darwinian "dog-chow" that nuking Lehman was necessary is totally absurd, and shows a lack of commonsense and understanding of the complexities of the Capital Markets today.

As my blog indicated, the FED should've "helped" out Lehman, to buy the World "TIME" for these massive CDS contracts to lapse or un-wind, since most of the default swaps are short-term... In no time the CDS market would've shrunk, and the implosions can begin, without continuous reverberations. This lack of insight by Treasury shows either they didn’t fully understand the structure of the CDS market, and fell victim to the Delta Hedging financial models, or Paulson wanted to administer an “upper-cut” to G.S. competitors - instead in leveled us!

Per Kurowski said...

In a truly free market this particular financial crisis would never have happened.

I am not against regulations but when looking at how to re-regulate the financial markets after this crisis it really behooves us all to acknowledge the fact that in a really free financial market this particular financial crisis would never have happened.

In a free financial market there would have been no official endorsement of the illusion of safety like the one generated by the bank regulators when they created the minimum capital requirements for banks based on risk and that led many to believe that, as far as the risks goes, the banks had been equalized. And of course neither would the market have suffered the distortions that originated in the regulatory arbitrage of these capital requirements.

In a free financial market no one would have given so much credibility to some few credit rating agencies paid by the issuers of debt and therefore there would have been no opportunity to peddle in the market such an extraordinary amount of such extraordinary lousy awarded mortgages to the subprime sector.

Per Kurowski

PS. The September 2008 issue of Euromoney quotes Georges Pauget the CEO of Crédit Agricole saying “Now if you go back over the decisions that were taken, and the context within which they were taken I have to say that, even with the benefit of hindsight they appear rational. We took triple-A-rated assets, reinsured with triple-A-guarantors and concluded that they carried zero risk”

http://teawithft.blogspot.com/
http://perkurowski.blogspot.com/
http://www.subprimeregulations.blogspot.com/

Anon 9:19 said...

In defense of Paulson (even though I too have some doubts about his motives), I think it needs to be acknowledged (tomorrow at least -- hopefully I won't eat my words) that the CDS market has handled Lehman very well.

It is entirely possible that the regulators thought they bailed out Bear in order to protect the CDS and repo markets (as reported by the FT). Both of those markets probably could have handled the Lehman failure well -- if it weren't for the money market fund default.

The commercial paper market we have now is fundamentally unstable. A 19th c. central banker would never have allowed it to develop since it is based on "fictitious paper".

Blake said...

Hi John - again thanks for the Blog - always a great read. I am just wondering on VW. This trade has probably been one of the greatest shorts for hedge funds in recent years ... and presumably one of the biggest disasters. The unwind must be causing the odd hedge fund explosion. More forced deleveraging to come?

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