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