Felix Salmon

John Gapper has the first best Lehman post-mortem:

Fuld never changed, not really. He was still the same dark, obstinate Lehman loyalist that he had always been – a man who never wanted his firm to be sold. And, in the end, Mr Fuld’s pride and obstinacy stood in the way of Lehman’s desperate efforts in the past half year to right itself…

He had devoted so much of his life and his personality into moulding the bank he could not accept its decline. If he had sold out earlier, Lehman might have survived but he was too proud. It was hubris, followed by nemesis.

Gapper’s right: the fate of 24,000 Lehman employees lies on Fuld’s broad shoulders. This credit crunch is a category-4 hurricane, and Fuld is the idiot who decided to hold his ground rather than evacuating and living to fight another day. Now his 158-year-old house has been destroyed. It’s sad, yes — but it’s also tragic.

As markets start to open in Asia, there’s still no real clarity on what on earth is going on with Lehman Brothers. But the base-case scenario at this point is bankruptcy: ISDA’s been netting derivatives transactions for four hours of Sunday afternoon, trying to minimize Lehman’s counterparty risk in the event it goes bust, and the BBC is reporting that PWC has been lined up to run Lehman’s UK operations under the same scenario.

Mohamed El-Erian isn’t sugar-coating anything:

"This is an extremely, and I stress extremely, rare event. It also speaks to the more general notion that, in today’s highly disrupted financial markets, the unthinkable is thinkable," said Mohamed El-Erian, the chief executive of Pimco, the world’s biggest bond fund, based in Newport Beach, California.

Wall Street is already one step ahead: Lehman’s bankruptcy would make Merrill Lynch’s position extremely precarious, so Merrill seems to be stepping gratefully into the welcoming arms of Bank of America. Meanwhile, AIG is lining up an emergency capital-raising, in the hope that an extra $10 billion or so will give the market some confidence in its solvency.

Would a bankruptcy be Chapter 11 or Chapter 7? There’s even less clarity on that, but my feeling is that it would be both: the brokerage units would file Chapter 7 and liquidate, while the holding company would file Chapter 11. In any event, things would surely get pretty messy for a while, and given the ability of financial markets over the past year to go from bad to worse, Paulson and Geithner are definitely risking a serious meltdown here.

That said, a meltdown would benefit no one, and Wall Street has every incentive to avoid it — as we’re seeing in the shotgun marriage of Merill and BofA. If people can keep their heads through the end of the week, this could turn out to be Wall Street’s finest hour since John Pierpont Morgan used his own money to save the day during the panic of 1907.

It’s a fluid situation, of course, as all the news stories are at pains to point out. But right now it looks like the best-case scenario is that Lehman goes bankrupt, with the rest of Wall Street playing a generally supportive role. And the worst-case scenario? You don’t want to go there.

Update: Yes, it’s bankruptcy, and liquidation, for Lehman.

There’s a lot of sympathy for Lehman Brothers today — a lot more sympathy than there ever was for Bear Stearns. Dick Fuld might not be the friendliest chap on Wall Street, but his shop is well-liked and well respected: there will be sadness when it no longer exists in its present form.

But although Lehman’s demise is sad, that doesn’t mean that the US government should step in to prevent it, and it also doesn’t mean that it shouldn’t happen, in some kind of normative sense. Indeed, the death of Lehman could be systemically helpful if it shows that the markets can survive a financial collapse without government cash shoring things up. Or that’s my point of view, anyway. Dear John Thain has the opposite opinion: here’s an IM conversation we had this morning.

DearJohnThain:

quick question … have you seen anywhere what is actually causing this shotgun wedding for Lehman?

Felix Salmon:

two words: share price

DearJohnThain: Doesn’t make sense to me.

Bear, at least, was about to be insolvent…

Felix Salmon:

what doesn’t make sense? why the share price is falling, or why a falling share price makes Lehman untenable?

DearJohnThain:

the latter

Felix Salmon:

because counterparties will stop doing business with Lehman, and the ratings agencies will downgrade

which of course for a bank is the kiss of death

DearJohnThain: Argh. Seems so …. "self fulfilling" … shouldn’t be this way

Felix Salmon:

all levered institutions rely on confidence

"credit" comes from the Latin "to trust"

without trust and confidence, no bank can survive

DearJohnThain:

Seems like, in this scenario, Treasury and the Fed should be able to step in and do something to show confidence … like guarentee a loan to Lehman

Felix Salmon:

why? so that Lehman can survive?

the survival of any individual bank should never be systemically necessary

DearJohnThain:

To leep the system stable

Felix Salmon:

why is a world with lehman more stable than a world without lehman?

DearJohnThain:

I agree that trust is a big piece… but it’s a chicken and egg problem here… Share price is falling because people don’t trust them and people don’t trust them because they see the share price keep falling…

Felix Salmon:

right

DearJohnThain:

So, what if this is being driven by shorts or rumors…

Felix Salmon:

capitalism needs bank failures occasionally, to punish institutions which lend $30 billion to commercial real estate at the top of the bubble

if you overlever yourself and make bad investments, you become susceptible to shorts and rumors, yes. That’s a good reason not to overlever yourself.

DearJohnThain: Or just people selling out because of skittishness

That’s an unstable system.

Felix Salmon:

the system should be unstable. it doesn’t exist to perpetuate banks, it exists to efficiently allocate capital.

DearJohnThain: Someone with trust should step in, make an objective call, and move on.

If they are indeed well capitalized, then they should be able to survive.

Felix Salmon:

The Fed and the Treasury have no responsibility to ensure that well capitalized banks survive

that’s not their job

DearJohnThain:

Well, if well capitalized banks can’t survive, then who can?

Felix Salmon:

transparent banks which can convince their counterparties and lenders that they’re solvent

DearJohnThain:

ehhh… seems inefficient that someone can believe you’re not solvent when you are and there’s no way to fix that

Felix Salmon:

it can be fixed ex ante, by not overlevering. It can be fixed if you’re really solvent by just selling the assets which people are worried about at a high price, if they’re really worth that much.

It’s not like Lehman didn’t have any warning. The credit crisis has been going on for over a year. They had every opportunity to derisk back at $65 a share, and they didn’t. Now they’re paying the price.

They knew full well that the more leveraged they were, the more likely they were to blow up. That was a risk they took with their eyes open.

DearJohnThain:

Well, they also took their precautions.

Felix Salmon: what precautions? Firing the CFO?

DearJohnThain:

They secured enough capital for a year…

and even raised plenty more to keep a cushion

they have 11% tier 1 capital now…

Felix Salmon:

it’s the asset side of the balance sheet that people are worried about, and they barely touched that

DearJohnThain:

I dunno… knowing that market, I just think it’s people trying to profit from their problems…

Felix Salmon:

This is Wall Street, of course there will always be people trying to profit from everything.

On Wall Street, profit is a good thing, remember?

DearJohnThain:

Something intellectually dishonest (and illegal) about profiting from something that is false and being perpetuated.

Felix Salmon:

There’s nothing intellectually dishonest or illegal about profiting from shorting LEH

The only thing which is illegal is spreading rumors about Lehman you know to be false

DearJohnThain:

Exactly.

Felix Salmon:

And there’s NO indication that anybody is doing that

DearJohnThain: And those "Lehman is going under rumors" started around the same time Bear did…

"Lehman is next."

Felix Salmon:

they were right!

DearJohnThain: Well, I would claim they were wrong if Lehman gets taken over and was never insolvent…

Or was never going to be insolvent without intervention

Felix Salmon:

Who knows if they’re insolvent? Lehman is a black box, no one knows what goes on inside

Jesse wrote about it back in March and none of those issues were ever really addressed

What are the risks of a systemic crash if Lehman Brothers is allowed to fail? As Sudeep Reddy says, Lehman is just as big and interconnected as Bear Stearns was:

Mr. Bernanke, testifying before Congress in July, outlined his three reasons for stepping in with Bear Stearns: One was the size of the firm and its implications for broader financial markets. Another was that financial infrastructure was not strong enough to protect against a failure in derivatives markets. The third was “extremely fragile” financial conditions.

Supporting the case for Fed action with Lehman: Most of those issues aren’t resolved today.

Yet the situation with Lehman is clearly not a re-run of Bear. Why not? That’s harder to answer. The main reason is that the Lehman unravelling has taken so long that everybody pretty much expects it to fail, at this point — and in the markets, if something is expected (a/k/a priced in), there’s generally little likelihood much chaos when it actually happens.

On the other hand, I suspect that although a bank failure might be priced in to the LEH share price, the same expectations have yet to percolate fully through the rest of the financial system. It’s easy for a stock market investor to anticipate a Lehman collapse: you just sell the shares. But what if you’re a widget manufacturer in Iowa whose treasurer has been doing a lot of business with Lehman’s derivative desk? Those positions are much harder to unwind. If you’re expecting a big payment next month on the interest-rate swap which Lehman wrote for you, what are you meant to do?

I would hope and expect that the New York Fed will somehow manage to backstop most of Lehman’s obligations to its counterparties, but given that nobody knows anything, it’s impossible to say for sure. There should be some way to keep the pure trading book functioning smoothly even if people who lent money directly to Lehman are forced to take a haircut. But it would be much easier for a big commercial bank to take over the entire Lehman Brothers operation — Bank of America seems to be the most likely contender, according to the WSJ.

Remember that when BofA took over Countrywide, it was careful not to guarantee Countrywide’s debt. It might be able to do something similar with Lehman: buy the bank, absorb its employees and traders, but then allow the subsidiary to default if it turns out to be insolvent.

That might be a desirable outcome from the point of view of the New York Fed, but I can’t see Ken Lewis being particularly keen on taking the reputation risk associated with such a move: no banker wants to default on his obligations, ever. It’ll be interesting to see whether Tim Geithner comes up with a clever way of twisting his arm.

Do you want to know what on earth is going on with Lehman Brothers, and with the whole financial sector more generally? Here’s some advice: go outside. Take a walk. Get some fresh air. Because nobody knows anything.

Today could quite possibly be the most rumorlicious in Wall Street history. Goldman’s buying Lehman! No it isn’t! The Fed’s going to cut rates between meetings! Maybe a private-equity shop can help! Interestingly, Lehman stock has not been particularly volatile today, trading in a band between $4 and $5 all day. (OK, that’s volatile on a percentage basis, but not on an absolute basis.) And the credit default swaps, too, seem to be keeping some grip on reality.

The fact is that anything could happen at this point, and the situation is very much up in the air. Lehman, with the help of the Fed, will probably muddle through today and tomorrow; I suspect that it won’t exist in its present form come Monday morning. But the range of possible outcomes for shareholders and bondholders is enormous, and anybody playing in Lehman securities right now is a gambler, not an investor.

If you think you know something, you’re wrong. Even Dick Fuld doesn’t know what’s going to happen: hell, he doesn’t even know if he’s going to have a job come Monday morning. Speculation and rumor can be fun, but they don’t really achieve anything. So go back to your day job, safe in the knowledge that the game will have played itself out within a week, tops.

Is "Lehman Crashing Again", in the words of Alea’s headline? The Lehman stock price reminds me of Zeno’s arrow: first it falls by half, and then by half again, and then by half again — and each time it’s "crashing". Quite impressive, really: a company can easily crash two or three times a week, at this rate.

Looking to the CDS rather than the increasingly-meaningless equity, John Jansen reports that "Lehman Brothers are wide but real at 750/800". I think that’s a more useful datapoint. The equity is already at zero (plus a little something for option value); if it falls further that makes little difference to the debt. And if you believe Michael Lewis, the moral hazard trade is still going strong:

This is one of the many unintended little side effects of the government bailout of Bear Stearns Cos.: to greatly reduce the interest of the people who do business with Lehman Brothers in the survival of Lehman Brothers…

After all, the Federal Reserve will give them their money back, re-insure their credit defaults, take another pile of these distressed assets out of the market.

We’ll see: I have a feeling that the NY Fed won’t be able to easily find a buyer for Lehman this time around, and that it won’t feel any great need to bail out the bank itself. A Lehman default would send shock waves through the financial system, to be sure — but if it happens slowly and with a lot of advance warning, those shock waves might not be substantially larger than some of the other events which Wall Street has weathered over the past 14 months.

Indeed, in a case of "that which doesn’t kill me makes me stronger", a Lehman default could actually be a good thing for the markets as a whole. If Lehman defaulted and the sun still rose the following morning, the single greatest fear of the markets — systemic meltdown following the collapse of a major intermediary — would be shown to be overblown. And that could trigger a major relief rally in credit.

Could Lehman Brothers be the first major default of the credit crisis? Portfolio.com has video of me saying yes!