Wall Street Lessons: DNA 18th September 2008

When a credit market gets overheated, governments and regulators must step in
Bear Sterns, Fannie Mae and Freddie Mac (and Northern Rock somewhere along the way), Lehman Brothers, Merrill Lynch and AIG are all big-sounding financial names which a year back inspired awe in the layman.
Today they are symbolic of what has gone wrong in an area where it seemed nothing could go wrong and whose impact stretches across the world. It involves not just the highly paid managers and other back-office employees, but also central banks and governments where everyone is involved and has to create new ideologies or break old ones to keep the system alive.
Lehman Brothers and Merrill Lynch have run large losses to the extent that one has filed for bankruptcy while the other has managed to find a buyer. This is a result of the fallout of the sub-prime crisis which claimed Bear Sterns and Northern Rock last year and hit the twins earlier this year. The story leading to this crisis was straightforward. While interest rates were lowered by the US Federal Reserve over the years, people borrowed like mad. Home loans were provided without due diligence and came to be called NINJA loans (no income no jobs no assets).
There was a property boom which sent prices upwards and cheap loans provided the enticements. These loans were bundled and securitised — a process where these loans are converted into securities (asset-backed securities) and resold in the market. This is where these investment banks stepped in.
These CDOs (collateralised debt obligations) fetched higher rates and the investment banks borrowed funds to invest in them. Once the rates started moving up, problems began. Home owners started defaulting. Simultaneously higher interest rates drove down the property prices and as indebted home owners left their keys back and disappeared, the collateral value had fallen. This meant that the housing finance companies took a hit as did those who dealt with the securities in the CDO market backed by these houses.
The crisis has now entered a dangerous phase. If Lehman's assets are avoided in the process of liquidation, there will be a chain reaction and similar assets on other firms' books will have to be marked down. One take-away from this Lehman episode is that the industry is harsh and is not willing to rescue the sick, even when the consequences of inaction are potentially dire.
The other concern is the impact on the credit-default swap market where Lehman holds contracts with a notional value of almost $800 billion.
The story obviously is more intricate but the gist was that such over-leveraged purchases of assets provided a double whammy on both sides leading to a collapse. Usually when there is a collapse of such a magnitude, a bail-out is expected. Northern Rock had it when Bank of England intervened and Freddie Mac, Fannie Mae and Bear Stearns had the US government intervening.
Governments either directly provide relief or get the monetary authorities to lower rates. This has in a way set a precedent of moral hazard as the so-called wrong-doers are bailed out.
The debate now is whether or not such bail-outs are desirable? Going by economist Joseph Schumpeter's theory, financial failures are necessary to separate the good from the bad and they start the process of creative destruction. If we destroy our own institution, then it may not matter. However, if your own destruction rocks the entire global system, then someone will help out. Therefore, if one has to destroy, make the destruction big! This line of thought is not sustainable.
Hank Paulson could be lauded for letting Lehman file for bankruptcy but the issue of AIG is ticklish, which has an exposure of around $ 450 billion. Goldman Sachs and JP Morgan were approached for a fresh fund infusion of $ 120 billion, but there was no interest.
The Fed has finally announced an $ 85 billion loan for its revival, which thus blows hot and cold over the approach to financial moral hazard. Spurning Lehman, it has in a fortnight bailed out huge mortgage companies and an insurer. The puzzle is, why not Lehman?
What are the lessons to be learnt? The first is that no institution is too big to fail. The second is that failures should not ideally be bailed out as they set precedents of moral hazard. Third, the securitisation market is still an unknown quantity.
Fourth, when assets are fraught with risk, over-leveraging in a booming market is not a prudent policy. Lastly, regulators and governments need to be more observant when there is a boom, rather than reactive when the crisis descends. This way the intensity of the crisis can be moderated and the pain lowered.