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Fire of moral hazard incinerated Lehman

15 Sep 2008

Lehman’s worst mistake was to get its timing wrong — six months ago it might have been saved by Hank Paulson. But Bear Stearns and the US mortgage agencies used up the Treasury’s willpower and that left Lehman horribly exposed and alone.

Six months ago, it seemed that the Federal Reserve had drawn a line in the sand. It rescued Bear Stearns, introduced a whole raft of liquidity measures and seemed to say to the market, “Now, now, don’t worry, none of you are going to fail.”

The dysfunctional family, full of schizoids and psychos that Wall Street had become breathed a sigh of relief. Dr Bernanke had the meds; no one was going to have to go the funny farm after all.

Certainly that’s the way Wall Street responded. There was a massive relief rally. High grade bond issuance set new records in April and May. It seemed to many people that the corner had been turned. There was now no reason for any institution to have a liquidity crisis, and the Fed had pledged the support of the US taxpayer to Wall Street.

We were all wrong. Liquidity measures could not save a business that was fundamentally broken and at the mercy of the rating agencies. And, on this occasion, the Federal Reserve was not prepared to take any steps to save a storied Wall Street franchise. There would no ring-fencing of bad assets, no short term loans, nothing. Nada.

Why? What had changed between March and September? Treasury Secretary Henry Paulson said that the failures of Bear Stearns and Lehman were very, very different.

Over the last six months, the Fed believes that the market has got better at being able to handle a massive default of this kind. It has had time to prepare, time to put procedures and mechanisms in place. A new CDS compression service has been unveiled by Markit and Creditex in the last two weeks, for example, while plans are well underway to develop a central clearinghouse. We shall see.

The liquidity measures have created a situation in which Chapter 11 bankruptcy can take place in a relatively orderly manner. It won’t just unravel in a hurry, seems to be the argument. But it’s still bankruptcy and that’s a very big problem for Lehman’s thousands of counterparties.

Rumour suggests that the Fed also believes that Lehman was not such a big player in CDS markets as Bear Stearns. That might be true, but it wasn’t exactly a small player either. Indeed, CDS dealers at one of the leading desks in New York said last night that Lehman was one of their biggest counterparties. Not does anyone really know their full exposure to Lehman yet. That has yet to be revealed.

The Fed seems to think the market less febrile and fragile than it was in March. Six months of horrible losses and write downs have perhaps hardened the sinews. The collapse of Bear Stearns came out of the blue, while rumours and speculation about the fate of Lehman had swirled for months. Indeed, it was an open secret on Wall Street that Lehman was 24 hours from failure six months ago and was saved only by the Fed’s intervention.

But the strongest reason for non-intervention in September seems to be that the political climate has changed since March. While the failure of Bear Stearns is different from that of Lehman, there were lots of similarities as well. But the biggest difference is the Fed itself.

It took a lot of stick for its support of Bear Stearns. The dangers of moral hazard have been discussed widely and loudly. “We’re not socialists, goddamit!” analysts, poticians and pundits have pronounced.

The Fed hoped that its actions in March would save Wall Street. They were wrong. Six months later, the political will was all used up. This time the market would have to find its own solution. Lehman got its timing all wrong. 

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