Tuesday, September 22, 2009

On Lehman... and its Failure

The most provocative line in last week's Newsweek is not the inflammatory headline that graced the cover, "the case for killing granny."

No, the most provocative line in the magazine comes on page 47 of the print edition, early in a story about Jamie Dimon, our post-millennial American hero, the man who somehow had the strength, courage and conviction to "eschew the siren call of investing in risky mortgage securities."

(That's what passes for heroic these days in America - god bless us everyone...)

The line I found most astonishing was this:

"The only remaining question was whether it would be Morgan Stanley or Goldman Sachs to fail next."


How's that for a bit of revisionist history?! Goldman Sachs on the verge of failure - at least according to those liberals over at Newsweek. That's trash talking there - language far more inflammatory than that bit about killing granny.

Because Goldman, as we know, is the gold standard for how investment bankers should act. And Goldman, as the folks at Goldman have stated in the year since the crash, was well-positioned to ride out the tsunami that brought down so many of their competitors. Here's their take on their health, described in a press release issued on 9/21/08, during the height of the turmoil:

"We are pleased that the Federal Reserve recognizes the strength and health of our liquidity and funding and the overall quality of our risk management."

No wonder Goldman is having one hell of a year this year, with estimates of "record" profits and bonuses back up at pre-crash levels. And no wonder that they were too healthy to fail last fall.

But not according to Newsweek. In their interpretation of the events that happened that black week in September last year, Goldman was as wobbly as the rest of them.

Because, as this New York magazine story points out, "before the market crashed, Goldman Sachs was betting 28 times its underlying capital."

That's quite a load of leverage to be carrying, especially after the markets crashed last September. And prior to the crash, they had carried that leverage proudly, had in fact eagerly sought out such leverage, thanks in part to some lobbying Henry Paulson had done prior to becoming Treasury Secretary, back when he was CEO of Goldman Sachs, to change the leverage requirements for investment banks back in 2004.

The failure of Lehman was a turning point in the history of American finance - as significant a turning point as the bailout of Continental Bank (now part of BoA!) was back in the 1980s. In 1984, Continental was the 8th biggest bank in America, loaded to the gills with debt, thanks to a business model that made it susceptible to making bad loans. The feds stepped in with a controversial bailout, noting that the bank was too big to fail.

A bit of moral hazard had been injected into the financial community.

In September 2008, there was nothing to indicate that TBTF institutions would NOT get bailed out. Earlier in the year, the government came to the aid of Bear Stearns. The government came to the aid of Fanny and Freddie.

And then in September, Treasury Secretary Henry Paulson did something generally viewed as extremely dangerous - he changed horses in midstream. He said that Lehman was on its own. Without the support of the government (that entity Reagan pointed to as "the problem"), Lehman failed.

Thus, the panic.

A central assumption that had gone unchallenged by the failures of Bear, Fanny and Freddie - that TBTF institutions would be bailed out - was not necessarily a fact set in stone. Even the healthiest, strongest banks were at risk, because when irrational exuberance is replaced by irrational fear, no one is safe. Especially when the off-balance books are loaded with toxic assets.

For the remaining banks that had operated so profitably for so long in those unregulated shadows, Lehman's collapse showed that in such turbulent times, the great capitalists are worth nothing at all without Uncle Sam's support.

Uncle Sam learned that in order to prevent massive and terrifying panic, bailing out TBTF banks is now absolutely essential. With TBTF even bigger in 2009, all those in such companies who risk big this year know that no matter what, the feds will prop them up with a TARP, should the risks fail to pan out.

That's a moral hazard that can kill even the healthiest "free market" system.

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