First a disclaimer. If you act on anything I write below, you are a goose. These are, as the title suggests, notes on the shockwave rippling through the global financial system. Not advice. Not investment tips. Go see your broker at Lehman Brothers or Merrill Lynch for that.
The Federal Reserve and U.S. Treasury Department have refused to step in and save Lehmann. They refused to buy them out (like they did with Freddie and Fannie) or provide cheap financing or guarantees for potential suitors (like they did with Bear Sterns). Namely, they turned to the big banks and said, "Enough work on our part. Your turn." Contrary to what you might read in the AFR tomorrow morning, this is a good thing. And it is a good thing because we are seeing moral hazard rush out of the financial system. This is going to cause some short term pain as everyone adjusts, but long term, this is a good thing.
It will mean that cocky bankers will have to actually think about risk before they swing their assets (excuse the pun) around. They won't have Freddie and Fannie to sell their crap to anymore. Shareholders, and in particular, creditors are going to be more curious about what banks hold on their balance sheets. The government ain't gonna save you. And the price of risk is readjusting to more realistic levels. I could argue the price of risk has overshot its mark, but that will be determined over the coming months.
Other positive developments are:
- Ten banks have set up a $70bn liquidity fund that is operating outside the purview of the world's central banks. This is another example of the world's central banks beginning to lose control over the monetary system and more active involvement on the part of private enterprise organising funding requirements. This is going back to the pre-Federal Reserve days where banks would sort out problems amongst themselves.
- As Lehman Brothers has filed for bankruptcy, ISDA has has activated a "Risk reduction trading session" to allow market participants to net off their exposure to Lehman. Someone is going to be left holding some swaps and other types of OTC instruments that have no counterparty (ie. these OTC instruments will be worth zero). This will cause swap rates and market rates of other instruments to go through the roof as participants look for someone (and there are fewer "someones") to re-establish these positions with. But it provides immediate stability to the functioning of the massive swap market (outstanding notional of $US393 trillion). Another example of where the private finance companies are working hard to bring stability to the market.
- Merrill Lynch was bought by Bank of America at a substantial premium (I think in excess of 70%) to the closing price on Friday. In this all-scrip transaction, BoA gets its hands on $40 worth of net assets for less than $30. That's a bargain. And it's going to be the sort of transaction that will be repeated over the coming months.
The bad things on the horizon:
- If AIG were to go belly up it will be VERY bad news. My understanding is that they underwrite lots of mortgage insurance and CDS stuff. If they disappear then lots of people are going to be holding some much riskier assets (although you could argue given AIG's position, that this is almost the case now).
- I am not quite sure how Lehman's bankruptcy will spread to other participants. Whether or not the equity holders taking a bath means that other market participants will lose little is yet to be determined.
- Freddie and Fannie are still unresolved and will be for some time. These are GSEs are monsters. I would prefer them to be chopped up and sold off.
Was just watching Bloomberg TV and an analyst was saying that it was only last week that people were thinking the US would come out of a recession. What recession exactly? Given the current situation in the financial markets, a recession is almost certainly going to happen. Oil prices and the Baltic Dry Index are factoring this in. The BDI has more than halved in the five months.
Best recommendation to stop this sort of stuff happening again?
- Diffuse concentration in the financial markets. Banks should be mandated to spin off business units. That is a very illiberal thing to say, but I think the lack of competition and the concentration of assets in the financial markets is very troubling. And in a sense competition is the cradle on which capitalism is built.
- Governments should get out of the banking business. I could present a very convincing case that their implicit guarantee of Freddie and Fannie and very loose monetary policy led to this crisis.
Politically? Look out for the anti-capitalist backlash. It will begin, I predict, by media quoting market participants crying out for government intervention (paging Bill Gross!). Then the media will focus on how evil capitalism is and how it is destroying people's lives. All the while ignoring that it was government sticking its fingers in the wrong place that got us here.
Those are my random thoughts. Not meant to be definitive or anything.