Wednesday, September 17, 2008

Lehman’s Bankruptcy: An Event to Remember

The most outstanding characteristic of the “pragmatic man” is lack of conviction. He believes in no ideology, honors no conventions, adheres to no principles, follows no set rules, finds nothing per se wrong and rules out nothing categorically.

This is neither criticism nor moral posturing. It is an elaboration of what logically follows from the word “pragmatist”, what it implies. A pragmatist is ruled by the exigencies of the moment. He is a compromiser, a deal maker, a justifier, a fixer.

Central bankers are a pragmatic lot.

The news of Lehman and Merrill reached me at sea, in Alaska’s Inside Passage, to be exact. Without the phone reception and the spotty and outrageously expensive access to the Internet in the glaciated valley, I do not know the details, but the details do not matter. There is only one central question. Why was Lehman allowed to fail after long words about the systemic implication of the failure of much smaller Bear Stearns– and, if you want to go further back, Long Term Capital?

The Fed’s decision to let Lehman go under will be explained by the usual hangers on in the media as a courageous call and a necessary message to the officers of private enterprises that they must face the consequences of their actions. This will be celebrated as the triumph of free market and the application of tough love that everyone agrees corporate America desperately needs.

But central bankers are a pragmatic bunch and the Federal Reserve is no exception. It is inconceivable that the Fed would force a major broker dealer whose CEO sat on the board of directors of the Federal Reserve into bankruptcy for the sake of making an ideological point. The Lehman failure is a defeat, a setback. The Fed would have done everything within its power to save the firm. That it did not, because it could not, is the central story behind Lehman’s failure. In the Lehman crisis, the Federal Reserve reached the limits of its omnipotence. It was rendered impotent because it did not have the financial wherewithal to intervene.

In several entries on this blog, I have pointed out how the Fed’s Term Auction Facility, like the Bank of England’s Special Liquidity Scheme, was being abused by banks and broker dealers, Lehman included.

These “facilities” were created as a temporary solution to the seizure in money markets. The institutions holding impaired mortgage-related securities could pledge them with the central bank and receive Treasuries in return.

The idea was a “pragmatic” one. The activities of broker-dealers, for example, fell outside the Federal Reserve jurisdiction, but the facility was extended to them any way. It was believed by men who know nothing of the fundamentals of finance capital and explain everything in terms of human behavior that the scheme would somehow jump start the markets.

It did not turn out that way. The financial institutions immediately began swapping their existing junk securities for Treasuries. As the junk ran out, they sought and created junk specifically for the purpose of swapping it with Treasuries. Junk trading was back, except that now the central banks – the Fed in the U.S., and the BoE and ECB in Europe – were on the receiving end.

As the central bankers tried to clamp down on the practice, the markets fell.

The Bank of England’s money-market “reforms” that is in the works is intended, gingerly and with extreme caution, to finally get the Bank out of junk trading business. Hence, the comments of the Mervin King, its governor that the bank “will not and cannot solve the shortage of funding to finance bank lending”.

It was against this backdrop that Lehman’s funding needs turned into a crisis. Every day, the bank had to finance some $600 billion securities in the tri-party market. The Federal Reserve, having destroyed its assets through its Facility, could no longer take on such crushing load. It had to stand aside and let Lehman go down.

I will have more on this topic when I return.