Tuesday, January 20, 2009

Why Was Lehman Allowed to Fail?

The question of why Lehman was allowed to fail had preoccupied me ever since the news reached me while on vacation.

That Lehman’s was the largest bankruptcy ever – with about $630 billion in assets – did not tell the full story. Lehman was a major prime broker and one of the largest players in the commercial paper market. Its notes were widely held by institutions of all stripes and there was a large and active credit default swap market linked to the company’s name. Additionally, the firm’s broker-dealer arm financed well over $100 billion a day in the tri-party market. These activities directly linked the firm to all the major banks, broker-dealers, pension funds, hedge funds, mutual funds and money market funds, to say nothing of thousand of small and medium size firms and municipalities. A place such as Lehman could not gently go into that good night even if it wanted to.

And it did not. On the news of Lehman’s bankruptcy on Monday, September 15, the short-term repo, interbank lending and CP markets froze. By mid-October, the crisis had spread to all parts of the credit markets in the U.S., the Western “liberal democracies” and many emerging markets. One could argue that a substantial portion of $9 trillion in commitments that the Fed and the Treasury have pledged to “calm” the markets in the past three months is the cost of the Lehman failure.

The decision to let Lehman go under is now universally recognized as an epic blunder. In an uncharacteristically harsh editorial, The New York Times called for grilling Geithner in his upcoming confirmation hearings for his role in Lehman’s bankruptcy. The editorial pointed to the shifting explanations of the Treasury and the Fed as evidence that the true story had yet to be told. Indeed, save for Paulson’s shifting explanations – first, “we had no business saving Lehman”, and then, as things got hairy, “we had no authority to save Lehman” – no explanation is given for the fateful decision. Presumably, only Paulson, Bernanke and Geithner know the answer – and they are not talking.

Or do they?

In Othello, Shakespeare reaches to the intellectual dominance of the man in man-beast relation to give us the visually compelling metaphor “being led by the nose”, making someone do something that he would otherwise not do.

The Moor is of a free and open nature,
That thinks men honest that but seem to be so,
And will as tenderly be led by the nose
As asses are.
I, too, was led by a faulty conviction to saying and writing things that I would otherwise not say and write. Here is what I wrote upon hearing the news:

It is inconceivable that the Fed would force a major broker dealer ... 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.
The passage is on the mark on its fundamental premise: that Lehman’s bankruptcy would become an event to remember and that it was a defeat for the Fed. But look at the unbridled faith in authority: “It is inconceivable that the Fed would force a major broker dealer into bankruptcy for the sake of making an ideological point.” The day I wrote this must have been my salad day, when I was green in judgment.

Or take the comment about the Fed’s lack of “wherewith”. It, too, was technically accurate. But if it only were true that the Fed would be restrained by legal constraints!

One learns. With what has come to light in the past couple of months, I can now surmise why Lehman was pushed over the cliff. As always, characters and incidental events matter, but they play out against a backdrop set by finance capital and the dynamics of its latest, most developed form, speculative capital.

Most immediately, Lehman was allowed to fail because no one in the position to save it understood the consequences of the failure as they unfolded. The haphazard response of both, the Treasury and the Fed, to the unfolding events – one observer characterized it as a ”Whack-A-Mole” approach – provided ample proof of that. I also wrote a long piece here , explaining why despite having detailed knowledge of technicalities, the officials did not understand the situation.

The incidentals played a role as well. Lehman’s broker-dealer arm was organized as a separate legal entity, an obvious “strategic” decision that, whatever original purpose or merits it might have had, ultimately contributed to the undoing of the firm. As a separate entity, the BD could be kept out of the bankruptcy proceeding, as indeed it was. The consideration of that scenario must have added to the bravado of the decision makers at the Fed and the Treasury, leading them to believe that with the critical BD out of the way, they could handle the post-bankruptcy situation. (On the very same day September 15, the Fed guaranteed about $90 billion of trades for the LBI New York trades, Lehman’s broker-dealer subsidiary.)

But why the bravado? Even if Paulson, Bernanke and Geithner did not understand the consequences of Lehman’s failure, why the cavalier attitude ?
This summer, as he fought for the survival of Lehman Brothers, Richard S. Fuld Jr., its chief executive, made a final plea to regulators to turn his investment bank into a bank holding company, which would allow it to receive constant access to federal funding. Timothy F. Geithner, the president of the Federal Reserve Bank of New York, told him no, according to a former Lehman executive … One week later, Goldman and Morgan Stanley were designated bank holding companies.

This claim that Fuld also repeated under oath in front of a Congressional panel was never denied. The question then arises: Why the intransigence, this uncompromising stand, under clearly risky circumstances from an institution with born-in bias to err on the side of caution?

The answer has to do with the machismo that, as a byproduct of the rise of speculative capital, has infested the financial culture in the West and particularly in the U.S.

At the root of this machismo stands the need to be “unpredictable”. The financiers of bygone eras who thought of themselves as gentlemen bankers would have taken offense at such characterizations. But with the rise of short-term trading driven by speculative capital, unpredictability, like being foul-mouthed, became a virtue. The latter meant to project an image of toughness in a business that was considered cut-throat. The former was fashioned after the conduct of gamblers; it was a virtue in the sense that the rivals could not "read" one's hand and, by extension, the next move. Both were the logical results of a system that promoted every-man-for-himself profit maximization.

I pointed to this mindset in Vol. 1 of Speculative Capital in discussing Robert Rubin’s conduct as a Treasury secretary. I looked at a case where he “ambushed” the currency markets to drive up the dollar against the yen and wrote: “So the Treasury secretary of the United States fixes the exchange rate of the dollar against the yen by sowing uncertainty about their exchange rate!”

It is perhaps worth commenting that one of the birth places of this traders' culture was Lehman. Ken Auletta’s Greed and Glory on Wall Street is a readable chronicle of the takeover of the control of Lehman Brothers by “traders” who pushed aside the "gentlemanly" investment bankers in 1984. The palace coup was led by the head of trading, Lew Glucksman. Auletta describes him:
Glucksman usually worked in a glass-walled office ... where his people could see him, feel his presence ... hear him bellow profanities ... watch his round face redden with rage, see him burst the buttons on his shirt or heave something in frustration, watch him suddenly hug or kiss employees to express appreciation ... He sometimes rewarded or terminated employees whimsically ... Employees fondly remember how would pause and laughingly instruct them how to use words like gelt or shmuck ... His legendary temper was carefully cultivated.
The “bad boy/tough guy” conduct, with the unpredictability that went with it, soon became the currency of the trading room and, from there, turned into an attribute of leadership. All office boys with executive ambitions wanted to be unpredictable and able to surprise.

In light of everyone’s expecting Lehman to be saved, letting it go down must have been seen as the ultimate sign of unpredictably, a tough executive decision under trying circumstances that pointed to leadership qualities.

Still, the decision of such magnitude could not have been made without consultation with the industry. The Times article quoted earlier said as much and then went further:

Mr. Geithner, 47, played a pivotal role in the decision to let Lehman die and to bail out A.I.G. A 20-year public servant, he has never worked in the financial sector. Some analysts say that has left him reliant on Wall Street chiefs to guide his thinking and that Goldman alumni have figured prominently in his ascent.
I have no knowledge that “Goldman alumni” were behind Geithner’s decision to play hardball with Lehman. But what is certain is that they did not intercede on Lehman’s behalf either. Neither did other broker-dealers. Had the “industry” rallied behind Lehman, it could have swayed the Fed’s decision; following a meeting between Geithner and Blankfein, the Fed rushed to bailout A.I.G., a Goldman client.

That brings us to the final piece of the puzzle: why other institutions, especially trading institutions, did not lobby the Fed on Lehman’s behalf given the strong bonds within the industry? While the competition amongst the financial firms for trading and business was always fierce and real, every competitor at the same time was a potential counterparty to a trade. That consideration created a common interest that rose above the local rivalries. This common interest was, and still is, reflected in many professional organizations that lobby and speak on behalf of the “financial industry”. In the case of Lehman, that common interest failed to save the day because it no longer existed.

Blame it all on speculative capital.

Speculative capital, capital engaged in arbitrage, is self-destructive; it eliminates opportunities that give rise to it. As the bid/asked spreads narrow due arbitrage, speculative capital increases its size to partially compensate for the falling profit. But the increase in size puts even greater pressure on the spreads, to a point that it is not possible to make any profit, especially when the leverage ratios are substantially reduced. In the face of a dwindling profit pie, the surest way of protecting one’s share is reducing the number of participants in the market. That simple fact is behind the seemingly high minded recent self-regulatory proposals that were recently announced with fanfare:
Complex securities businesses that once fuelled explosive profit growth on Wall Street and in the City of London would be dramatically limited in scope and size under proposals revealed yesterday by leading banks in response to the credit crisis.

The blueprint would restrict complex financial products to only the most sophisticated investors, tighten oversight of large swathes of the derivatives markets and require banks to spend more on technology and risk management.

The plan – backed by banks including JPMorgan Chase, Merrill Lynch, Citigroup, HSBC, Lehman Brothers and Morgan Stanley – will be presented to US and global regulators considering various ideas for increasing oversight of the credit markets ...

Perhaps the most unexpected proposals by the banks involve new criteria for the “sophisticated investors” allowed to buy complex financial products. Under the plans, even pension funds and other institutional investors would no longer be automatically allowed to buy bonds backed by assets such as subprime mortgages.
It was the natural expansion of speculative capital in search of arbitrage opportunities that created conditions that led to the demise of many financial institutions, including Lehman. Lehman’s case stands out. Other financial institutions could have prevented it but chose to stay on the sidelines because they calculated that Lehman’s demise was their gain. This was a consideration that had never before entered the calculus of the Wall Street – certainly not in relation with a firm of Lehman’s size and stature.

But Lehman was an integral part of the “the Wall Street”. In letting Lehman fail, the Wall Street also took an ax to itself. In a few places, I have written about the self-destructive tendency of speculative capital that manifests itself by the self-destructive action of the financial agents. Lehman’s failure was the most compelling example of that tendency to date.

The subject of the dialectics of finance is studying these self-destructive tendencies which arise naturally, i.e., logically, from the internal developments of the systems.