Lehman Brothers collapse: Bernanke and Greenspan at last see sense

15th September, 2008

American politicians and regulators have called Dick Fuld’s bluff this weekend.

Until the weekend, there was a view that certain banks are simply “too big [and too pivotal to the global financial system] to fail”. Fuld, chief executive of Lehman Brothers, one of the least responsible of America’s rapidly diminishing band of investment banks, believed his bank was among their number.

Well, it seems that the US authorities — led by Ben Bernanke at the Federal Reserve and Hank Paulson at the Treasury — have decided to put this theory to the test.

Stung by criticism of their extraordinary nationalisations of Fannie Mae and Freddie Mac, Bernanke and Paulson have shown there are limits to their, and the US taxpayer’s munificence. So rather than kowtow anymore to the struggling investment bankers, they have effectively hung Lehman out to dry.

They did this by refusing to provide any state-backed guarantees over the troubled investment bank’s dodgiest loans and other assets. Without these, putative buyers such as the Bank of America or Barclays were not prepared to shoulder the risk of acquiring the New York-based investment bank, which has about 26,000 employees. Instead the “venerable” institution has been allowed to go bust — or, more accurately, put into Chapter 11 administration.

It is little wonder that the authorities’ patience ran out given Fuld’s extraordinary arrogance, lack of friends on Wall Street and refusal to acknowledge anything was wrong with his dysfunctional and greed-infected organisation.

I have repeatedly argued in this blog the financial system desperately needs a correction (I first argued for this on 18th August 2007, as the credit crisis started to unfold. On 7th July 2008, I said “asset prices must be allowed to find their natural level, without further impediment or intervention from jittery regulators, central bankers and politicians. Some banks must be allowed to fail.”)

In allowing Lehman to fail, it seems the US authorities have recognised the dangers of providing an unlimited safety net to the failures of Wall Street. As Gilbert Schwartz of the boutique law firm Schwartz & Ballen puts it:

“If every time a big institution went bust the markets expected the government to step in, no one would ever adapt.”

Bernanke’s predecessor at the Fed, Alan Greenspan, also seems to be coming round to this point of view. Speaking about the risk that other financial institutions (including possibly Lehman Brothers) might fail in an interview with ABC’s This Week at the weekend, Greenspan said:

“In and of itself that does not need to be a problem.”

(By the way there are many in US financial circles who are none too happy about Greenspan’s new found loquaciousness). Greenspan added:

“It depends on how it is handled and how the liquidations take place. And indeed we shouldn’t try to protect every single institution.”

Global carnage?

However, allowing Lehman to fail is not without risk. The bankruptcy can be expected to send shock waves reverberating around the global financial systems for months, if not years, to come.

Of immediate concern is what’s going to happen to Lehman’s counter-parties across the financial spectrum — including those on its $730 billion of derivatives contracts. When these parties realise how much they stand to lose from Lehman’s collapse, they may also be driven into bankruptcy. In the UK, the two most vulnerable banks are HBOS and the Royal Bank of Scotland.

Michael Auyeung, chief executive of Malaysia-based Pacific Mutual Fund, told Bloomberg News:

“The reach of the carnage will be global and system-wide.”

Already global stock markets are feeling the pinch. The FTSE-100 index was dragged down by 5% by midday today (Monday) because of Lehman’s collapse and worries over giant US insurer AIG, as investors fretted about what the future now holds for other banks and insurers.

HBOS was the worst hit, shedding nearly one-third of its value to 180p, while Barclays was down nearly 19% and RBS was down 14%. This could be the beginning of a long and painful slide that could spell oblivion for some of these banks.

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Posted by Ian Fraser on Sep 15 2008. Filed under Blog. You can follow any responses to this entry through the RSS 2.0. You can leave a response or trackback to this entry