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Unforeseen Side-Effects of Lehman Bankruptcy

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Apparently there may be up to $360B dollars in losses tomorrow as the auction for the Lehman CDS contracts are settled according to this Reuters article: Lehman CDS sellers face massive losses in auction

Banks, hedge funds and other sellers of protection on Lehman Brothers’ debt are facing losses in the area of 90 percent the insurance sold when the value of the failed bank’s credit default swaps are settled in an auction on Friday.
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The auction to settle credit default swaps protecting the debt will be one of the largest settlements of contracts in the $55 trillion market, with around $400 billion in contract volumes estimated on Lehman’s debt.

Fannie Mae and Freddie Mac’s credit default swap settlements on Monday were the largest to date. But unlike swaps on the agency debt, which recovered more than 90 percent of their value, Lehman’s protection sellers face the possibility of being virtually wiped out.

This component of the Lehman bankruptcy highlights some of the unforeseen repercussions of their filing that are causing ripples throughout the financial markets.

It also highlights the magnitude of the $60 Trillion notional value CDS market. One way to think about this is that there is somewhere between $15 and 20 Trillion of face value between MBS, CMBS, and Corporate bonds. The CDS market thus represents 3-4x the total amount of credit outstanding in the economy.

Thus, whenever corporate defaults happen, the losses associated with these failures can be much larger than the “balance sheet” of the failing company. Given the fact that there are people on both sides of these CDS transactions, this arguably should not be a net loss to the economy (i.e. there are both winners and losers).

However, when losses come in spikes like this, it can clearly threaten the viability of individual firms, forcing them to sell other securities, which exacerbates the pressure of normal losses.

Furthermore, given the already strained nature of a number of these firms, it is clear that continued losses like this will cause failures.

As we are in the midst of the turn of a credit cycle, losses are inevitable and part of a slowing economy. The problem this time around is that institutions are highly levered and losses are being felt in ways that were unforeseen…causing more firms to lose money, sell assets, and creating further downward pressure on asset classes globally.

All of this adds to the fear and uncertainty that you are feeling and seeing in the markets right now.

Things are looking bad. Things will probably get worse.

BUT, don’t forget, things are also very good. There are a lot of phenomenal companies that are going down with those that are challenged, and particularly in technology, these companies will be making money for years to come.

I am convinced our best days are ahead of us…we just may have a few more bad ones in between now and then.

UPDATE: Last night’s estimates were accurate. According to this arcticle, losses will be upwards of $360B: Lehman Debt Protection Cost Set at Auction

Issuers of unregulated derivatives promising a payout in the event of a Lehman Brothers default will pay more than 91 cents on the dollar to settle credit default swaps related to the bankrupt company.

Warren Buffett On The Crisis By Charlie Rose (video)

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A long, but worthwhile explanation on where we are…and why the bailout was necessary. Thx to ADK.

Some highlight Buffett-isms from the video:

  • I would rather be approximately right than precisely wrong
  • This is truly an economic Pearl Harbor.
  • The patient on the floor in cardiac arrest is not Wall Street, it is the American Economy
  • Everyday you don’t react to Pearl Harbor you are otherwise behind in a war that you would have fought.
  • Sheila Bear and Hank Paulson are great leaders…need more tools. They need money and flexibility.
  • Derivatives…financial weapons of mass destruction.
  • We naturally go through the 3 I’s: Innovators, Imitators, and the Idiots.
  • Leverage is a lot like Cinderella at the ball…we all know they turn into pumpkins at 12…nobody wants to leave before then.
  • Confidence in institutions is a lot like oxygen…when it is gone for 5 minutes it is the only thing you think about.
  • The American System unleashed more potential in human beings…we have all the ingredients for an incredible future.
  • Beware of Geeks bearing formulas.
  • I’m not worried about the country, I’m worried about anything that gums up the potential of the country.
  • The recession is going to get worse…best case is 6 months. Worst case is a long time….5 years.
  • It is more important who the Treasury Secretary is than who the Vice President is.
  • I would hand a blank check to someone like Hank Paulson.
  • Mark to market is a good idea. Telling the truth never hurt anybody. You get in a lot of trouble when you start putting fictitious numbers on assets.
  • I am paying the lowest tax rate in my life…and that is crazy. I should be paying more taxes.
  • We need real leadership in government. Someone who can explain things to people.
  • If AIG had tried to unwind its derivatives book, it would have hit every financial institution in the world.
  • It would be crazy not to do this….you are going to see more bad news. But over time the system will work.

On Laughter And The Importance Of Leadership

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Have you ever noticed that when you are sitting in around a table in a meeting, when the “alpha” laughs everyone else typically follows suit?

Often this is the boss, and I remember reading somewhere this is explained by some social-psychological theory about pecking order or something like that.

I think of it as another example of the fact that most people in the world are followers. It is really hard to be a leader, because leadership implies taking chances and putting yourself out there, which is scary.

But this phenomenon also explains why leadership is so important.

On the global stage it is hard to argue with the fact that America is the alpha. Foreigners follow our media, our companies and our politics.

That’s why it is not surprising to see that foreign governments are now following suit in applying the “too big to fail” moniker.

Hypo Real Gets EU50 Billion Government-Led Bailout

The German government and the country’s banks and insurers agreed on a 50 billion euro ($68 billion) rescue package for commercial property lender Hypo Real Estate Holding AG after an earlier bailout faltered.

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The government and the Bundesbank have said that Hypo Real Estate, Germany’s second-biggest property lender, is too big to fail.

In these challenging times it is important for leaders to be principled in their decision making and in their actions.

This need for leadership is all the more reason why the “pork” included in last week’s bailout bill is all the more troubling.

The government had the chance to take a decisive step in the direction of bringing the country together to help stave off a deeper economic crisis. But in this moment, when the spotlight was shining and the microphone was in our hands, we faltered. Rather than booming with laughter, we mumbled, and stuttered. And although we did take a step in the right direction, because of the body-language, the message was not nearly as powerful as it could have been.

This need for clarity and precision is somehow related to the appeal of clean design in user interfaces, but I’m not sure that I understand Aristotelian ethics enough to make the connection intelligible. I think it has something to do with simplicity and directness.

In any event, as we head into the final months of this election season and beyond, it is important that we demand this kind of leadership from our government. The world is watching.

The Problem With Binary Thinking (And The 2 Party System)

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What caused the credit crisis?

People have been speculating about this for months, and until recently most of the conversation on the topic was relegated to our corner of the blogosphere and academia.

During the lead up to the current headline events, this debate has been enriching, and although people disagree about the fundamental causes, it is clear that a full accounting of the problems includes a variety of the following:

  1. Everyone was overconfident in their understanding of the world and risk
  2. Mortgages were issued to people who could not afford it with terms that some people didn’t understand
  3. Sophisticated institutional investors invested in products with risks they misunderstood
  4. Credit Rating Agencies rated securities much more highly than they should have
  5. “Wall Street” created complex securities (including CDOs and CLOs) which increased leverage throughout the system, making the repercussions of failure greater, and they were highly incentivized to do so
  6. Insurance companies and bond insurers guaranteed far more risk than they realized or should have
  7. Mortgage brokers and originators were incentivized to issue as many mortgages as possible
  8. Banks were allowed to create off balance sheet entities, which did not affect their regulatory capital requirements
  9. No one (with any clout) was standing outside the system thinking about and measuring what would happen if things went wrong
  10. Etc.

However, now that the credit crisis has entered the mainstream dialogue, rather than recognizing that this issue is complicated and that many factors are to blame, people are trying to wrap a bow around things and blame it on the “left” or the “right”.

Case in point, one of many similar blog posts from this morning:Who is to Blame for the Economic Crisis? The Republican Argument

The post references a video suggesting that somehow the push to issue people affordable mortgages is to blame for the credit crisis.

This blatantly political maneuver would be more infuriating if it was not so obviously overly simplistic and false. One simple counterargument to this is that if institutional investors bothered to do their homework on the securities they were purchasing rather than relying on credit ratings and the assurances of “derivatives” salesmen, they would have charged more, pricing in the reality of people’s inabilty to pay. But they didn’t…for lots of reasons.

Overly simplistic binary thinking is widespread in politics.

Unfortunately, this idiotic binary debate is symptomatic of a broader phenomena in our society: politicians are too intellectually condescending to describe things in the honest and nuanced way that they are in the world.

I refuse to believe that the American people are too stupid to understand. In fact, perhaps the reason people are fed up with politics is because the smokescreen is so obviously false.

Throughout my life I have found the “us against them” mentality of the two-party political system to be stomach-churningly simplistic. There are far more people and ideas than can be represented by “red and blue.”

It is no coincidence that the two presidential candidates both espouse politics beyond “party”. In times like today, it is clear that people “hope” that things will “change” and that someday it will be true that politicians put “America first.”

In the mean time, why don’t we seek to engage in a more nuanced debate. I for one reject this antiquated binary thinking. Computers can’t replicate human ingenuity, and I think we can avoid using their language.

Fatigue = Complacency

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So the Senate passed the bill…kind of.

They passed a bailout plan, but they also included a load of pork along with the bill.

Although arguably not a bad development, the fact that a website called “Treehugger.com” is blogging about the fact that this bill has a tax credit for plug-in vehicles shows you how business really gets done in Washington (Pork-Laden Senate Version of Bailout Bill has Plug-In Hybrid Vehicle Credits).

The self-congratulatory Senate praised themselves for coming together to aid the American people in their time of need. As I have grudgingly acknowledged here, I think some kind of bailout is arguably necessary in order to keep systemic risk contained. Out of respect for someone I really admire, I wanted to acknowledge a logical counterpoint to the bailout that is probably right:

  • $700B is arguably not enough unless we do something to stem the decline in housing values and household credit which are driving the majority of this contraction.

But, even though that is likely true, I think we need to get this thing done before the glad-handers go off to parade around the nation.

Although the Senate did get something done, it is disappointing that rather than focusing on passing the bill we needed, special interests lobbed in requests to get their pet projects included in what is now an over 400 page document…this one is even too long for me to micro-analyze.

And that is part of the problem. America is so shell-shocked at considering the prospect of an economic crisis that we have complacently shrugged our shoulders as Washington jammed this bill full of pork.

Even people like me, who have been shouting into the blogosphere for the last two years on this topic, are starting to simmer with our diatribes.

I am somewhat disappointed in myself for not even mentioning it when the government slipped a $25B loan to U.S. automakers through Congress last week.

Or that the SEC is helping banks cook the books by altering Mark-to-Market accounting rules: S.E.C. Move May Relax Asset Rule:

Under pressure from banks and legislators, the Securities and Exchange Commission issued an interpretation of an accounting standard that could make it easier for banks to report smaller losses, or perhaps even profits, when they announce results for the third quarter, which ended Tuesday.

The move on Tuesday drew praise from the American Bankers Association

Can you believe the Bankers Association is happy that the SEC is going to let them manipulate their financial statements in the open and get away with it?

I think that we have collectively become so worn out with the emotional debate and dialogue around what is going on in the financial markets, that we are running the risk of complacency.

Anytime in life when fatigue sets in, it is sometimes easy to just push snooze and roll over. But I think it is important that we keep paying attention and that we keep our elected representatives accountable in the upcoming election season.

I expect the House will pass the pork bailout bill tomorrow. And hopefully that along with the SEC manipulations will help stabilize things for the time being. Unfortunately, I think the economy is going to be in for some tough times for awhile, so be careful out there if you are an individual investor with any kind of short term horizon.

Hopefully, I can turn to brighter topics sometime soon. In the mean time, I’m going to get a cup of coffee, watch the debates, and try to keep my eyes open to see what other shenanigans come across the screen.

Stop The Blame Game. Pass The Bill.

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Stop pointing fingers.

A friend of mine asked me tonight: didn’t you tell me you were against a bailout a few weeks ago? 

The reality is: Yes, I was against a bailout of any kind until Congress proved they were capable of coming up with a reasonable compromise in the context of a very dire situation. As discussed, I discussed below, I believe the regulatory process is working. Whether the bill as it currently stands is the best solution is debatable, but that intervention is necessary at this point has become almost certain.

However, unfortunately, as discussed here (Barnum and Bailey Would Be Proud) today’s House vote on the proposed bailout turned into a finger-pointing session with the politics of old ruling the day: Democrats pointed fingers at Republicans and Republicans defiantly stood against supporting Democrats.

All the while, the stability of our economy is suffering. The stock market was down more than it has been in history…and this was not a matter of pointing fingers. It was the market’s reaction to the outlook for the economy if nothing is done.

So why should you care? Shouldn’t we dig our heels in and protect our “free market ideals”?

Why the Bill should pass.

1) Normal people depend on credit in a number of ways in their daily lives. From grocery shopping, to buying a car, to paying for college, the majority of Americans rely on credit to live. Although people have legitimate concerns about an over-reliance on credit over the last half-decade, we are not living in an academic textbook. We should address financial literacy with education, not with a smack to the head.

2) If we do not do something, many more banks will fail, and credit will significantly contract as a result. As you have seen, a number of banks made mistakes and lent too much money to people based on a failed economic models. If we do not do something, many more banks will fail. In fact, even if we do intervene, it is almost certain that there will be continued bank failures as the economy begins to slow and corporate defaults begin. As the credit crisis continues, the reality of credit evaporation will hurt normal people in real ways. We should seek to minimize this unfortunate reality.

3) Our economic theories have been proven wrong…why rely on them now? Those who want to take a hand’s off approach to the current situation don’t have much of a leg to stand on. If you believe in the effectiveness of the free market, how can you explain the excesses that put us where we are today? The market failed. Of course it did. It was based on models built by human beings. We are imperfect, so we built imperfect models. This isn’t rocket science. Continuing to bang our head into the wall based on economic principles that have been disproven is not only illogical, it is dangerous.

4) People are afraid. When I first started learning about economics, I remember thinking the ideas of “consumer confidence” and “economic sentiment” were wishy washy terms. Why would we care about people’s opinions when thinking about economic growth? The reason people’s opinions matter is because people are our economy. The market is comprised of millions of people, and their subjective understanding of the economic outlook can be just as important, perhaps more important, than what that understanding should be. Watching the stock market plummet today and gyrate over the last few months has made everyday Americans wary of our future. We need to rebuild confidence in our economy to keep it from slowing more than it already inevitably will.

Is the Bill perfect? No. Will it create moral hazard issues for future executives? Maybe. Will the economy really suffer if the government does nothing? Almost certainly.

The government needs to put party politics behind us.

Unfortunately, the government is facing a credibility crisis.

Sure the Bush Administration has made mistakes.  It is unfortunate that our confidence in government has sunk to such a low level that people are finding it difficult to believe how bad things will get if we do not intervene. As John Stewart cleverly pointed out in a side by-side view of Iraq and Economy announcments, President Bush’s speech last week was similar to the announcement of the War in Iraq.

However, the fact that you disagree with the President about Iraq should not lead you to stubbornly refuse to recognize how bad things are looking for our economy. No matter what some people might believe, the stock market is not controlled by anyone, and today’s market downturn showed that investors – Democrats, Independents, and Republicans - are worried about our economy. And they should be. We are witnessing an historic failure of our financial institutions the ramifications of which will be felt for years to come no matter what we do.

Now is not the time to put Party before Country.

Remember…at the end of the story of The Boy Who Cried Wolf the wolf comes. He is now standing on our doorstep. The question now is what are we going to do about it?

I remain confident that we will do the right thing.

Just One Of Those Days (Video)

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As all of you are now aware, the proposed bailout Bill did not pass.

Here are some thoughts on what was a difficult day in many ways…even on a day like today, though, there were good moments for all of us. I hope we can focus on these moments rather than on the negative. I am confident Congress will come back and pass a Bill later this week…until then, good luck in the markets.

The Bailout Proposal – The Regulatory Process Is Working

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Congress has released a draft of the proposed bailout Bill, the full text of which is embedded below (information on download is here: Bailout Bill)

In summary, it seems like 3 major positives have emerged from the negotiations. On the whole, I think people are making reasonable compromises and that as a result something will get passed shortly.

1) Mortgage Modifications. Beginning on page 27, the bill discusses the requirement that the fund work with homeowners to modify their mortgages to the extent doing so would save money for all involved (i.e. foreclosures can destroy value for all involved if home values in the area are already severely depressed). This is an excellent idea, and for those of you who are familiar with my work on this topic, it is one that strikes close to home. Basically, it looks like Congress is trying to take some of the stumbling blocks out of the way for rational the renegotiation of home mortgages.

2) Equity Participation. Beginning on page 45, the bill introduces a requirement that the fund take warrants in any company that is registered, or has approval to be registered (Read: Goldman Sachs or Morgan Stanley), and is aided by the bill. The purpose of which is to:

provide for reasonable participation by the Secretary, for the benefit of taxpayers, in equity appreciation [created by the bailout]

This is great news, and this addresses my primary concern with the initial draft. Although it does not eliminate moral hazard, at least we (taxpayers) get to benefit with those who are bailed out.

3) Judicial Review. As expected, on page 65, the Bill introduces the concept of judicial oversight which was lacking in Mr. Paulson’s initial proposal.

These are phenomenal developments, and it shows that the regulatory process is working. I would love it if a bailout was unnecessary and preventable. However, given that it is inevitable at this point, I am very glad to see that our government and our leaders are coming to reasonable and rational conclusions on these matters.

It gives me faith in our government and our country. Let’s hope they keep moving in this direction.

Another interesting structuring detail: On page 50-51, the bill discusses a gradual provisioning of authority. Basically, the fund will start with $250B, then with Presidential authority and Congressional notice, the limit is raised to $350B, and finally it can be raised to $700B (it looks like Congress has veto power over any amounts over $350B, although it must exercise disapproval before the limitation kicks in).

One final somewhat “negative” develoment. Suspension of Mark-to-Market Accounting. A sign of the likely trade-offs made to get the bill closer to the finish line is buried near the back of the Bill, starting on page 95. It appears that the Bill gives the SEC authority to ban mark-to-market accounting as well as requiring a report on the accounting standard. This seems like an example of the regulators getting the cart before the horse. One would imagine that a study should precede any rule change, but it seems like Banking lobbyists have a lot of pull.

Here is the bill:


Bailout Plan – Get more Legal Forms

An Explanation Of The Crisis: Why Do We Need The Bailout? (Video)

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Following President Bush’s excellent speech last night, I thought it might be worthwhile to review the various issues contributing to this crisis with a focus on the institutional side of the problem and why these companies need to be bailed out. Having spent the last year and half focused on this problem, I thought my perspective might be worthwhile.

To be clear, I think intervention may very well be necessary and preferred at this point. My biggest concern with the proposals to date is that they: 1) do not allow taxpayers to particpate in the upside of saved financial institutions and 2) have not made it clear that taxpayers may suffer losses on these investments.

The video is a bit long, because I tried to walk through the history as simply as possible. Hope it is helpful.