The Lehman Shock: An Interim Report

Many people say that we are in the worst financial crisis in a century. It is certainly bad and the worst in the U.S. at least since the Great Depression. We have seen, however, many other crises in other parts of the world. The current crisis in the U.S. involves some new financial products, and the U.S. financial system and economy are large, but there are some issues that emerge repeatedly in many financial crises including this one. These include importance of systemic risk, trade-off between financial stability and moral hazard, central bank’s responsibility in maintaining stability of financial system, benefits and costs of nationalization of failed financial enterprises and/or government asset management companies that buy toxic assets, just to mention a few.

Having studied “smaller” crises in the past U.S., Asia, Northern Europe, Latin America, and Japan (this was quite large for contemporary observers), we think we know something about the nature of these financial crises and what the regulators should and should not do. Against this (admittedly incomplete) knowledge, we can evaluate the handling of the current financial crisis in the U.S. The financial crisis is still developing and not over, but I want to start taking my notes on the responses of the U.S. regulators so far.

The Treasury and the Federal Reserve made a gutsy call to allow the Lehman to fail. As I argued elsewhere, an important lesson from the Japanese financial crisis a decade ago is that helping troubled (and probably insolvent) financial institutions just delays the inevitable resolution and prolong (and deepen) the crisis. The handlings of Bear-Stearns in March and Fannie Mae and Freddie Mac a couple of weeks ago, which many people criticize, had some rescue components, although they were certainly different from outright rescues and forbearance practiced by the Japanese regulator before the late 1990s. In the case of Lehman, the U.S. regulators went one step further and refused to provide financial help.

A rationale for rescuing large troubled financial institution is, of course, potential systemic risk. One can argue that the U.S. regulators judged the Lehman was not systemically important although Bear Stearns was. We will find out if this judgment was correct. If not, we will be able to find out how large the cost of the systemic risk of the failure of an investment bank of the size of Lehman. Either way, the U.S. is conducting a great experiment from which everyone can learn.

So far, I view that the financial market has been absorbing the shock of the Lehman failure quite well. The stock prices, especially those of financial institutions, are down. But, this is what we should expect if shareholders were expecting the government to continue to rescue all seemingly systematically important financial institutions. Now that they know such help may not come, it is natural for the stock prices to go down. The failure of Lehman also intensified the troubles at Lehman, AIG, and WaMu. But, the troubles at these financial institutions have been already well known for months. The problem has not quite spread to other financial institutions (yet) which have been considered rather healthy.

An alarming sign exists, however, in credit markets. As Bloomberg reports, for example, overnight lending rates have been pushed up everywhere and credit default swaps on some healthy financial institutions such as Goldman Sachs have been rising. To quote from the Bloomberg news,

The cost to protect against a default by Morgan Stanley and Goldman Sachs Group Inc. rose to a record amid the credit-market seizure triggered by the collapse of Lehman Brothers Holdings Inc.

Credit-default swaps on Morgan Stanley rose to levels typical of companies in distress. Contracts on Goldman rose for a third day following Lehman’s bankruptcy, while those on Wachovia Corp. approached a record reached yesterday. Contracts plunged on American International Group Inc., the insurer bailed out by the U.S. government.

Credit markets have been locked up since New York-based Lehman, which was the fourth-largest U.S. securities firm, filed for bankruptcy protection on Sept. 15, raising concern that other financial companies may fail. Investors have been unwilling to take on new debt risk and overnight lending rates have soared.

This is an important development to watch. The central banks all over the world are pumping in liquidities to interbank markets. The question is whether the efforts will be sufficient to calm down the market.

The fate of AIG is quite different from that of Lehman, at least for now. The Federal Reserve committed to lend up to $85 billion to AIG at a quite high rate (LIBOR plus 8.5%) and the U.S. government takes about 80% stake in the form of warrants. This is almost (but not quite) nationalization of AIG. In this case, the Treasury and the Federal Reserve seem to have decided that the failure of AIG would create too big a systemic problem.

A problem here is that the U.S. does not have a systematic mechanism to deal with failure of large non-bank institutions. This is essentially the same problem for Japanese banks before 1998. Japan, where no banks were allowed to fail (after the WWII) until 1995, did not have a mechanism to deal with large banks with systemic importance. This emerged as a huge problem when the Long Term Credit Bank of Japan (LTCB), which had many international transactions, was in serious trouble in 1998. (Earlier, in November 1997, one of the largest banks, Hokkaido Takushoku Bank, and the fourth largest security firm, Yamaichi Securities, were allowed to fail, presumably because they were not considered to have international systemic importance. Lehman was the fourth largest investment bank. Maybe the number 4 is an unlucky number.) In the end, the Japanese government passed the Financial Revitalization Act, which enabled the government to nationalize troubled large banks temporarily. Late in 1998, LTCB and another troubled long-term credit bank, Nippon Credit Bank, were nationalized (and eventually sold to new investors after restructuring), and this marked (probably the most important) turning point for the resolution of banking crisis in Japan.

The U.S. has a mechanism to deal with failed large banks: FDIC can take them over and restructure. Perhaps we would be better off with a similar mechanism of temporary nationalization of systemically important investment banks, insurance companies, and other financial institutions, but it will take time (and the Congress’s involvement) to institute that. Until then, the Treasury and the Federal Reserve may have to continue improvising. The financial market will continue guessing. The financial crisis may not end until the regulators establish a rule on these interventions and the market comes to clear understanding of the rule.