Everything I know about the global financial system comes from cartoon stick figures. Still, this doesn’t sound good. (Via, via.)
Nouriel Roubini | Sep 13, 2008
It is now clear that we are again – as we were in mid- March at the time of the Bear Stearns collapse – an epsilon away from a generalized run on most of the shadow banking system, especially the other major independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley, Goldman Sachs). If Lehman does not find a buyer over the weekend and the counterparties of Lehman withdraw their credit lines on Monday (as they all will in the absence of a deal) you will have not only a collapse of Lehman but also the beginning of a run on the other independent broker dealers (Merrill Lynch first but also in sequence Goldman Sachs and Morgan Stanley and possibly even those broker dealers that are part of a larger commercial bank, I.e. JP Morgan and Citigroup). Then this run would lead to a massive systemic meltdown of the financial system. That is the reason why the Fed has convened in emergency meetings the heads of all major Wall Street firms on Friday and again today to convince them not to pull the plug on Lehman and maintain their exposure to this distressed broker dealer.
The Fed doesn’t want to simply bail out Lehman Brothers, as they did Bear Stearns, for a bunch of reasons — including, it appears, that it doesn’t set a good precedent to keep failing out banks that take crazy risks and then fail. Also because Lehman is in worse shape than Bear — insolvent, not just illiquid.
So will anyone step in and save Lehman? Signs point to no.
Unable to find a savior, the troubled investment bank Lehman Brothers appeared headed toward liquidation on Sunday, in what would be one of the biggest failures in Wall Street history.
Should we be surprised to learn that many of Lehman’s problems stem from worthless mortgage-related assets, known colorfully as “toxic waste”? Probably not.
Lehman put itself on the block earlier last week. Bad bets on real-estate holdings — which have factored into bank failures and caused other financial companies to founder — have thrust the firm in peril. It has been dogged by growing doubts about whether other financial institutions would continue to do business with it.
Everything is connected, which is why we can’t just let bad banks fail and to hell with them. My cartoon-based knowledge of the economy doesn’t accurately predict what will happen if banks start falling like dominoes, but it can’t be good, right?
Well, it happened at the start of the Great Depression. Lots of great big public works projects happened after that, building our infrastructure. Then again, people were homeless and starving all over the country, too.
It did result in us starting to regulate financial institutions, however. We figured out that their money lust wasn’t always lined up well with the greater picture of reason and ethics. It also resulted in us having the FDIC, where the government guarantees deposits in some banks up to a certain amount, so that people’s money they deposited in banks won’t simply vanish one day. That’s nice.
Who knows what will come from this? Advocates of a deregulated free market might be seen like advocates of Supersymmetry and the LHC. That is, even if the LHC doesn’t show Supersymmetry, the advocates will just say the conditions were such that you couldn’t say one way or the other.
What you can count on is that people with a passion for something will always seek ways to increase their rolling around in the tub with it. Oftentimes without regard for longer-term considerations and consequences, for themselves and others. A little like addiction.
What about the failure of regulation and oversight?
Some people are always going to be greedy, and CDOs sounded like a great way to distribute high risk products into layered tranches.
Why should the government be willing to take the word of Fitch and Moody seriously? They missed the risk due to suddenly high foreclosure correlation (or worse, wilfully ignored it) in rating the lower tranches as AAA. The govt did nothing because it increased liquidity in the low-deposit mortgage market.
Banks should be allowed to make bad choices but ultimately the failure here is political.
You surely aren’t contemplating banning derivatives; what we need is risk measures that are robust in low liquidity; high vol high correlation situations. VAR models just don’t cut it because they are overwhelmingly based on historical data.
Yes, it is interesting thinking that as we deregulate, we should also alter the predominant methods we use to analyze the flow of money, and associated risks.
Something is unclear to me, though: “Banks should be allowed to make bad choices but ultimately the failure here is political.”
It seems this is arguing for tighter/better regulation. However, at the same time, allowing banks to make big mistakes seems to be arguing against regulation.
I can’t seem to follow the logic in saying the failure was ultimately a political one. Unless, by political, you are also including the “private” politics inherent within the financial industry.
Considering my understanding of economics is probably not even to the level of stick figures, I hope this doesn’t sound TOO ignorant, but why is it that when individuals make bad judgement calls in debt/asset management, they lose their assets/homes… but when BANKS (who should KNOW better, in my mind, than offering obviously predatory loans to underqualified buyers) make “poor judgement calls,” the government bails them out?
Maybe I should take a class or two in economics…
I mean, it was legal for banks for do what they did. If they make these bad choices within the legal framework then let them fail. Yes, the consequences will be ugly, but that is exactly what counterparty risk is all about. You pay a premium for whatever product because your counterparty might default.
But the legal framework should be tightened so that risk isn’t encapsulated in simplistic metrics. And the government failed, partially, I contend, because it was politically convenient to do so.
In short, therefore, I think Lehman should be allowed to bankrupt itself, but it’s sad and a testament to bad government as well as bad banking that it was preventable.
Derivatives have done great things for the economy, and it is wrong to say they should just be banned.
It is impossible to anticipate all the risks which will arise, but it is feasible for “worst-case scenario” models should take the unknown into account, and it is feasible to ban extreme leveraging without having far greater capitalization ratios (only in the form of US government bonds, no “equivalent” “AAA” products) to finance it. The rationale: if the US government is about to default there are frankly far larger problems than investment banks failing.
@ Amy Wing
Because while the individual loses their own assets the banks lose their customers assets. If an individual goes broke it has little if any effect on the economy, however thousands and thousands of investors can have enough of an effect that bailing out the bank is required to prevent a larger collapse.
Which means, of course, you have to trust the people running the bank to “do the right things”. Either that, or watch them like a hawk, and carry a big stick.
They don’t like being watched, though. And they really hate big sticks. It distracts them – hinders them.
Which leaves us with trust.
Down down down Lehman goes:
http://www.cnbc.com/id/26708143
CNBC has confirmed press reports that Lehman Brothers is likely to file for bankruptcy protection as soon as Sunday evening.
But then Lehman didn’t exactly help its case when DoJ and IRS discovered their tax dodge schemes.
http://www.forbes.com/business/2008/09/11/senate-dividends-tax-biz-beltway-cx_ar_0911divtax.html
And the dominoes fall one by one:
http://seekingalpha.com/article/95396-lehman-spelling-trouble-for-the-dollar-and-carry-trades
http://www.bloomberg.com/apps/news?pid=20601087&sid=aRVspw_Rse64&refer=home
We appear to be witnessing a slow motion disintegration of the financial system in this country. In the space of a week F.Mac/S.Mae were bailed out, largely because they are the system which effectively manages our foreign debt, and now Lehman has tanked. Over the last 6 months we have witnessed a chain reaction ever since Bear Sterns. I’d be surprised if we have seen the last of it.
Curiously back in the 1920s it was thought that the market would work everything out. It didn’t, collapsed and constraints had to be placed over it. Then in the 1980s we were told again that markets could do it all, as Milty Friedman won a Nobel and Reagan’s “rocket scientists” under Stockton said that market logic was supreme. Now we might be back again to learn the same harsh lesson one more time!
Lawrence B. Crowell
Are you suggesting the government should bail out these private banks? Why should taxpayers pay for the mistakes of rich guys who took bad risks and are now suffering the consequences of their short-sighted greed? I think it would do the financial system some good if a few bankers had a bit of trouble affording their Hannakuh presents this winter.
Eew! Lawrence, not the “F” word! I’ve always felt really sorry for the University of Chicago because of that man, and feared it a little, too. He did some really great stuff for South America, too… years ago. We really should pay attention to experimental evidence.
I don’t know if it matters, if we learn any lessons from this, this time. People seem always more apt to listen to spin and marketing, rather than examining history. Rather than to exert any effort at all. Hopefully, I’m overly pessimistic.
Welcome to the Anglo disease. Hopefully this will spell the end for the dominance of financial capitalism.
This is the beginning of the end of investment banks in the US. When the dusts settle, all the famous names – Bear Stearns, Leyman Brothers, Merrill Lynch, Morgan Stanley, Goldman Sachs, etc, all will disappear. Some will go Chapter 11, but most will be absorbed by commercial and retail banks.
The destruction of these Wall Street rackets is a very good thing for the USA and much of the world. With each going down, I open a good wine to celebrate.
Nobody’s talking about the really important aspect of this. Who’s going to hire theoretical physicists who leave academia now?
The Discovery Channel?
Damn Quants and their risk assessment models that managed to create massive and irrational leverages for poor unsuspecting banks.
Whenever there is a problem in the world, it always comes down to theorist hubris~
I take that as an axiom.
The problem with the private capital model is that to save money, it must be invested and in an atomized economy, with everyone needing their envelope of wealth, lending standards were relaxed to accommodate that much wealth. The debt bubble expanded till it burst.
Money is not just an accounting of wealth, but primarily a public medium of exchange, like a road system. We are going to have to do away with the private banking system and make it a public institution, local, regional and national. Since the public is responsible for the risk, it may as well benefit from the rewards. This would lower taxes as well.
How about the brilliant idea of privatizing Social Security? So who do we let manage our retirement savings? Merrill Lynch? Society invests in its old age by taking care of its elders and safely raising and educating its young so they will do the same. That’s investing for the long haul.
Political power was originally a function of private initiative, but it became necessary to make it a public trust. Today, few people want to return to a monarchy. It is time to make economic power a public trust as well.
Since my ideas don’t get much traction, here is someone making the same argument:
http://webofdebt.wordpress.com/monetary-proposal/
That’s just it, John. People are very quick to extol the virtues of a free market unhindered by regulation. The freer, the better.
If you look at people that way, you end up with anarchy.
And in anarchy, there’s always someone who wants to be the big guy to lord it over on others, for one reason or another (or no reason but self-interest).
You end up with power clustered around a small number of individuals that way. The same seems to hold true with financial markets.
It’s basically back to feudalism.
John (#17), yes private enterprise has its faults; but nationalization leads inevitably to long term decline and failure. This has been proved time and time again, but is something naive and idealistic socialists can never grasp.
One problem is that muddleheaded politicians and civil servants, largely ignorant of the businesses they oversee, impose goals and limits inconsistent with the needs of the business to flourish or even survive without massive and ever increasing subsidies.
Also, a monopoly (which with all banks nationalized they would essentially become) engenders arrogance and high-handed behaviour by the bosses _and_ the staff. I presume you still favour a democratic society, and don’t propose to shoot strikers; but if so, in your new utopia I’d be prepared for lots of strikes and walk-outs at the drop of a hat.
That’s what happened in the UK with miners and dockers and postal staff and airlines, etc etc, in industries foolishly privatized by a socialist government (Labour) after WW2, until Maggie Thatcher blew away all the cobwebs and sold off the lot to private enterprise.
I thought most Americans instinctively understood all this, but evidently not.
Mark R on Sep 14th, 2008 wrote: Eew! Lawrence, not the “F” word!
Yep!, It find it too bad he died before he could see the bitter fruit of his life’s work. Of course since he and his Chicago school mafia worked with Pinnochet he might not be so concerned.
The current (Friedmannian) market ideology suffers from the delusion that any complex self-adaptive system can regulate itself. A lesson from biology is in order, for there are webs of molecular pathways which regulate a cell cycle and cell growth, or on a larger scale a healthy ecological system is one which has a diversity of species. If this is not the case then some molecular process, say a loss in the regulation or negative feedback on the activity of a tyrosine receptor for cell growth, will lead to runaway cell cycles. This is a mechanism for transformed cell growth or cancer. The loss of preditors in an ecological system can lead to population booms of other species or the run-away spread of “weeds,” or the explosion of algae and so forth. By the same token the market system needs to have external structures which act as negative feedbacks.
Of course corporations are not happy about this idea. A negative feedback amounts to limits on profits. Besides, with the ecological analogue we have some problems as well on that front. Come to think of it, there are few negative feedbacks on us human beings. We have been pretty good at getting rid of them ever since our Australopithicus ancestors started taking themselves off the menu. We seem “wired” for this!
“Spaceship Earth to Houston, we have problem!”
Lawrence B. Crowell
Money is nothing but a promise. Exchanging it is a tool we use to optimize distribution of resources and future investments. Events like this and the panic they cause signal that were not capable of properly using this tool.
Aaron,
Now those former academics might become teachers instead of quants. This may be good for our educational system. Or I may be delusional. 🙂
John R,
The intersection of economics and politics is more complicated and controversial than the simple dichotomy of socialism vs. democratic capitalism and this probably isn’t the best forum for that discussion. That said, society is a relationship between top down order and bottom up growth. The most ordered society on earth is likely North Korea and the least ordered is likely Somalia. The trick is structural flexibility that enables healthy growth, which requires the feedback mechanisms Lawrence mentions, in order to mitigate some of the more corrosive aspects of growth. The very top down processes which tend to squash our individuality are the very same natural evolutionary tendencies which evolved multicellular organisms in the first place. Your own body is a function of this relationship between top down order and bottom up growth. When the order overwhelms the growth, you get old and die, but if the growth rejects the order, you get cancer and die. So the issue is how to further develop our economic and political systems to be able to survive the current problems and build a better model from the lessons learned. The fact is that there is no going back because the old model is broken. Whether they want to, or not, governments are going to find themselves in the position of nationalizing the banking systems. Many people are going to be crying foul, but the public is ultimately responsible for the health of the monetary systems on which a modern economy depends. I, of all people, am not advocating any form of totalitarianism, either of the socialist or fascist persuasion, nor am I a particular fan of anarchy. There is no happy medium either, as that’s another form of stagnation, so there will always be a swinging between varying poles and preferences. Rather than look to the past, consider the future: The banking system is broken. It will be propped up by government to whatever extent is possible. Rather then cry socialism, do you have any ideas? Should we return banking to a private profit system, or would it be to the larger interest to try it as a public function. Think in terms of other public functions, the roads, the courts, the military, legislative and executive branches, etc. How many of those would you want to see run as private enterprise? It is possible to have effective public sector functions. In fact the private sector depends on them. Consider the court system: Do you think a viable society could exist with a private legal system? How about the military? The fact is that our military has become privatized and from what I’ve read, I find it disturbing, to say the least. I could go on, but you get the idea.
P.S,
Keep in mind that issuing currency is a public function which has been effectively leased to what amounts to a GSE, the Federal Reserve System, which is owned by its member banks and pays its primary profits back to the Treasury, but not those earned through fractional lending by the member banks. I’m saying that the function of banking could be incorporated into all the various levels of government, from small banks at the county and town level, up through state and regional banks, to various national banks. They would feed their profits back to the levels of government at which they are incorporated, as a form of community income. This would maintain a serious level of competition between communities as they seek to develop the most desirable standards of living and outreach to local businesses, because people and businesses would migrate away from poorly run communities.
Rather then go back to systems of local currencies, which do have their benefits, continuing to use a national currency would maintain a general interconnectivity and prevent isolationism.
All economic ideologies will fail if not managed in ways required. Only ‘hubris theorists’ engaged in endless arguments about this or that -ism being better.
Wall Street investment banks fail because they engaged in practices far beyond sense, way into gambling, with vast unregulated powers, driven by unlimited greed. In short, they used their banking power to create trillion of dollars of private money (in the form of credits) by taking a meager amount of real capital and leveraged it to an insane proportion. For a while they got away with it by sheer complexity of their products, aided no less by an army of physicists and mathematicians, Trojan Horse racketeering, and secrecy. For a while they paid themselves salaries and bonuses so great it makes King Louis IV boil with envy.
Have no pity for these asshole executives and ‘financial engineering’ con artists. They came, they screwed, and now they got screwed.