Titanic and iceberg

Titanic and iceberg

Update: Ten of the world’s big banks have kicked in 70 billion into a liquidity fund, not to buy Lehman but to shore up the market tomorrow.  70 billion is still a lot of money, the market will probably make it through.  If it doesn’t, flee for the hills.

Well, the big shit pile, as it is affectionately known, continues to hit the fan. It looks like Lehman Brothers has not found a buyer and will have to declare bankruptcy tonight. Merrill Lynch has reached an agreement to be bought by Bank of America for $29/share in stock, which is about 50% more than it’s current valued at, so it’s a good deal for Merrill, though I doubt BoA is going to be pleased with it in the long run.

Lehman going bankrupt means that its trades are going to have to be unwound. A lot of these are very long term, things like currency swaps, and the amounts of money involved in clearing them are going to be significant. Others of them are securitized assets such as mortgages which currently have no real market value.

It’s that market value folks need to be scared of. The banks and the remaining brokers have a lot of this toxic waste on their books, and they don’t have it on the books at market prices, because there is no market price. A market price is about to be created for a ton of it, as Lehman is forced to sell during its bankruptcy liquidation. That will force banks and brokerages and other holders of this crap (like municipalities, States and pension funds) to also have to value it. A lot of them are going to find out that they’re bankrupt. Merrill did the right thing selling itself while it still has value, because if Lehman goes down, in a couple months Merrill’s assets might be in the negatives.

Lehman itself wasn’t bought because as Peter Morici, among others, points out—it’s insolvent. The value of its assets is worth less than its liabilities. It’s worth negative money. The banks didn’t want to buy it because of this, unless the Feds were willing to pony up as they did with Stearns and make it worth their while. The Feds didn’t want to keep doing that because damn, they already own a huge chunk of this heaping pile after taking over Freddie and Fannie and giving the banks and brokerages access to Fed loans in exchange for crap collateral. Personally, I’m surprised they blinked. Once you’re pushing "owning" half the bad mortgages in the country, what’s a few more billion?

It seems to be about moral hazard more than an unwillingness to take on more public debt—they don’t want to bail Lehman, but they are increasing loan facilities which take on crappy securities. So Lehman is allowed to go under, but the Fed hopes that this buttress will damp down the storm. My guess: Paulson and Bernanke have stopped worrying about saving Republicans and started worrying about how they’ll go down in the history books if they keep treating this as "privatize the profits, socialize the losses."

However on Monday, even with the improved loan facility this is going to mean a run on the remaining brokerage houses and against any banks or other financial institutions which are considered weak. If the Feds are withdrawing their implicit promise to socialize all the losses of the last expansion, then no one knows anymore where the bottom is.

This is because of the joy of leverage in reverse. Because the companies involved were so heavily leveraged and because the securities are also so heavily leveraged, even small increases in default rates or small decreases in performance transalate into huge losses. If you’ve got 10:1 leverage, every dollar move against you is 10 bucks. If you’ve got 42:1, it’s $42. And some places have higher leverage event than that, before you add in the innate leverage in many of these securities.

When you don’t know where the bottom is, when you don’t even know how bad the potential losses are because you can’t evaluate the securities in question because underwriting standards were so low that you have no idea if AAA is really B or C, or toilet paper… you can’t make decisions of what companies or securities are worth. And if you don’t know that, you don’t know where the bottom is, even if you knew when the economy in general and the housing market in specific was going to turn around.

So unless the Feds blink before midnight, and I don’t think they will, tomorrow is going to be very interesting. Lehman won’t be the last major firm to go under. Next up appears to the be the insurer, AIG, which needs a capital infusion to survive. And there will be more, including some of the larger banks.

I don’t think anyone in the room, and the room is the world, is going to avoid getting hit by this crap in the months and years to come.

Oh, and those economic plans, including tax cut plans, that both candidates have? Forget them, they’re based on fantasies about what the economic situation is going to be. Revenues will be way down and the economy in the toilet. And I just don’t know how much more money the Chinese are going to be willing to lend the US on concessionary terms when US consumers aren’t buying their goods anyway.

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