We do not yet have the details of Treasury’s plan. With respect to its effectiveness, if they do plan to buy most the troubled paper from banks, there’s one crucial question that must be answered, as Benjamin Graham would say, how much? This is crucial, because it’s even now not impossible to find buyers for CDO’s and ABS; as long as the seller is satisfied with a price in the order of 10-20 cents on the dollar, such paper can be disposed off. But such a disposal doesn’t ease the problem, as it will only cause further writedowns for the capital-constrained institutions, contracting credit further.


We must wait to see what the details of the Treasury’s proposal are. There is a suggestion that the purchases will be at market prices – such a choice would be accepted by very few of the troubled banks.


The goverment is faced with an extremely difficult situation. I have written before that the psychological pressures, the disasters that an uncontrolled unwinding of today’s problems can create, do not allow policymakers much calm or peace as they formulate their responses. The speed at which they modified their vision, in a few days, from no bailout for AIG, to a general bailout for the entire banking industry, demonstrates the lack of direction and calm at the highest levels. 


There’s no justification for blaming the government for all that is unfolding, the heavier part of which, in my opinion, lies with Alan Greenspan, and the private sector. But the lack of a unified vision, the ad-hoc nature of the solutions, are likely to complicate the developments.


The markets are delighted at the Treasury’s announcement, and as I wrote on 16th September, we do have euphoria now. On the other hand, a deeper analysis shows that there’s no reason to expect that taking out CDO’s and some ABS will necessarily clear bank’s balance sheets. The problem is not a housing industry crisis anymore, it’s the collapse of the triangle of high debt, high leverage, and overspending that has been fueling growth and bubbles during the course of more than a decade. Of course, if we had not had the direction change in August 2007, the build up could have continued indefinitely.  But now that the direction has reversed, rising unemployment, collapse in confidence, and continued bankruptcies show that this structural disease needs more than a financial solution, and more than a few quarters, in order to be eradicated. In that sense, if the Treasury’s remedy had been applied 6-8 months ago, I believe that there would have been a very high chance of success; now however, with almost every source of credit and financing constricted or shutdown, the problem is not only banking sector losses or failures, but failures and bankruptcies on a universal level. As far as I’m concerned, this will probably prevent the Treasury’s plan from succeeding.


Eventually, the government has the means to defuse this crisis, but at a cost. By issuing more debt, the government is capable of paying off every household and bank’s delinquent debt, but the cost will almost certainly be high inflation. And what does high inflation mean? It means general turmoil and continued crises in emerging markets, which are the only pillar on which the limping world economy is leaning at the moment.










Mostly from Bloomberg; commentary below:



“Lehman has 195 billion yen ($1.8 billion) of samurai outstanding. Its default on samurai bonds, yen-denominated notes sold in Japan by foreign borrowers, would be the first ever default by a U.S. company.


Samurai sales rose 61 percent this year to 2.6 trillion yen as investors sought bonds paying higher yields than notes from Japanese companies, data compiled by Bloomberg show. New issuance may exceed 3 trillion yen by year-end for the first time since 1996, Merrill Lynch & Co. predicted in July.


National Grid Gas Plc postponed what would have been its first samurai, sale manager Mitsubishi UFJ Securities Co. said in a faxed statement today, citing “market conditions”. The London-based company filed on Sept. 2 to sell 10 billion yen of the securities.


Deutsche Bank plans to sell yen bonds when “the market has recovered.”


Societe Generale SA spokesman Hideaki Hoshina declined to comment on whether the Paris-based company will proceed with its debut samurai bond offering. France’s second-largest bank filed with Japan’s Ministry of Finance on Sept. 5 to sell three- and five-year notes


“It will be difficult for independent investment banks to sell samurai bonds after this,” said Tetsuo Ishihara, credit analyst at Mizuho Securities”


Comment: In order to understand the significance of this development, one must first recall that the greed for higher yield by Asians has been one of the fundamental building blocks of the past bubble. As they recycled their export earnings into US and other higher yielding debt, the bubble could be inflated, and the cycle perpetuated.


The carry trade, samurai bonds, and similar paper, have indirectly been some of the major sources of funding for consumption in the West. As defaults fell globally in the low interest environment, and as perception of risk fell to very low levels, ever more Japanese and others had been buying these bonds in order to escape the very low returns at home. And the Asian financial markets, so far evading many of the worst aspects of the credit crisis, had offered an outlet for US financials and others facing often difficult conditions at home.


Lehman’s collapse appears to have been a shock for them, as their issuance was close to ten percent of the entire samurai bond market. The Asian mentality is in general more risk-averse than the Western, and the severe damage from the Lehman bankruptcy may cause contraction or freeze in another funding source for corporates.


Lehman will probably fail to repay almost all of its debt after filing for the biggest bankruptcy in history, according to S&P.

AIG has been downgraded by all three of the ratings agencies, and this will trigger around $13-17 billion in collateral calls from debt investors. There’re plans to support it with $70 billion to $75 billion in loans arranged by Goldman Sachs and JPMorgan, but the plan of this bailout appears similar to the SIV bailout plan of last year, which failed to materialise back then. These banks also failed to create a pool for saving Lehman just last week. AIG sold banks and other investors protection on $441 billion of fixed-income assets, including $57.8 billion in securities tied to subprime mortgages, according to Bloomberg.

The size of this company, the widepsread exposure of the financial system, its proximity in time to the bankruptcy of Lehman, and the general state of panic in the markets should assure government involvement in the resolution of this issue. Nonetheless, both the Fed and the Treasury have refused to bail out or backstop a bailout of this firm so far, and it’s unclear if this is a mere bluff. There appears to be a genuine conviction that the finances of the public are not deep enough to rescue all the large financial firms. The Federal Reserve will probably try to alleviate the symptoms of this crisis by ever increasing liquidity measures, and rate cuts, while Mr. Paulson keeps reassuring the public that the financial system is sound, and that the long term prospects of US are the best in the world. But one should by no means discount the possibility of future government bailouts.

As expected, CDS and corporate bond spreads are widening, with spreads doubling in many cases. In the CDS markets, yesterday’s early quiet appears to have been replaced by heavy activity to cover positions and determine exposure to AIG, Lehman, and the failed GSE’s. The rollover of indexes has been postponed because of uncertainty over pricing.  Overnight dollar libor rose to a massive 6 percent at one point yesterday, three times the Fed’s target rate. The Fed’s response was an injection of 70 billions. In both Europe and the US there is great difficulty in pricing everything from short term liquidity, to corporate debt.

In the rest of the world, Bank of Indonesia and People’s Bank of China have both reduced rates this week. More are expected to follow, but the wisdom of this choice is not entirely clear. What happened to Korea’s won recently is a good reminder that confidence in emerging markets is fading rapidly, as general risk aversion is extracting liquidity and threatening financial stability. Lower interest rates will probably lead to an acceleration of investors’ and speculators’ flight from these markets.

Taiwan’s government instructed its four major funds and state-owned banks to buy shares to help reverse the stock market’s 9 percent slump following Lehman Brothers Holdings Inc.’s bankruptcy filing yesterday, effectively nationalising a part of the economy. This is similar to Asian government response during the 1998 Russian and Asian financial crisis.

The Bank of Japan added a total of 2.5 trillion yen ($24 billion) to the financial system. Both the ECB and BoE will hold a second round of exceptional fine-tuning operations to ease tensions in the short term markets, among many others, from Norway to Australia.

This appears to be the turning point for the markets; the calm and complacency of the last year, the illusions that this issue was limited to financials, that there would be no contagion, seem to have disappeared with the speed of lightning. But this is how markets manage themselves.

Remember how the market for asset backed  securities suddenly seized up in August last year, and evaporated?

According to traders at Loomis Sayles, a bond trading firm, corporate bond market have completely seized up, and bidders have disappeared. It was “not possible to get quotes” in many cases, there was a “complete lack of liquidity”. The same case was being made for the CDS market today.

This reminds exactly of the situation in August of last year, when securities firms and brokerages found it impossible to value their asset backed securities. If this is confirmed by developments of the next few days and weeks, the significance and seriousness of this situation cannot be overemphasised.

The expectation, until recently, that no large financial firm would be allowed to fail reminds of the conviction that securities rated AAA would never lose their value. When that conviction evaporated, the markets for those assets disappeared, bringing us to where we are right now.

If this same chain of events is repeated for CDS and corporate bonds, it will lead a doubling of the economic troubles that we’re suffering today; a rapid escalation in corporate bankruptcies would be the outcome. The next few days and weeks will be crucial.

We will now see major deleveraging in a large number of firms, as derivatives, swaps and other positions to which Lehman was a counterparty are unwound. According to Bloomberg, 10 large banks including JPMorgan , Goldman Sachs and Citigroup have pooled 70 billion in a fund to create liquidity as deleveraging and unwinding of positions is taking place. As of May 31st, Lehman’s total debt is 613 billion dollars, according to Financial Times.



With respect to the CDS market, because Lehman’s bankruptcy filing came one hour after ISDA’s cancellation deadline,  there’s some fear that netting trades that were agreed between counterparties may have become useless. This would significantly complicate the counterparty risk issue. 



From FT Alphaville:


“The cost of insuring European corporate debt against default shot up on Monday morning, however, market participants said very little trading was actually going on and that market liquidity could be frozen for days or even longer as everyone awaited clarity on the impact of the collapse of such a large counterparty as Lehman Brothers. Traders and analysts said they hoped there might be some improvement once the US credit default swap markets opened this afternoon, but that that was far from assured.


“This is a big threat to the CDS markets as a whole, which is truly scary because that was the last liquid market. Here, we’re all wondering whether Lehman might have blown up the market”, said one hedge fund trader”



To deal with liquidity issues, BoE has offered 5 billion pounds for three days in an exceptional operation, attracting bids for 24.1 billion pounds. The European Central has also allotted 30 billion euros ($42.04 billion) in a one-day liquidity operation; again, there was far greater demand, with 51 bids for 90 billion euros. The Fed has increased the collateral window for PDCF to include stocks, and the amount offered on term securities lending facility has been expanded by 25 billion.



The hope is that a bottom can be found to the firesales, and liquidity issues that arise can be prevented from turning into solvency issues at any major firm.



Meanwhile, Fitch has downgraded Lehman’s long and short term issuer debt rating to D, and outstanding debt has been downgraded to C. The expectation for recovery in Lehman’s highest ranking, senior unsecured debt, is thought to be around 60 cents on the dollar, with  138 billion of Lehman’s bond debt owned by Bank of New York Mellon and Citigroup. Bank of New York Mellon’s role is that of a trustee, and the firm has no direct exposure, according to its statement. 



There’s also the issue of AIG’s rating downgrade, which could potentially be more problematic on the longer run.


Lehman bankruptcy imminent

September 14, 2008

Statement from the International Swaps and Derivatives Association, via Bloomberg:

“ISDA confirms a netting trading session will take place between 2 pm and 4 pm New York time for OTC derivatives. Product classes involved are credit, equity, rates, FX and commodity derivatives. The purpose of this session is to reduce risk associated with a potential Lehman Brothers Holding Inc. bankruptcy filing. Trades are contingent on a bankruptcy filing at or before 11:59 pm New York time, Sunday, September 14, 2008. If there is no filing, the trades cease to exist. These trades are subject to a protocol which is being distributed by ISDA (International Swaps and Derivatives Association). Traders should execute the protocol and return to ISDA.”

What this means is that they believe that Lehman will file for bankruptcy soon, and they’re trying to net out all the counterparty risk related to its positions, in commodities, forex, and every other kind of derivatives transactions. It should prevent any major disaster on Monday.

Lehman’s CDS Risk

September 14, 2008

*See below for a list of Lehman counterparties in derivatives*

There’s right now fear of financial chaos on Monday, in case Lehman is forced into a liquidation. The problem is the size of the CDS market, and Lehman’s important role as a counterparty to a large number of deals. The CDS market is larger than the MBS, stock and treasury markets combined, and it’s unregulated. There’re often more contracts on credit insurance than there are bonds outstanding: in other words, leverage has found its way into this section of the financial markets too. Today the size of this market is 62 trillion dollar on notional amount, which means that it kept growing in size even while the stock market, commercial paper market, and the securitisation markets shrank during the last year.

Gra ph of CDS market’s size

My expectation is that Lehman’s end will happen with less trouble than some are fearing at the moment, since there has been ample time to make preparations for this widely publicized and discussed eventuality. The end of Bear Sterns was abrupt and relatively unexpected. There were rumours, but the collapse of the firm was too fast to allow a period of readjustment. In that sense, the Fed was right in bailing out Bear’s counterparties. The choice of less involvement is also the proper way of dealing with the particularities of the Lehman issue.

The size of Lehman’s CDS involvement is unknown, according to Wall Street Journal’s article. In a survey last year by Fitch Ratings, Lehman was listed among the 10 largest CDS counterparties by number of trades and the amount of debt to which the contracts were tied.

Update on CDS developments related to Lehman for September 15th is here.

Updated on September 15th, from JPMorgan, via Financial Times:

Lehman counterparty exposure

Lehman counterparty exposure

Counterparty exposure to Lehman of various major European firms. The top three are JP Morgan, UBS, and Societe Generale,  in that order. The exposure of  Deutsche Bank is in the order of 1 trillion dollars, although the actual losses on this notional amount is unclear.

Will Lehman be the last?

September 13, 2008

The media concentrates on the demise of Lehman, but whatever befalls this institution is not of great consequence anymore. It’s almost a certainty that all the major financial actors have already made their preparations for any contingencies that will arise from this issue, and apart from the usual sell-off or rally to occur on Monday, nobody should hold his breath about the decorations of Lehman Brothers’ shroud.

The real issue here is the aftermath of this event. The half-hearted measures of the government are unlikely to instill much confidence in the markets, nor is it realistic to expect the Fed or the Treasury to have any success in reducing this very large body of continuing losses. As long as fear and pessimism persist, people will keep speculating on who will be the next to fall, increasing risk spreads and premiums, and eventually creating more bank failures, more bankruptcies, more defaults, and so forth. There’s already speculation about the fate of Merril Lynch, and there’s no reason to think that Lehman will be the last to die among the large institutions. Indeed, as long as the rumour mill is turning, as long as there’s a scarcity of goodwill, and as people realise that solvency issues are behind today’s difficulties, it’s a certainty that other institutions will fall too.

Just like the happy bubbles of yesterday fed on themselves to create ever more euphoria, the negative bubbles of today and tomorrow have the power to feed on panic and fear and reach irrational sizes. The only way to stop this from occurring without ruining the global financial system is global action by the central banks of the world, arguably nationalization and dismantling of bankrupt institutions. Essentially, there’s a need to create a central pool among central banks and treasuries to deal with the contingencies that are arising day after day. Because if this is not done, fiscal constraints, and political problems will prevent the actualisation of the very radical measures that are needed: in essence, the dismantling of the failing institutions, and socialisation of their losses. Of course it’s very unpleasant to even discuss this prospect, but what must be understood is that the failure and self-destruction of the financial system will hurt every single nation and individual in the world. There’s no way to escape the consequences of the debt binge of the past decade. And that bubble was a universal phenomenon, it inflated everything, now it will deflate everything.

The worst that can be done right now is an attempt at perpetuating the crisis by refusing to recognise the paradigm shift that has happened. To try to goad the US consumer to spend like he did in the past by stuffing ever more money into his pockets is only a way of delaying the inevitable for a few months. The positive effect of the latest stimulus package apparently lasted for only two months, indeed a very disheartening outcome for those who were expecting this to sustain consumption as during the 2001 recession. Today, however, people know that the era of non-stop borrowing is over, and just a single glance at the foreclosed homes of neighbours is enough to make them reconsider their plans of spending as if they had printing presses in the living room.

The growth potential of the US is less than what it was during the last decade. This is a fact that everyone has to realise. But of course, before that, we must first do our best to prevent the recession from turning into a depression: most reasonable people would now probably admit the clear potential for such an outcome.