The collapse of
of other major financial institutions, has now produced perhaps the
worst U.S. financial crisis since the banking panic that faced former
President Franklin Roosevelt at the beginning of his administration in
The uncertainty created by the reluctance of the Treasury and
Federal Reserve to subsidize the acquisition of Lehman (along the lines
of JPMorgan Chase's
March takeover of Bear Stearns), and the process of unwinding Lehman's
huge portfolio of securities and derivatives trades, is likely to
produce a major surge in counter-party risk aversion. The resulting
unwinding of leverage and flight to quality threatens to destabilize
the global financial system, which may thus be facing a period of rapid
change and re-regulation.
Regulatory response. Market anxiety has been heightened by
the government's unwillingness to prevent the failure of such a large
investment bank. Measured by assets, Lehman is larger than Bear Stearns
before its March 16 collapse. This has increased uncertainty, as Wall
Street has been left to guess how large an institution must be before
regulators deem it to be "too big to fail."
Treasury Secretary Henry Paulson, a former chief executive officer of
understands the risks posed by such uncertainty. However, with other,
much larger U.S. thrifts and insurers in an increasingly precarious
financial position, he has been increasingly reluctant to put
taxpayers' dollars at risk backstopping less than indispensable
Spreading contagion. The bankruptcy of Lehman Brothers
threatens to saddle financial institutions around the world with new
losses. Those could come if Lehman's creditors dump its poorer-quality
investments onto markets, forcing investors who own similar securities
to write-down their value, or AIG's contracts in credit default swaps,
a type of insurance for securities, become worthless. Another concern
is that financial regulators outside of the United States may lack
resources to bail out institutions in their jurisdictions.
Back to basics? Undoubtedly, the financial sector is likely
to see important mergers and acquisition activity as the crisis
persists. A larger question is whether more traditional banking
interests with access to retail deposits will acquire independent
broker dealers, such as Goldman Sachs and
two remaining independent players. In the last decade, investment banks
have increasingly become hedge-fund-like entities, utilizing high
degrees of leverage and making significant income from proprietary
operations. With more traditional banking interests retaking the lead,
major players are likely to be seen taking less risk.
High-risk/high-leverage activity will continue, but in the boutique
market (i.e., hedge funds).
Shadow banking? The bigger worry is the state of the
shadow-banking sector-- hedge funds and structured investment vehicles.
These entities tend to have short-term liabilities, while their assets
are long-term, and in many cases illiquid. As primary brokers continue
to have their own difficulties, it will be harder and harder for them
to service this sector. In the short-term many of these will likely
fail. Whether their counter-party risk is enough to cause further
knock-on effects remains uncertain.
Coordinated response? The toolkit for monetary and
fiscal policy remains relatively constrained at the moment. A
continuation of the crisis might manifest more policy coordination
among major central banks, though a coordinated fiscal response remains
unlikely. Given inflation pressures have eased as commodity prices
continue their decline, central banks may feel inclined to lower
interest rates sooner. It appears likely that the Fed may lower rates
following its decision to relax its the collateral quality requirements
associated with its existing term-auction facility. The ECB and Bank of
England could also reduce interest rates, having today already injected
close to $50 billion into the financial system.
Wither recovery? Even if the immediate systemic risks
posed by Lehman's failure are contained, a U.S. (and global) economic
recovery is not a near-term prospect. Stabilization of the U.S. housing
market is a necessary condition for the end of the global credit
crisis--given that most of the problematic assets that trouble the
balance sheets of major financial institutions are linked to U.S.
housing. However, there is little indication that U.S. housing prices
will stabilize until mid-2009, at the earliest. This means that banks
and financial firms face further write-downs, greatly increasing the
chances of additional failures.