Only a child could fail to be amused by the steely response of the US authorities to the collapse of Lehman Brothers, and the speed with which the futility of that response became apparent. The decision to let the struggling investment bank go under was a risky gamble - and useless if it was supposed to signal a change of strategy.
Each in the series of critical developments was hailed as the crisis point, before the next broke, yet more serious and more spectacular. Hardly surprising that this should have plunged the regulators into confusion and bewilderment. The weekend emergencies exploded one after another, faster and faster: 16 March, the investment bank Bear Stearns; 12 July, mortgage giants Fannie Mae and Freddie Mac part one; 6 September, Fannie and Freddie part two (see " US: from New Deal to new New Deal"); 13 September, Lehman Brothers and the financial services company Merrill Lynch; 16 September (less than a week later), the insurance group AIG (American International Group). Each time the Federal Reserve and the Treasury Department believed they had surpassed themselves, they quickly realised that nothing was working and they would have to go through it all again.
Their achievements were not enough to halt the collapse of the US financial system. And the cost wasn’t merely financial: neither Fed chairman Ben Bernanke nor Henry Paulson (former boss of Goldman Sachs, the flagship of uncompromising capitalism, and now Treasury Secretary in a rightwing administration) could ever have imagined that they would find themselves facing accusations of socialism each time they were forced to use state money to rescue private finance.
That sad paradox must have been one factor determining the decision they took as they staggered away from the rescue of Fannie and Freddie into the crisis at Lehman; they refused to intervene - a signal that the financial community would have to handle this one on its own. Personal humiliations apart, the Fed-Treasury position was understandable. The authorities were worried that each new intervention set a precedent, and were nervous that private bankers might dash happily to the brink of bankruptcy convinced that at the last moment they too, like Bear Stearns, Fannie and Freddie, would have to be saved. Such nonchalance was an affront; it was difficult to ignore the way in which arrogant financial institutions lined their pockets during the good times, then fled, screaming for protection and special treatment, to a state that they had previously dismissed as a quasi-Soviet absurdity.
There is always a danger that moral indignation will preempt analysis. Anger is legitimate, a necessary spur to gathering the political resources necessary for an eventual, vigorous reaction. But, analytically, clarity is essential. The immediate issue is systemic risk: the danger that, given the complexity of inter-bank commitments, the collapse of a single institution might generate shock waves leading to a cascade of collateral failures.
Let me remind any liberals who are slow on the uptake that systemic risk means what it says: the entire system is at risk, any and all institutions of private finance are now the potential victims of a global collapse. The destruction of the system of finance, of credit, would mean the end of all economic activity. It is important to be clear about the enormity of the consequences. Once a financial bubble has burst and the genie of systemic risk has been released, central banks lose any room for manoeuvre. Private finance can take the rest of the economy hostage, fatally tying the economy’s fate to its own. Since the collapse of one entails the collapse of the other, the state has no choice except to come to the rescue. This lies at the heart of the crisis. Financial re-regulation is pointless unless it is carried out with the strategic objective of preventing bubbles from reappearing.
Once systemic risk reconstitutes and reactivates itself the battle is lost, so the only solution is to eradicate it. The Fed may demonstrate no serious will to do this, but it is at least aware of the degree to which it is strategically outmatched in its campaign against the crisis in private finance (which is all the stronger for being moribund). So the Fed has submitted hopelessly to calls to bail out tottering banks, terrified that a refusal could precipitate an irreparable catastrophe.
In March 2008 Bear Stearns threatened to default on $13.4 trillion in credit derivatives transactions (1), ten times more than Long Term Capital Management, which almost brought the US financial system down in 1998. In July Fannie and Freddie threatened to default on their $1.5 trillion debt. Leading financial institutions had invested in these securities: pension funds representing the retired, mutual funds holding the savings of ordinary people, and even foreign central banks. Such a catastrophe threatened the survival of the US financial system.
At the Treasury, Paulson didn’t hesitate: on 12 July he made $25bn of public money available as lines of credit and to start recapitalisation. On 6 September it emerged that the sum required was more like $200bn, which taxpayers duly stumped up. "I didnwant to have to do that," said Paulson, horrified by the socialist future before him. But he did it all the same, because he had no choice.
A smaller fish
That Lehman was a smaller fish meant that the Fed and Treasury did have a choice. Determined to send the right signal, they decided to make Lehman pay for the sins of its brethren. But although Lehman afforded an excellent excuse to vent their anger, it required careful examination before being condemned to death: given its size and the exposure of the other banks that were its counterparties, did Lehman’s default constitute a systemic risk?
The bank’s exposure to derivatives was infinitely less than Bear Stearns’ - $29bn against $13.4 trillion (2). But Lehman, with debts of $613bn, overtook Worldcom to become the hugest bankruptcy in US history. Technically the default was not equivalent since Lehman had assets and the object of liquidation was to realise them. But what were those assets worth?
There was at least $85bn in damaged assets, $50bn of which was in subprime derivatives. The initial rescue plan, discussed over the weekend of 12 September but abandoned, was to warehouse these in an ad hoc "bad bank". Their value would have dropped after liquidation, even if the authorities, conscious of the risk of letting the value fall even further, envisaged an orderly liquidation over several months.
The dramatic downgrading of its assets was just one of the problems created by Lehman. The accounting convention of mark-to-market, whereby assets are valued at what they would currently fetch in the open market, would have forced all the other financial institutions to set a Lehman special knockdown price on their holdings of similar assets, with additional collateral depreciations.
Because Lehman was involved in many unsettled transaction, there was further counterparty risk. And there was the activation of credit default swaps (CDS), derivatives that insure their purchasers against any fall in the value of their bond holdings. Since you can’t have insurance without an insurer, Lehman’s collapse would trigger the CDSs issued to cover its debts; and the settlement was likely to be costly.
The CDS insurance system looks better on paper than it has proved in practice. The market in CDSs is shaky and creates shockwaves every time it is called upon to respond to another failure. The Lehman catastrophe came soon after the threat to the CDS market from the nationalisation of Fannie and Freddie.
The Fed and the Treasury hoped such fears would help justify their refusal to bail Lehman out and help persuade other major investment banks to take it over. But no private rescue plan emerged from the discussions: Wall Street is an abstract concept that covers a collection of individual, sometimes contradictory, interests.
A game of poker
There was a rescue plan - its failure led to Lehman’s liquidation - and it involved Barclays and Bank of America (which eventually picked up Merrill Lynch) acquiring Lehman’s good assets, and Wall Street paying collectively for its bad assets to be warehoused. But this meant that those banks that couldn’t afford the good assets were left to absorb the losses on the bad assets. They were reluctant to subsidise two more fortunate institutions, while they were left to rebuild the ruined edifice.
The weekend of 12-14 September was spent over the poker table. The Fed and the Treasury refused to give way. Wall Street wrongly interpreted this as an attempt to bully a greater commitment out of the private banks. Some of these were raiders after a killing; but others were there under pressure and were struggling to balance their reluctance to do their opportunistic colleagues a favour against the awareness that their own interests depended upon Lehman’s survival.
True to their word, the Fed and the Treasury let events take their course. But what they failed to foresee was that this renunciation of socialism would only last two days. They did their best. For almost a week their supporters, somewhat disoriented, offered their enthusiastic backing. The Financial Times commented: "It is time for the authorities to step back... What has been done so far should be enough" (3). But the situation, not the FT, decided what was enough. Only 48 hours later the Fed’s renunciation of socialism looked premature.
A textbook case
AIG is a textbook demonstration of the insanity of contemporary finance. Bored with being a simple insurance company, it set up a subsidiary, AIG Financial Products, and launched itself into the specialist CDS insurance market. When the financial crisis hit, AIG found itself providing insurance on $441bn of securities, £57.8bn of it related to subprime mortgages (4). Its losses were colossal. It had already lost $18bn over the previous three quarters; now, with CDSs kicking in and collateral devaluations, the collapse of Lehman seemed likely to raise AIG’s total losses to $30bn, $600m of it due to the complete collapse in Fannie and Freddie’s shares after nationalisation.
The rating agencies, desperate to repent for previous mistakes, dramatically downgraded AIG’s credit rating. This immediately forced it to meet margin calls to compensate for the damage to its credibility as the insurer on the CDSs it had written. But where was AIG to find $10bn-$13bn when it was already sinking?
The Fed and the Treasury, still euphoric after their weekend escape from the clutches of socialism, but shaken by the scale of the potential damage, came up with a plan for a private rescue. Goldman Sachs and JP Morgan would front a $75bn syndicated loan to AIG. Coming only a couple of days after Wall Street’s 10 leading banks had refused to put up $70bn to underpin the orderly liquidation of Lehman, the failure of a private rescue plan for AIG was predictable and the necessity of state intervention inescapable. Even so, the form that this took was astonishing: in return for an $85bn bridging loan from the central bank, the state acquired 79.9% of AIG stock.
The brief statement issued by the Fed on 16 September was extraordinary. The fact that there was no precedent for it to lend to a non-banking institution is a measure of the scale of the crisis. In March it had decided to allow investment banks to refinance, something that only deposit banks had been able to do since 1929. And now here was an insurance company knocking at its door.
With the Fed and the Treasury working together, as if conjoined, the state’s 79.9% stake in AIG looked like compensation for the Fed’s loan. But since when has a loan been granted in exchange for a share of capital? The loan has to be repaid; it is guaranteed by all AIG’s assets and was deliberately set at a penal rate to encourage speedy repayment. But once the Fed’s loan has been repaid, the state will remain a 79.9% shareholder in AIG. It has taken control without spending a cent, a shocking act of expropriation.
The New York Times reported that when Paulson and Bernanke appeared on the evening of 16 September to announce their plan, they looked grim. Compared with them, Venezuela’s president Hugo Chávez is a puppet in the hands of capital. At least he pays when he nationalises.
But this was just the beginning of the socialist contortions of Paulson and Bernanke. The crisis had moved on from the liquidity problems that the Fed was equipped to handle. With astronomical losses undermining the foundations of equity capital, the financial sector had a general solvency crisis. Since March there had been a frenzy of recapitalisations in which each new crisis - Bear Stearns, Fannie and Freddie, Lehman — had been precipitated by doubts about the ability of the banks to raise capital (5).
Recapitalisation requires capital. But by now, with the banks fighting to save what little capital they still had, there was nobody out there with enough money. The sovereign wealth funds (6), upon which everyone had, perhaps excessively, counted, examined their recent disappointments. Their dramatic intervention in March had been based upon the assumption that the prices of homes and shares had bottomed out; their subsequent losses made them more cautious. That left only the state to pick up the pieces.
So "Karl" Bernanke and "Vladimir Ilyich" Paulson still had work to do. They at least, unlike the mad neoliberals still calling for a moral purge in which the failed banks would be allowed to go under, understood what was required. The former head of Goldman Sachs was forced to recognise that there is an explosive instability built into unregulated finance: guaranteed to spark off endless catastrophes, but incapable of resolving them itself. Only the state had the sovereign power to ride roughshod over the law, nationalise now and pay later, unilaterally grab all the dividends, even from shares it didn’t own. It alone had the power to halt the disaster provoked by the mechanisms of the sacred market. It was socialism or the apocalypse.
Another danger is looming. After the subprime crisis comes the threat from Alternative A-paper (Alt-A) mortgages. Alt-A loans are considered riskier than prime mortgages and less risky than subprime. They supposedly depend upon borrowers answering questions, with allowances made for incomplete information or "mistakes". According to a study by the Mortgage Asset Research Institute, almost all Alt-A applications (drawn up by brokers for the banks) overstate borrowers’ incomes by from 5% to 50%. The Alt-A category includes option adjustable rate mortgages (Option-ARMs), which offer a range of repayment choices. Under one attractive option, for the first few years borrowers are exempt from repaying the principal and don’t even have to pay the full interest rate. The offer of an initial rate of 1% is hard to turn down.
Of course the inevitable has merely been postponed until later, when the reset - the readjustment of repayments - comes as even more of a shock. The average Option-ARM borrower can expect to see repayments increase by 63% at a stroke. According to the financial services company Bloomberg, 16% of holders of Alt-A mortgages agreed since January 2006 are more than two months in arrears. Since there is a delay of between three and five years before the rate is reset, defaults can be expected to increase next year and continue until 2011.
Subprime loans totalled $855bn; Alt-A mortgages amount to £1,000bn, of which Fannie Mae holds or guarantees £340bn. Wachovia (now taken over by Citigroup) holds £122bn in Option-ARMs; and Countrywide, saved from bankruptcy by Bank of America, £27bn. Washington Mutual (WaMu) held $53bn, £13bn of which was due for reset next year. On 15 September Standard & Poor’s (S&P) cut WaMu’s credit rating to junk bond level, the lowest. On 25 September it collapsed in the largest bank failure in US history and was sold to JP Morgan.
WaMu is a savings and loan association that holds the savings of ordinary people, who are beginning to feel the cold wind. Money market funds, hitherto assumed to be as liquid and safe as current accounts, have been overwhelmed by withdrawals since clients saw their assets devalued following the collapse of the Lehman shares in which the funds had so cleverly invested. A rush by savers would be the last straw.
Given the significant and widespread need for bank recapitalisation, and the refusal of those institutions still afloat to come to the rescue, that leaves only the state to act as the lender, shareholder and recapitaliser of last resort, and to confront a financial challenge that is becoming less susceptible to conventional solutions. On top of the $200bn it spent bailing out Fannie and Freddie, the federal state will end up buying warrants (7) and then shares, giving it ownership of AIG. Now - despite the House of Representatives’ initial rejection of Bush’s massive rescue plan on 29 September, causing further panic on the financial markets - it intends to commit a further $700bn to buying up toxic debts held by the banks.
Whether it requires across-the-board recapitalisation or a massive warehousing operation to rescue private finance from all its toxic assets, S&P puts the eventual total cost at 10 points of US GDP. If this comes, as seems likely, from taxpayers’ pockets, it will destroy what little growth still remains. If the public deficit and debt are allowed to increase, this will undermine Treasury bonds and the dollar, and extend the current private financial crisis to the public finances and the currency.
Judged by the usual rules of financial orthodoxy, every solution is bad. Which is why Bernanke and Paulson will take every necessary step to do what must be done; and also why the beliefs of so many of the faithful have been destroyed. Recapitalisation by currency issuance, confiscations or exchange controls - if things turn nasty, that could just be the beginning. We’re in unknown territory. ________________________________________________________
Frédéric Lordon is an economist and the author of Jusqu’à quand? L’éternel retour de la crise financière (Raisons d’agir, Paris, 2008)
(1) This was not a net exposure since commitments to buy/pay compensated for others to sell/receive.
(2) Office of the Comptroller of the Currency, New York, 30 September 2007.
(3) "Decisive inaction", The Financial Times, 11 September 2008.
(4) Housing loans to borrowers with questionable credit or even with no bank account at all.
(5) The Lehman crisis was precipitated by the collapse of negotiations for the Korea Development Bank to buy a stake in the company.
(6) See Ibrahim Warde, "Are they saviours, predators or dupes?", Le Monde diplomatique, English edition, May 2008.
(7) Securities conferring the right to buy stock.