donsutherland1

Over the weekend, discussions were underway under which Lehman Brothers would be acquired by another firm. As the hours toward Monday's opening of the U.S. financial markets wound down, two major candidates for acquiring Lehman, Bank of America and Barclays, dropped out.

In addition, some extraordinary efforts were underway so as to avoid a potential systemic impact should Lehman Brothers file for bankruptcy. CNN reported:

the International Swaps and Derivatives Association staged a special trading session so that big brokers could limit their Lehman Brothers risks.

The session was called "to reduce risk associated with a potential Lehman Brothers Holding Inc. bankruptcy," according to a statement on the ISDA's Web site.

As per the ISDA's statement, the transactions are "contingent" on Lehman Brothers' filing for bankruptcy at or before 11:59 pm EDT tonight. In other words, the trades would be meaningless if Lehman does not file for bankruptcy by the above-noted timeline.

In the broader context, a potential bankruptcy filing by Lehman would increase the focus on such other financial firms as AIG and Washington Mutual Bank. Both firms have had the need to raise capital. Such enhanced scrutiny could increase the headwinds currently eroding confidence in the U.S. financial system. Should such a filing take place, U.S. stocks could be significantly lower tomorrow, perhaps 2% or more.

Finally, given what is at stake, one cannot rule out the possibility that additional efforts to close some kind of deal (and possibly with some public financing) could still be in the works leading up to and perhaps even going on beyond midnight. It will be interesting to see how things turn out.

donsutherland1

Should Lehman Brothers file for bankruptcy, one can probably expect that private and perhaps public money/guarantees would be used to help assure an orderly liquidation of Lehman's positions and perhaps the company, itself. Such measures could include loan guarantees, an expansion of the Fed's temporary liquidity facilities (particularly the PDCF), etc. The action that followed the collapse of the Long-Term Capital Management (LTCM) hedge fund in 1998 could provide a working model. Nonetheless, such steps would not likely overcome the gathering erosion of confidence in several major U.S. financial institutions.

donsutherland1

There's another interesting angle to the story that hasn't garnered much attention, at least so far. Lehman Brothers is one of 19 primary dealers. Given that Lehman Brothers has access to the Fed's Primary Dealer Credit Facility (PDCF), Lehman's possible bankruptcy could raise questions as to how effective the PDCF is.

After all, in the past some argued that if Bear Stearns had access to the Fed's discount window, it might not have failed. Through the PDCF, Lehman Brothers has such access. Therefore, if, in fact, such questions arise, market confidence in the Fed's overall temporary liquidity framework (TAF, TSLF, and PDCF) could suffer. In turn, that could increase pressure on the already stressed U.S. financial system.

donsutherland1

The Federal Reserve just announced a broadening of its Primary Dealer Credit Facility (PDCF) and Term Securities Lending Facility (TSLF). Such terms allow for a larger range of collateral. The Fed announced:

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.

The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

These changes represent a significant broadening in the collateral accepted under both programs and should enhance the effectiveness of these facilities in supporting the liquidity of primary dealers and financial markets more generally.

Also, Schedule 2 TSLF auctions will be conducted each week; previously, Schedule 2 auctions had been conducted every two weeks. In addition, the amounts offered under Schedule 2 auctions will be increased to a total of $150 billion, from a total of $125 billion. Amounts offered in Schedule 1 auctions will remain at a total of $50 billion. Thus, the total amount offered in the TSLF program will rise to $200 billion from $175 billion.

The Board also adopted an interim final rule that provides a temporary exception to the limitations in section 23A of the Federal Reserve Act. It allows all insured depository institutions to provide liquidity to their affiliates for assets typically funded in the tri-party repo market. This exception expires on January 30, 2009, unless extended by the Board, and is subject to various conditions to promote safety and soundness.

ARealConservative

Tomorrow morning is going to be interesting.

Onion Eater

I am not prepared today (Sunday) to comment on the fate of Lehman Brothers. However, I will point out that the question of who has access to the Fed's Discount Window is important, and far more important than the discount rate that the Fed charges these privileged few.

In my Axiomatic Economics by Victor Aguilar: Critique of Austrian Economics, I write:

“Credit limits are more important than interest rates and there are many people who cannot get credit at all. Interest rates only affect how much money is being transferred. They do not affect who gets it…

“Recently, Stiglitz and Greenwald have raised the same issue. ‘That some loans are not repaid is central… Thus, a central function of banks is to determine who is likely to default, and in doing so, banks determine the supply of loans.’ (2003, p. 3). This idea, that bank loans redistribute wealth from one class of people to another, is a fundamental departure from the classical view that banks merely divide the world into those who are willing to borrow at x% but not at x.1%, without regard to who those people are, their class or their importance to the government.”

Recent events have confirmed my belief that credit limits are more important than interest rates:

Alan Zibel writes, “Lenders [who must satisfy Fannie and Freddie] are demanding bank statements, big cash reserves and second appraisals before they approve a loan to refinance a home. Mortgage rates are hovering around 6.6%, about the same level as a year ago.”

Clearly, if mortgage rates are the same as a year ago but the housing market is so much different (and worse) than a year ago, then mortgage rates are not the best measure of the market. Credit limits are.

Martin Feldstein concurs, “The dysfunctional state of the credit market means that many individuals and businesses are unable to get credit. Lowering interest rates will not stimulate demand for those who cannot get credit.”

At the macro level, most economists agree that the Federal Reserve loaning money to investment banks and holding loan auctions to avoid shaming the recipients is far more important than the fact that they lowered the discount rate. Also, the repeal of the Glass-Steagall act in 1999 is widely seen as a precursor to the current credit crisis, yet it had no direct impact on interest rates.

REFERENCES

Stiglitz and Greenwald. 2003. Towards a New Paradigm in Monetary Economics. Cambridge, England: Cambridge University Press

Note: Zibel and Feldstein are newspaper columnists and I don't have the sources for their quotes, though I can probably find them.

__________________
Website: www.axiomaticeconomics.com

Motto: Critiques and rebuttals are how science advances.

jfuh

It almost seems like wallstreet just got hit by Ike.

__________________
The facts and science of the theory of anthropogenic Global warming

donsutherland1

Certainly, big changes are underway. Bank of America has acquired Merrill Lynch. Lehman Brothers may be gone. Bear Stearns was purchased by JP Morgan earlier in the year.

Although I believe that the headwinds buffeting the nation's financial system coupled with pressures on consumer spending have increased the risk of a recession beginning later this year and continuing into at least a portion of next year, I do not expect U.S. stocks to crash (a 10% or greater drop over 1-2 days). Nevertheless, tomorrow could be a fairly tough day for stocks with a potential decline of more than 2% by the close, though that scenario is not cast in stone. For example, if the CPI shows an increase vs. the consensus forecast of a 0.1% decrease, that could add to the selling pressure. On the other hand, if AIG can make progress toward addressing its financing needs, there could be some improved market sentiments that could mitigate selling pressure.

ARealConservative

Lehman Brothers - eBay (item 110289318047 end time Sep-20-08 16:58:22 PDT)

donsutherland1

The failure of Lehman Brothers probably will not lead to a significant worsening of the present macroeconomic environment e.g., it likely will not drive the economy into recession by itself. However, it will likely reinforce and perhaps accelerate ongoing trends toward deleveraging. It will also likely have a modest adverse macroeconomic impact as it tightens the ongoing credit squeeze and further erodes confidence in the U.S. financial system and the business models that guide its operations.

Outstanding mortgage debt continues to exceed 100% of GDP. That remains well above the historic peak prior to the most recent real estate bubble when mortgages came to 65.9% of GDP in 1991. In the second quarter, credit card charge-off and delinquency rates rose further. The delinquency rate has now risen to 4.90%, the highest figure since 2002 Q1. The charge-off rate stood at 5.47%, its highest figure since 2005 Q4. Those levels of indebtedness highlight the need for a deleveraging by American consumers and such a trend appears to be getting underway in its very early stages, presently in the mortgage market.

The demise of Lehman Brothers, despite its having had access to the Primary Dealer Credit Facility (PDCF), and continued strains facing additional financial institutions such as Washington Mutual Bank, suggests that the ongoing credit squeeze could tighten further. If the systemic problems plaguing the nation's financial system are not addressed meaningfully in the near-term, there is a possibility of the onset of a full-blown credit crunch. A tigher credit squeeze, and credit crunch if it develops, will further amplify the trend toward deleveraging.

Furthermore, the stock market is not providing any “wealth effect” to bolster consumer spending. Since October 2007, the Dow Jones Industrials is down 19.4% while the S&P 500 is down 20.0%. In real terms, both indices are down 24.0% and 24.7% respectively.

As a result, the American consumer will likely play a gradually smaller role in the economy in the quarters and years ahead. The transition toward that outcome will likely entail a period of slower growth and a heightened risk of recession as real personal consumption expenditures (PCE) declines as a share of GDP.

The revised 2008 Q2 GDP data showed that real PCE amounted to 71.1% of GDP vs. 71.4% of GDP for the first quarter. That remains well above the figure for the previous decade.

During the 2000s, real PCE increased to 70.6% of real GDP. That was more than 3 percentage points above the 1980s and 1990s figure. The fallout from the dissipating housing bubble and resulting credit squeeze could begin steering the economy back toward recent historic norms.

Real PCE will likely decline relative to real GDP toward 70.0% of real GDP and possibly even 69.0% of real GDP. That figure would still come out above the 30-year average of 68.0% of real GDP and the 67.3% average for the 1990s. Whether or not an even larger decline takes place would remain to be seen.

The bottom line is that the U.S. economy is in the midst of a gradual structural deleveraging. The turmoil associated with the failure of Lehman Brothers and concern about other financial industry firms will likely reinforce that structural adjustment. That restructuring and a continuation of bad fiscal policy in Washington will sustain headwinds against sustained robust economic growth in the near-term.

Finally, in the absence of comprehensive financial system reform, there remains the possibility that a significant slice of the U.S. financial system could ultimately need the kind of restructuring that was undertaken in South Korea during the Asian financial crisis of 1997-98. Otherwise, the danger that investor confidence in the U.S. financial system could wane to the extent that capital inflows into the U.S. diminish or even capital begins flowing out of the U.S. could emerge. I do not believe the U.S. is in that position right now, but the overall risk has increased. Such perceptions could have future implications for the federal government, raising its long-term borrowing cost and thereby making it costlier to avoid fiscal discipline efforts. Creditors are not likely to be fooled by underreported deficit figures on account of such practices as the recent announcement by the Office of Management and Budget (OMB) that it will keep federal financing of Fannie Mae and Freddie Mac off-budget.

A restructured U.S. financial system almost certainly would be less leveraged than is currently the situation, play a reduced role in real estate lending (portfolio diversification), maintain fewer off-balance sheet vehicles, and report financial information in a more transparent fashion. Increased transparency and the return of more effective risk management practices i.e., maturity matching, portfolio diversification, increased capital buffer, would likely would become the rules of that new environment. Needless to say, as has historically been the case, over time there the danger that complacency and a new softening of risk management discipline would return would persist.