Paul Krugman had wanted to use a title for his column last weekend, when there was still a glimmer of hope that Lehman would be bailed out by the Fed. This putative title is too good not to be happily plagiarised here: ?If life hands you a Lehman, make Lehman aid?. As we know now, this did not happen.
But a tumultuous financial weekend culminated in a gigantic buyout by the US government of American International Group (AIG), the largest US insurance company. The Federal Reserve and the US Treasury authorised a $85 bn loan to AIG. The US government, in return, among other collateral, got a 79.9 per cent equity stake in AIG. This followed a bankruptcy filing of Lehman Brothers and the sale of Merrill Lynch, staving off another inevitable bankruptcy in the nick of time. All this within a span of three days. This followed the earlier gigantic bailout of Fannie Mae and Freddie Mac in August and the earlier ?modest? bailout of Bear Stearns Companies (facilitated by the Fed through backstopping $29 bn of dubious assets) and Northern Rock in the UK. All of this has led to the increasing frustration that the (in)actions of financial regulators have led to a situation where ?profits are privatised and losses are socialised?.
Allowing Lehman to fail was a weak and brief attempt to demonstrate a parlous adherence to principles of moral hazard, which was promptly jettisoned with the AIG bailout. This brief display of resolve has become the pivot for evaluating the circumstances in which the tattered banner of moral hazard is allowed to flutter. The interventions have been borne of fears that the systemic risks of the current financial situation are simply too great to be left alone. Systemic risk in the current context comprises of two elements: (a) inter-connectedness of financial transactions and (b) what is politely called ?disorderly deleveraging?.
To appreciate the extent to which the demise of a financial institution imperils the financial system as a whole, one has to understand the nature of the interlinkages of the modern financial system. How interconnected are the firm?s transactions with others? This looks to be the acid test for having determined that Bear or AIG was worth intervention and Lehman was not. Bear had $9 trillion derivatives on its books (much of them credit default swaps), Lehman reportedly had just over $700 billion. Barry Ritholtz, CEO of Fusion IQ, said on CNN that ?Lehman was only incompetent enough to blow up and destroy themselves whereas Bear?s degree of incompetence was enough to threaten the entire financial system?.
This interconnectedness then leads to the phenomenon of disorderly unwinding. This links the sharp contraction of market liquidity to a shortfall in funding liquidity and sets in motion a feedback loop. Leveraged institutions like banks must necessarily cut back credit lending more than 10 times their losses and capital erosion. The counterparty risks of a Bear, Fannie or AIG failing would produce a domino effect that produces a massive counterparty credit risk that rapidly increases uncertainty and destabilises the system.
This is the other side of moral hazard: information asymmetry. The notional value of derivatives held by US banks is about $180 trillion and probably about three times that size globally. Of course, notional values absurdly overstate market risk, but not default risk, i.e., the consequences of what happens when a Bear fails. The alarming thing is that 90% of these derivatives are non-exchange traded OTC and there is no mechanism for keeping track of them.
It was speculated that Lehman was allowed to fail since regulators today have a much better understanding of the systemic implications of the failure of a large financial institutions than during the early months of the crisis. This relates to the phrase that the RBI Governor has popularised in India: ?Known unknowns?. Northern Rock would probably have been allowed to go under had its problems surfaced about now rather than at the start of the crisis.
Financial regulation and oversight have worked more or less as advertised for banks, even if the risk levels at these banks have turned out to be far higher than expected and modelled. The reported $500 bn losses and write-downs, while mind-boggling, are not unwarrantedly large for the global economy to digest. The problem is patently the mammoth, largely unregulated, shadow banking system that has emerged rapidly over the past half decade; what the Economist called the ?baroque superstructure? of exotic mortgage-backed derivatives, conduits, SIVs and the rest.
In this superstructure, once a financial crisis sets in, all ex ante declarations of letting financial institutions fall by the wayside go waste. Interconnected and leveraged financial markets are here to stay and, to an extent, this is a good thing. The quest for higher returns will also persist with investors. In future, therefore, much tougher standards on transparency and disclosure are probably the only mechanism that will prevent excessive risks building up.
The author is vice-president, business & economic research, Axis Bank. These are his personal views