It now looks likely that, unless the US Treasury blinks and makes public resources available to support a private take-over of Lehman brothers, the investment bank will have to file for bankruptcy.
The argument for putting public money into the rescue/take-over by JP Morgan Chase of Bear Stearns was that Bear Stearns was ‘too interconnected to fail’. As the smallest of the investment banks, its systemic significance was argued to derive from the damage that would be done to the rest of the financial system if Bear Stearns were to attempt a last-gasp escape from oblivion through a desperate fire sale of its illiquid assets. A vicious downward spiral of market illiquidity and funding illiquidity could have resulted, dragging down potentially viable financial institutions and causing unnecessary harm to the real economy.
Lehman Brothers is larger than Bear Stearns, so what’s different now?
One obvious difference is that since the demise of Bear Stearns in March, the Fed has created the Primary Dealer Credit Facility and the Term Securities Lending Facility. These facilities permit financially distressed primary dealer (both Bear and Lehman are/were primary dealers) to use illiquid collateral to borrow from the Fed (overnight Fed reserves in the case of the PDCF, up to a month Treasury Bills in the case of the TSLF). With these market support facilities in place, the threat of a fire-sale of illiquid assets is less daunting. The presence of a market maker of last resort makes it easier for the Fed, the other regulators and the Treasury, to let even household names in the banking world fail.
The second obvious difference is that since Bear Stearns crashed, the US Treasury has, through its de-facto nationalisation of Freddie and Fannie, taken an additional $1.7 trillion of debt on its balance sheet, as well as a $3.7 trillion exposure to mortgage- and MBS-guarantees, with a fair value of around $350 bn. The mortgage and MBS assets the Treasury acquired in the deal should not be ignored, of course, but are subject to non-trivial default risk. In addition, the pressures from Congress are mounting already, for the Treasury to restructure these mortgages to minimise the hardship and financial discomfort of the mortgage borrowers. The argument (made by the Congressional leadership) that forgiving part of the mortgage debt (or equivalent measures) would actually increase the present discounted value of the cash flows the Treasury would derive from these mortgages is deeply suspect. I have never seen any evidence that subprime- and alt-A mortgage borrowers are in a debt-trap to such an extent and in such a way that Fannie and Freddie are on the wrong side of the mortgage debt Laffer curve, where the fair value of the debt would increase if part of the notional debt were foregiven.
If the US Treasury, either directly or indirectly (say, through the kind of off-balance-sheet vehicle created by the Fed for $30bn of Bear Stearns’ most toxic assets) were to offer financial support for a rescue of Lehman or for any other investment bank (or commercial bank, for that matter), the floodgates could open and the fiscal-financial position of the US Federal government could be materially affected. Japan not that long ago shared a sovereign credit rating with Botswana. A trillion here, a trillion there and the US Federal debt could lose its triple-A rating.
Another explanation is that the argument in support of the Bear Stearns bail out is wrong, or at any rate is no longer considered true in the US Treasury. If an investment bank is like any other business with a comparable value added, and if the size of an institution’s balance sheet, or the magnitude of its exposure in the contingent claims markets (including the CDS markets), are not the right metrics for the damage to the financial intermediation process and to the real economy that would be caused by the bankruptcy of the institution, then there is no argument for tax payer support for Bear Stearns, Lehman or any other (investment) bank. Or at any rate, no stronger argument than for the tax payer to support US automobile manufacturers, steel manufacturers or manufacturers of garden gnomes threatened with bankruptcy.
We may have a test as early as tomorrow morning (Tuesday, 15 September 2005), of whether there are signficant systemic externalities from the failure of a household-name investment bank. I am optimistic that investment banks will turn out to be more like normal businesses than like the negative-externalities-on-steroids painted by the Fed and the Treasury during the Bear Stearns rescue. The frantic attempts by the Fed and the Treasury to broker a private sector rescue/takeover of Lehman sugggest that the monetary and fiscal authorities are not too confident that a household-name investment bank can fail without causing signficant systemic damage. If that is indeed the case, one wonders why, six months after Bear Stearns went belly-up, there still is no special resolution regime (SRR) for investment banks, along the lines of the SRR for commercial banks admininstered by the FIDC and the SRR for Fannie and Freddie admininstered by the Federal Housing Finance Agency (FHFA, the regulator of the GSEs). The Treasury and the US Congress have much to answer for.