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Saturday, September 13, 2008


LTCM part ii

per the wsj, regarding the pending failures of some large financial institutions:

The Federal Reserve Bank of New York held an emergency meeting Friday night with top Wall Street executives to discuss the future of venerable firm Lehman Brothers Holdings Inc. and the parlous state of U.S. financial markets.

The meeting, which began at 6 p.m., was called by the New York Fed in an attempt to find a solution to the problems plaguing Lehman. The group, which consisted of the heads of most major financial institutions, is expected to meet throughout the weekend to see if it can agree on some way to rescue the ailing firm, according to a person familiar with the matter.

The meeting appeared similar to one a decade ago when the New York Fed pulled together top Wall Street executives to prevent the collapse of hedge fund Long-Term Capital Management.

One big issue: Most of the firms at the meeting have themselves been hit with big losses and may not have the excess capital to step in.

... The future of Lehman could open a new chapter in the government's handling of the financial crisis, which is sweeping up an increasing number of firms, including American International Group Inc. and Washington Mutual Inc.

the meeting has extended into saturday. many reports have secretary paulson, having just mounted perhaps the greatest nationalization in the history of western civilization and now coming under an acerbic rain of catcalls which ring of sad truth, apparently wants to deny the repetition of the government backstop that characterized the jpmorgan/bear stearns deal.

there's a decent chance lehman will be allowed to fail. this could indeed be a very dangerous moment. willem buiter is calling it the endgame in the banking sector.

Now, with Lehman Brothers fighting for its survival, there is better access for investment banks to external finance through the PDCF and the TSLF. It is, however, incredible that, despite 6 months having passed since Bear Stearns hit the rocks, there still is no special resolution regime for investment banks in the US. The US Secretary of the Treasury and the responsible parties in the US Congress should be taken away and shot after a fair trial for this dereliction of duty.

Note that in the US too, the dominos are not falling randomly. ... Illiquidity now is mainly the result of fear of insolvency. More than a year since the crisis started, banks find it increasingly difficult to hide the true extent of the mess they have accumulated on their balance sheet or are carrying through off-balance sheet exposure. The dominos are falling in order of their perceived insolvency risk, and the perceived insolvency risk appears increasingly congruous with the fundamentals.

... The disappearance of a large number of banks, including, on both sides of the Atlantic, some household names, will boost the profitability of the survivors and is likely to produce a more speedy resumption of normal lending and funding activities than an equal sharing of pain, of the kind that was attempted in Japan following the collapse of its asset price bubble. With a bit of luck the endgame for the banking sector will be short and the financial players will be able to start another game - with a rather different set of rules, I would hope.

the massive financial sector contraction that buiter sees coming is of course already underway, and paul krugman notes that the consequence is not inflation but deflation. that's what i've expected, but that it's on the radar for the new york times shows that awareness is still rising and -- as brad setser also concludes -- a policy response may soon follow.

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┬źNote that in the US too, the dominos are not falling randomly. ... Illiquidity now is mainly the result of fear of insolvency.┬╗

HAHAHAHA! Buiter is such a pussyfooting establishmentariamn that he cannot really bring himself to say it clearly!

Illiquidity not just now, but for the past many months has been the result not of fear but of actual insolvency.

Many banks have lost their capital many times over, and only continue to trade by borrowing capital from the Fed*mart or the Bank of England. We now have inverse reserve requirements, where the Fed*mart or the Bank of England in effect are depositing reserves with the banks that regulated them, instead of the regulating the banks that have to deposit reserves with them.

The big deal is mass insolvency, not illiquidity, which is just a silly euphemism.

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certainly illiquidity has been the euphemism du jour from the start.

the banking establishment has been widely insolvent before, of course -- 1982 and 1990 come to mind. but the scale of the insolvency this time is truly new.

in those past cases, a steepening of the yield curve and forebearance on marking assets -- maintained over several quarters -- was enough to allow banks to earn their way back to solvency. that seems to be the plan of attack still from the fed and treasury.

but scale is their enemy now -- as they must surely be aware, the losses are so large and pervasive that they are materializing faster than many banks can earn, resulting in progressively worse quarterly writedowns as we go on. unless housing prices stabilize very soon, losses will overwhelm capital on a systemic -- not isolated, but systemic -- basis.

this narrative may in part seem common knowledge, but i wonder how deeply its implications are taken to heart. so far the political will to recapitalize the banks has not materialized thanks to the election season. once seats are safe, congress will come running i suspect. or will it?

and even if it does, will it be too late? the deerioration of aig, lehman, wamu, merrill, wachovia, general motors and others seem to indicate perhaps yes. the liquidation spiral may already be self-reinforcing and beyond easy fixes.

and then there's the question of whether the united states treasury will experience funding problems if it intervenes too deeply. it makes one's head spin.

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