The New York Times and the Wall Street Journal provided Saturday afternoon updates on Lehman. The discussions increasingly acknowledge that a deal may not be in place by Sunday as initially hoped (understandable, given the authorities’ unwillingness to provide support and the near-impossibility of doing adequate due diligence in a few days) and have moved to fallback options. Reader Saboor alerted us to the fact that the Journal reports that Lehman had engaged Weil Gotschal, a New York law firm known for its expertise in bankruptcy (and for being tough negotiators), to prepare a filing.
The Journal has the recent and most detailed sighting. From the Wall Street Journal:
The outlines of plans to determine the fate of Lehman Brothers Holdings Inc. emerged today even as it became increasingly clear that a clean sale of the entire firm to a big bank would be too difficult to execute.
A sense of optimism that a rescue could be arranged today dimmed …After 6 p.m., the formal meeting ended for the day with no resolution, though some participants stayed behind to continue talking….
At about 8 p.m., New York Fed President Timothy Geithner was still at the bank’s headquarters. Officials from the New York Fed and various banks were expected to continue working through the night.
Yves here. The break in discussions with the pressure of markets opening in Asia in less then 36 hours is decidedly not a good sign. It signals an impasse of some sort, with the principals retreating to their corners to consider whether they need to cross lines they had formerly considered inviolate. Back to the Journal:
Under one plan, either Barclays PLC or Bank of America Corp. would buy Lehman’s “good assets”, such as its equities business, people familiar with the matter say. Lehman’s more toxic, real-estate assets would be ring-fenced into a “bad” bank that would contain about $85 billion in souring assets. Other Wall Street firms would try to inject some capital into the bad bank to keep it afloat for a period of time so that a flood of bad assets don’t deluge the market, damaging the value of similar assets held by other banks and insurers. The banks are also looking for the government to somehow financially backstop the bad bank.
So explain to me why I as a private company with crappy assets of my own that I am worried about, provide scarce capital to fund someone else’s bad assets?
The problem, though, is getting enough banks to back that plan. While teams of bankers are working through structures, it’s clear that only a handful of banks are in a position to provide enough funding. Many banks are inclined to preserve capital ahead of third-quarter and year-end cash preservation moves. Also, banks aren’t keen to see a big rival such as Barclays or Bank of America walk away with valuable assets by only paying a pittance.<.blockquote>
So basically, Plan A doesn’t work. Lehman was visibly in distress for months. The lack of planning for a possible crisis is stunning.
As of Saturday afternoon, Barclays, the U.K.’s third-largest bank in terms of market value, appeared to have more interest in pulling off a deal…Bank of America, an obvious buyer, appeared to be cooling….Of course, some of this could be the posturing …. Barclays nor Bank of America wants to buy all of Lehman without some government assistance….Both Bank of America and Barclays remain fixated on the disposal of the bad real estate assets, and are less focused on evaluating Lehman’s investment bank, said one person involved in the due diligence process….
The real fear in the discussions, this person added, was that the fire-sale prices, or “marks” of Lehman’s real estate book could set off a cascade of problems for other Wall Street firms. If those marks were made against other banks’ portfolios, it could eventually force those firms to raise more capital, too. For firms’ considering funding the bad bank, the calculation has thus become the price of that contribution against the price of a widescale markdown….
So an impediment is that no one wants to expose where the market for dodgy commercial real estate debt is because everyone is afraid of being held to current market valuations (yes, the argument will be that Lehman is forced to sell at “fire sale” prices, that is, that a Lehman liquidation would be so large that it would artificially depress prices. But is this mere price discovery?)
“Unless something is settled, it’s going to be a bloodbath Monday,” said this person…..
Is Paulson, after all the heroics to date, really wiling to risk a disorderly liquidation? Is he assuming he can play a game of chicken and win? Why should any firm pony up for the bad bank, particularly when the firms in the best shape, and thus less irresponsible, may wind up making a larger contribution (let’s face it, if the crappy ones put up the same amount, it might be the event that will have lead them to go into a death spiral, so all you are doing is spreading rather than ring-fencing the problem). Oh, I forgot, “From each according to his abilities, to each according to his needs.”
With it unclear whether the gap between the federal government and potential buyers can be bridged, a second group at the New York Fed is focusing on the possibility that there might be no alternative to liquidating Lehman and winding down its operations in an orderly fashion.
On Saturday afternoon, the credit-trading heads of major investment banks gathered at the meeting to discuss how to deal with their exposures to Lehman in the intertwined credit-default-swap market. The lack of a central clearinghouse in this market means that dealers, hedge funds and others are directly facing each other in insurance-like contracts that are tied to trillions of dollars in debt instruments.
Credit derivative traders at some firms were asked to come to work over the weekend to help quantify their exposures to Lehman and compile lists of outstanding contracts they have with the investment bank.
One person familiar with the matter said large dealers are trying to decide if they should show each other all their credit default swap trades with Lehman. Disclosing their positions could enable dealers to offset their positions with each other wherever possible. For example, if one dealer has bought a swap from Lehman and Lehman sold a similar swap to another bank, the two banks could agree to face each other directly.
Such moves could also help prevent individual firms from scrambling to find new counterparties to re-hedge their positions with when the markets reopen on Monday, potentially unleashing turmoil in the credit markets. They could also help facilitate an orderly wind-down of Lehman’s derivative positions, if that becomes necessary.
It is not known how much in CDS contracts Lehman has. In a survey last year by Fitch Ratings, Lehman was listed among the 10 largest CDS counterparties by number of trades and the amount of debt to which the contracts were tied…
As I read it, the only options are the Treasury relenting and providing some support, or plan B immediately above, which is clearly in flux, but in concept is a partial liquidation.
One trader said conditions in the credit default swap market and the short-term repo markets are more stable today than they were in March, when Bear Stearns nearly collapsed, but still, “if they go into liquidation,” it is going to be a bad situation on Monday…..
In a Lehman bankruptcy, the firm’s brokerage units would have to enter a Chapter 7 liquidation, in which a court-appointed trustee would take over, liquidate the firm’s assets and get Lehman customers back their money. In general, securities that a customer holds at a brokerage firm are legally the investor’s property and aren’t exposed to the claims of the firm’s creditors.
In trying to hold firm to their no-bailout stance even while pressing for a deal, federal officials could try to pit Bank of America and Barclays against each other. But that leverage can work only if both banks stay in the discussions…..
While some executives had left the Fed meeting, those of other firms, including three carfuls of Barclays executives, remained at the Fed office past 6 p.m.
At least 20 New York Fed staffers left from another exit. They refused to say if they were done for the night.
The New York Times’ story, although now somewhat out of date, confirmed the two broad approaches discussed above, It also noted, as the Wall Street Journal did in sections we omitted, that worries about AIG, Merrill and WaMu were contributing to the time pressure. This quote was apt:
“You have to think of this like there is an epidemic going on — an epidemic of capital destruction,” said James L. Melcher, president of the hedge fund Balestra Capital, who has been bearish on the stock market.
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Yves,
I agree that no one around the table has the means to solve the problem (capitalize a bad bank). Plus what are they going to do when AIG, WM, MER, WB come hat in hand to the Fed? How many weeks can this weekend at Bernie’s charade go on?
I think the mention of a second meeting going on at the Fed to assess derivative positions and attempt to pair them off is instructive.
My guess is that the Fed doesn’t blink, the banks don’t put up, but the Fed jawbones everyone to keep doing business with Lehman as they wind down the book to the point where BK won’t swamp the street. Eventually the will work their way down to the dreck that isn’t liquid and a vulture fund can capitalize the bad bank in bankruptcy at a valuation that reflects the real value of the assets.
This Wall Street Brinkmanship has had the same result for the last many years. Ultimately, the Fed/Treasury will blink and backstop the “bad bank”. They will say it was necessary for blah blah blah blah, and only be used as a last resort. Bottom line, tax payers will yet again pay for Wall Street Follies.
P.S. Weekend at Bernie’s is a great line.
I am told that the key issue in the meeting is whether the special master appointed to do the “mark” (in an XI) can be “induced” to avoid reporting until after the election and after the change in government in January.
It is that valuation report that will trigger the “mark tsunami” which will sweep through the world financial system like a broom sweeping up spent peanut shells.
Thank you very much for covering this, Yves.
This weeks bail in/ blow up LEH coming up.
Next weeek AIG, MER and WaMu!
Does anyone have information on Morgan Stanley’s toxic soup of assets?
I will assume that the largest banks can come in and do this ‘bailout’ even if it costs them.
If they won’t do it out of greed, I think the government can threaten full and relentless investigations into all their activities.
Jail time is a bitch.
What are the flaws with the following approach:
(1) Lehman files for Chapter 7 bankruptcy on Monday, BUT
(2) The Fed provides enough liquidity (at market interest rate) to the firm to allow the CRE assets to be sold off over a year (instead of this “fire sale” we keep hearing about), on some kind of semi-strict schedule
(3) The other Wall Street firms keep trading with Lehman so that Lehman’s brokerage operations aren’t disrupted and, in the meantime, such brokerage operations are sold off in an auction and eventually tranferred to the buyers
(4) Lehman’s other assets (asset management, etc.) are sold off in an orderly liquidation
Here, the common equity holders are wiped out, the preferred holders are likely wiped out, and some portion of the debt gets repaid… but only after the CRE is disposed of and the govt is made whole. The government makes a little bit of interest and doesn’t take any risk of loss. And the marks to the CRE aren’t “fire sale” marks but rather “long-term liquidation” marks, which should be less. Am I looking at this too simplistically?
In theory, that ought to work, but the fact that the powers that be didn’t immediately go to that option suggest that there are some flies in the ointment. I believe one issue is how trading position collateral is treated (I discussed what I had heard the issues to be during the Bear implosion and never got any feedback, so I am loath to put forward something that may not be accurate). Second are the CDS guarantees. I am not certain how senior the claims are of holders of CDS written by Lehman. If they are subordinate to other claims in bankruptcy, that could lead to widespread concerns about the adequacy of CDS hedges in major trading books.
Isn’t it also true that bankruptcy might be considered a credit event that would trigger a series of actions against current assets?
The bankruptcy judge has who’s interest to resolve? Certainly s/he has no responsibility for the functioning of stable markets.
I hear you regarding the CDS issues, Yves. I guess my larger point is that given how far we’ve come down the bailout road, I don’t have a problem with Lehman’s liquidators using the Fed’s balance sheet (at a price, of course) to buy time and liquidate things slowly, particularly the CRE. In a slow, orderly liquidation most of the CDS issues can be sorted out as well. Even in a disaster scenario senior bondholders get “something” (although it might not be much) and the government is repaid in full. I hate all this bailout BS but under the circumstances I don’t have a problem with the approach I outlined, which is basically using govt. capital to facilitate a slow, orderly liquidation which should only be mildly disruptive (but still quite painful) to the markets.
The problem with the above approach is Moody’s. If Lehman files monday, thay HAVE TO downgrade theircoutner-party rating to junk. This forces everyone to stop doing business with Leh. If you do business with a junk counter-party, you risk your rating falling to junk as well (you are only as good as your shakiest counter-party). Most buyside accounts have rules against doing business with junk counter-parties. Racall that this was the trigger that buried bear.
No way Moody’s will agree to keep a bankrupt broker with an investment grade coutner-party risk rating.
Also, expect Moodys to downgrade them Monday if nothing is done. They warned they will do exactly this last Thursday.
If this situation weren't so grave, it would be comical. privatise losses? Nooooooooooooo! We can't do that!
One thing I'm shocked at– all those masters of the universe financial engineers in the same room and they are still unable to come up with a solution? Is it because their ids are designed to only know ways to manufacture p&l on their books while redistributing losses to others?
Then surely they can come up with some newfangled, acronymic, charitable vehicle with the intent to time machine assets until either they gain in value or everyone else with similar securities has marked them to zero– wait, maybe they don't want to make the fund charitable because they wouldn't be able to capitalise on the ready losses… .
The govt came up with a superfund to clean up the love canal, maybe they'll have to do something similar this time. Remember, most of Asia is closed on Monday, so there's room for an 11th hour negotiation…. that is, if you don't mind Europe crashing in the morning. Maybe it's just as well to get back at the BoF for not informing us of the SocGen mess as it happened, saving the embarassment of Bernanke cutting rates.
Dave,
Given the immediate circumstances, I don’t think anyone would object to the use of liquidity facilities. But those have been for high-quality collateral. The issue here is what to do with Lehman’s toxic waste,
The problem I have is the lack of an overall game plan. Yes, you can argue that a lame-duck Treasurer can’t (or shouldn’t) do too much. But the Fed does not suffer from these end-of-term considerations. The financial services industry has to consolidate. But Bernanke is fighting deleveraging, which means he is endeavoring to keep asset prices at unsustainable levels, and isn’t willing to work through how to shrink the financial services industry to post-bubble levels. That is admittedly a very difficult and complicated question, but failing to address fundamental issues will probably result in more crises.
Instead, we have ad-hoc responses. A bailout of Lehman is being resisted not because it is the right thing to do, but because another rescue is politically inconvenient.
The reason Lehman has not gone to the discount window is very few accounts have stopped doing business with them (or, the number of accounts that have stopped can be dealth with out the window). Wall Street has agreed to all hold hands and pretend nothing is wrong with Leh. Som tehy are all still doing business with them and ensouraging everyone else to do the same.
If Leh files for bk, look for discount window borrowing to skyrocket as everyone lines up to get their collateral back.
If the Fed is concerned about price discovery on L’s book, it’s too late, the cat is already out of the bag. Right now, no firm with big Level 3 numbers or heavy CRE exposure can raise fresh capital, with the possible exception of GS. Neither the equity nor the credit markets believe the balance sheet valuations. If the Fed manages to swing a super-SIV style bad bank, which is doubtful, that will do nothing to stabilize other institutions with similar balance sheets. The Fed bet everything on time and secrecy as the remedy for capital erosion, and they are losing their bet.
What about actually using the capital structure of the bank to bail it out by itself? Doesn´t it have subordinated debt that can be transformed into capital and buy time with that? I understand the fear of regulators of transforming debt into capital for its implications for the debt markets but don´t subordinated debt (and senior debt holders y the way) investors know the risks that they are buying? So, why not punish them also as it should be?
Speculators that are shorting stocks are betting on the extreme shareholder dilution that arises from “bailing out” debt holders. Additionally, they are selling protection betting on the debt bail out. So, why not passing losses to sub-debt and do a debt cut to debt-holders and you could then have your recapitalization.
Probably what actually you need is a bankrupcy filing
From CNBC.com:
*****
Because the consequences of not doing a Lehman deal are so grave, though, people with direct knowledge of the deliberation say both sides will begin to compromise on Sunday. One Wall Street executive involved in the meetings put it this way: “I’m thinking logically; if they do nothing it’s Armageddon. That means they do a deal. It will be announced at 6 p.m. (ET) Sunday.”
*****
This makes sense to me as well. “Something” will be done. My guess is everyone, including the Fed, bites the bullet and takes some pain to avoid Armageddon. Frankly, I’m perversely curious to see what exactly Armageddon looks like, so I hope nothing gets done. But that outcome seems unlikely.
“Because the consequences of not doing a Lehman deal are so grave, though, people with direct knowledge of the deliberation say both sides will begin to compromise on Sunday. One Wall Street executive involved in the meetings put it this way: “I’m thinking logically; if they do nothing it’s Armageddon. That means they do a deal. It will be announced at 6 p.m. (ET) Sunday.”
Talk about a high stakes game of chicken!
Anyway, I’m not sure the Fed blinks this time. While the ramifications of not getting a deal done are obviously huge; when you couple this (http://www.chinadaily.com.cn/china/2008-09/12/content_7020656.htm):
China may cut its dollar holdings – CICC
China, which holds a fifth of its currency reserves in Fannie Mae and Freddie Mac debt, may cut the portion held in US dollars, according to China International Capital Corp (CICC), one of the nation’s biggest investment banks.
The US government this week seized control of the two mortgage-finance companies, which account for almost half of the home-loan market in the world’s biggest economy, to prevent defaults from crippling them. China holds up to $400 billion in the two firms’ debt, CICC Chief Economist Ha Jiming said in a report Thursday.
“The crisis has made Chinese officials realize it’s a bad idea to put all their eggs in one basket,” wrote Hong Kong-based Ha. “This will likely lead to greater diversification of foreign exchange reserve investments.”
with the rather large drop in the dollar, the writing is on the wall that China isn’t liking the inflationary monetary policy that has become the backstop for the street. If they have made this known to Paulson, which isn’t unlikely, he may be hamstrung.
While there may be some give by these other banks, despite their own capital issues, I don’t see the Fed getting behind this one.
Steve: “The Fed bet everything on time and secrecy as the remedy for capital erosion, and they are losing their bet.” In one sentence, that summarizes the ‘game plan’ of the US Fed through 14 months, yes. A more activist approach would have been desirable, although the outcome might not have been significantly better, only somewhat different. Now, the Fed and the Treasury are Fortune’s Fools: they can only re-act as one rotting firm implodes after another, as they lack capital in some cases, authority in another, political maneuvering room in other cases. They are no longer in a position to ‘execute a plan;’ events execute _them_. Are we ready for the bailout of the FDIC when it pops? A rush to spend $giga held overseas when it becomes apparent that into the mid-term they aren’t going to be worth present levels?
A small point. Japan and HK are closed on Monday, although Australia is open. The deal, I think will probably still be done before Japan would have opened had it been an open day, because people want to get some sleep!
I think Dave’s approach is the likeliest, if only because I don’t see anything else to be done. Nobody’s going to buy a big firm like Lehman with oodles of tough chewy toxic Level 3 assets on a weekend of due diligence. If ever. The Feds can’t bail everybody, so they have to draw the line somewhere, and it may as well be now. In terms of the junk rating preventing further deals and swaps, further deals should be very restricted anyway, since Lehman will need to be unwound. If they need to set up new swaps the Fed can step in as a conservator, using its credit just as Dave describes using liquidity.
I’ve been speculating along the line ericlindros suggested. It seems reasonable that there exists some level of US indebtedness beyond which foreign creditors would prefer to risk a loss in value of present holdings rather than throw good money after bad.
Perhaps a combination of circumstances such as the FRE-FNM debt socialisation, general instability and flight-to-quality pressuring foreign currencies might incline China and others to sell rather than buy dollar debt?
Political considerations seem dwarfed by the threat of financial decompensation. It seems plausible that other factors may be dominant. Possibly there is some evident reason why this could not be the case; it would be instructive to hear it considered.
«The Feds can’t bail everybody, so they have to draw the line somewhere,»
The Fed and Treasury surely can bailout everybody, it is the consequences that they cannot avoid.
Anyhow there is a presidential election due November and a handover due January, and the Republican guys at Fed and Treasury would be traitors to their party if they let trivial issues like banks failures reduce their candidate’s chances.
Which way things are going to go will only be known when the new president is known. If it is John, things will go one way, if it is Obama, another way.
The operative metaphor for me here is a nuclear war battle space. This is no ordinary tsunami.
Greenspan’s idea for a coherent framework to handle investment bank failures requires Congressional approval. And because of key chairmanships and minority members in the appropriate Congressional committees, nothing gets done until a crisis stifles debate and forces hasty legislation.
As just one example, I cite the recent GSE legislation that had ENORMOUS implications for our future, but only Jim Bunning objected and the bill was passed in a New York hurry without competent debate.
I would therefore state that Congressional failures and corruption have contributed substantially to the lack of a coherent framework (or game plan as Yves describes it).
As the governmental entity directly responsible for investment bank regulation, the failures of the SEC are also a primary consideration here.
One reason why I describe this catastrophe as a nuclear war battlespace is that we are trying to deal with a rapid succession of massive and spectacular implosions.
An extraordinary amount of time has been spent over the last two months trying to bring a coherent approach to the GSE fiasco. The thousands of person-hours spent on that enormous task diminished the time available to address looming nuclear implosions at the investment banks. It’s an opportunity cost type of thing.
I would disagree with the statement that Bernanke is fighting deleveraging. It is clear from his paper in the Vol. 84, No. 4 issue of the Kansas City Federal Reserve Economic Review that he believes that excessive leveraging is a key component in creating asset bubbles. He agrees with Buiter on this key point.
As such, I would argue he is not FIGHTING deleveraging here. Rather, he views the correct role of the Federal Reserve as making sure that the Fed fosters stable market conditions for the substantial repricing of risk that must now surely follow.
He (and the Fed) are trying to foster ORDERLY deleveraging. That’s an extremely difficult task, but it is the goal. And Geithner’s temperment is probably more suited to the job than Bernanke.
I think that is a key reason why Bernanke stayed at home in Washington during this phase of the crisis.
Geithner appears to be doing a plausible job at crisis management. I tip my hat to him
Matt Dubuque
Yves, I disagree that a bailout of Lehman might be the right thing to do, only it would be politically expedient. Regardless of how this turns out, bailing out this firm, in whatever form, sends a terrible message to Main Street, Wall Street and to everyone in between.
Anon of 11:06 AM,
Please re-read the post. No where did I advocate a bailout. I am describing what I think are likely outcomes, based on news reports and what one can read between the lines in them.
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