Do they really need more public money?
Over the weekend, I was quite disappointed to find the fourth largest investment firm, Lehman Brothers collapse. There had been plenty of speculation on companies that could bail out Lehman, and with Barclays walking out late Sunday evening, Lehman had no option but to file for bankruptcy. As far as my memory recollects, even last year, Lehman had posted above average net profits, despite the volatility in the market. Filing for a chapter 11 bankruptcy protection comes as a huge surprise. Arguably, it is one of the biggest collapses of the century. With a little over £300 billion bankruptcy, is the largest company ever to file for a Chapter 11 Bankruptcy protection, sending the world markets into a turmoil. A Chapter 11 Bankruptcy protection allows businesses to continue trading while they restructure and reorganise their sick units. This could also spell thousands of job losses around the world for a company which employs over 25000 people.
In essence, the public feel the pinch for Lehman’s failed fortunes. The repercussions may be varied affecting economies all around the world. A situation which even Adam Smith wouldn’t be proud of to theorise his learning. Yesterday, one of the employees of Lehman brothers was quoted in a leading national daily about how there were no jobs in the economy and how he had managed to save enough to last the gloom without seeking employment. Despite the economic gloom in the last couple of years, finance executives have paid themselves unimaginable and envious bonuses, for investing in financial instruments which are incomprehensible to the common man. Shares, bonds, yields, derivatives, mortgages, swaps, futures and all other complicated jargon you could find in a finance text book. But in the end, who shoulders the burden of a failure? Many companies have been bailed out recently. From Northern Rock in the UK to Bear Sterns, Fannie Mae and Freddie Mac in the US. With Merill Lynch selling itself to avoid a similar situation and a troubled insurer AIG facing a similar collapse, are we prepared for another bailout?
Firstly, a collapse of such magnitude could potentially wipe out other valued businesses. Since the announcement yesterday, markets world over have nearly lost one third of their values. It is hard to unravel Lehman’s investments as it literally works with every major entity worldwide from Governments to businesses and financial institutions. It manages funds and investments for these entities. So a collapse would mean the credit in the market has evaporated. Which again means no 0% finance on anything, from credit cards to housing, macbooks to automobiles, iphones to holidays, everything on credit will be seen as a risk. When there is such apprehension in the market, the consumer spending power reduces drastically, resulting in a severe economic crisis. Moreover, such failures will result in lower capital inflows to developing countries leading to a slower investing growth. End of the India Shining story unless the Government intervenes to relax regulations for businesses to borrow from overseas. For individuals, bridging the rich and poor divide becomes much more harder as banks tighten their policies towards mortgages. There was a nice illustration by an Indian TV news channel when Bear Sterns went bust. “Mr. India cannot afford a house because, Mr. America had defaulted on his mortgage payments”.
It all started with one mismanagement – that of Bear Sterns which has had a Domino affect on the world financial industry. Inadequate regulation, which in effect, allowed financial firms to risk investments should have been tightened earlier to avoid such crisis. This would have encouraged financial firms to spread their bets evenly rather than exposing investments to a high degree of risk.
Economics is indeed a complicated subject!
Hey Adarsh…interesting post. Let’s go for a beer and talk this over as I think you’re missing a few points. eg banks can’t file for chapter 11, which is why all the uk lehman’s people got sacked on the spot rather than, as in a chapter 11 situation, continuing to work as the business resolved chapter 11.
Let’s discuss over a beer. I think you’ll find it interesting, as nothing is as simple as it seems. Heroes and villains – definitely not.. Maybe I’ll set up a drink with us and one of my friends who’s a fund manager and has a few billion under management. He’s extremely bright and I think you’d find his insights fascinating.
PS This line cracked me up: “Mr. India cannot afford a house because, Mr. America had defaulted on his mortgage payments”.
Hello Will,
I thought Lehman did file for chapter 11 as I read about that in the newspapers. Investment banking does sound interesting to discuss.
The Mr. India and Mr. America thing was even more funny on TV as they had illustrations. And the best part is it wasn’t Mr. India or Mr. America, it was Mr. Sharma (An Indian surname) vs. Mr. Smith.
Here was an interesting comment back from nath when I sent him your post:
One of our senior strategy dudes did presentation recently on Asia (he is Vietnamese). Leaving aside the lower leverage* in Asia he pointed out that you would never get a similar situation there. Basically you couldn’t just default and walk away because this crazy situation of there being non-recourse wouldn’t be allowed to happen. In the US for first home mortgages are non-recourse, which means that once people get into the situation of negative equity they just walk away. Also there has been a mis-selling of mortgage of the most egregious type. That nationwide advert of hooking customers on attractive rates etc.
The reason it is all fallen apart though ultimately comes down to the extreme leverage through the system, from the consumer upwards. And unrecognised by anyone at the time, ultimately backing that extreme leverage were US mortgages. Yes, those very instruments that are non-recourse. D’oh!
And ref the chapter 11 point:
They (banks) can do chapter 11 but unlike with other entities they cannot trade as a going concern. I.e. rules are much harsher for banks. Ch.11 for non-banks is basically a free ride…up to 6mths moratorium on debt which gives chance to restructure and come out back end a stronger viable entity. I don’t know the precise rules for banks but suffice to say that isn’t an option.
That’s the whole problem. Finance industry thrives on speculations and those who are good at speculating. High interest mortgage lending, when there is no recourse is certainly a liability. In an ideal world, it would be better to have a regulation allowing banks only to borrow against liquid assets as security instead of allowing derivatives and other ‘toxic’ instruments based on sub-prime lending. Of course, that would be too stringent on financial firms, but if we had it that way, there would be far more stability in the system.