Debating the Lehman Collapse

There's a lot of sympathy for Lehman Brothers today -- a lot more sympathy than there ever was for Bear Stearns. Dick Fuld might not be the friendliest chap on Wall Street, but his shop is well-liked and well respected: there will be sadness when it no longer exists in its present form.

But although Lehman's demise is sad, that doesn't mean that the US government should step in to prevent it, and it also doesn't mean that it shouldn't happen, in some kind of normative sense. Indeed, the death of Lehman could be systemically helpful if it shows that the markets can survive a financial collapse without government cash shoring things up. Or that's my point of view, anyway. Dear John Thain has the opposite opinion: here's an IM conversation we had this morning.

DearJohnThain: quick question ... have you seen anywhere what is actually causing this shotgun wedding for Lehman?
Felix Salmon: two words: share price
DearJohnThain: Doesn't make sense to me.
Bear, at least, was about to be insolvent...
Felix Salmon: what doesn't make sense? why the share price is falling, or why a falling share price makes Lehman untenable?
DearJohnThain: the latter
Felix Salmon: because counterparties will stop doing business with Lehman, and the ratings agencies will downgrade
which of course for a bank is the kiss of death
DearJohnThain: Argh. Seems so .... "self fulfilling" ... shouldn't be this way
Felix Salmon: all levered institutions rely on confidence
"credit" comes from the Latin "to trust"
without trust and confidence, no bank can survive
DearJohnThain: Seems like, in this scenario, Treasury and the Fed should be able to step in and do something to show confidence ... like guarentee a loan to Lehman
Felix Salmon: why? so that Lehman can survive?
the survival of any individual bank should never be systemically necessary
DearJohnThain: To leep the system stable
Felix Salmon: why is a world with lehman more stable than a world without lehman?
DearJohnThain: I agree that trust is a big piece... but it's a chicken and egg problem here... Share price is falling because people don't trust them and people don't trust them because they see the share price keep falling...
Felix Salmon: right
DearJohnThain: So, what if this is being driven by shorts or rumors...
Felix Salmon: capitalism needs bank failures occasionally, to punish institutions which lend $30 billion to commercial real estate at the top of the bubble
if you overlever yourself and make bad investments, you become susceptible to shorts and rumors, yes. That's a good reason not to overlever yourself.
DearJohnThain: Or just people selling out because of skittishness
That's an unstable system.
Felix Salmon: the system should be unstable. it doesn't exist to perpetuate banks, it exists to efficiently allocate capital.
DearJohnThain: Someone with trust should step in, make an objective call, and move on.
If they are indeed well capitalized, then they should be able to survive.
Felix Salmon: The Fed and the Treasury have no responsibility to ensure that well capitalized banks survive
that's not their job
DearJohnThain: Well, if well capitalized banks can't survive, then who can?
Felix Salmon: transparent banks which can convince their counterparties and lenders that they're solvent
DearJohnThain: ehhh... seems inefficient that someone can believe you're not solvent when you are and there's no way to fix that
Felix Salmon: it can be fixed ex ante, by not overlevering. It can be fixed if you're really solvent by just selling the assets which people are worried about at a high price, if they're really worth that much.
It's not like Lehman didn't have any warning. The credit crisis has been going on for over a year. They had every opportunity to derisk back at $65 a share, and they didn't. Now they're paying the price.
They knew full well that the more leveraged they were, the more likely they were to blow up. That was a risk they took with their eyes open.
DearJohnThain: Well, they also took their precautions.
Felix Salmon: what precautions? Firing the CFO?
DearJohnThain: They secured enough capital for a year...
and even raised plenty more to keep a cushion
they have 11% tier 1 capital now...
Felix Salmon: it's the asset side of the balance sheet that people are worried about, and they barely touched that
DearJohnThain: I dunno... knowing that market, I just think it's people trying to profit from their problems...
Felix Salmon: This is Wall Street, of course there will always be people trying to profit from everything.
On Wall Street, profit is a good thing, remember?
DearJohnThain: Something intellectually dishonest (and illegal) about profiting from something that is false and being perpetuated.
Felix Salmon: There's nothing intellectually dishonest or illegal about profiting from shorting LEH
The only thing which is illegal is spreading rumors about Lehman you know to be false
DearJohnThain: Exactly.
Felix Salmon: And there's NO indication that anybody is doing that
DearJohnThain: And those "Lehman is going under rumors" started around the same time Bear did...
"Lehman is next."
Felix Salmon: they were right!
DearJohnThain: Well, I would claim they were wrong if Lehman gets taken over and was never insolvent...
Or was never going to be insolvent without intervention
Felix Salmon: Who knows if they're insolvent? Lehman is a black box, no one knows what goes on inside
Jesse wrote about it back in March and none of those issues were ever really addressed