When Can We Start Breathing Again?

The Bank of America deal to buy Merrill Lynch is the first bit of unambiguously good news we've received all weekend. Of the four big independent investment banks, Lehman is toast; Morgan Stanley and Goldman Sachs are safe; and Merrill is, well, not an independent investment bank any more. So in terms of investment bank failures, that's probably it, for the time being.

But Lehman alone is interconnected enough for its failure to start a nasty chain reaction and cause a systemic crisis all on its own. Everybody's trying their hardest to ensure that doesn't happen, since it's in nobody's best interest. But when will we know that disaster has been averted?

The answer, I'm afraid, is not particularly reassuring.

This isn't like Y2K, when if computers were still working at 1am, you knew that they'd survived the test. If AIG hasn't collapsed after New York markets open and the broader stock market is down less than 5%, all that will mean is that there hasn't been a systemic meltdown yet. It's going to take a long time to liquidate Lehman and unwind all of its positions, and nobody has a clue how that's going to play out. Specifically, there might well be a levered-to-the-eyeballs multi-billion-dollar hedge fund or two with enormous Lehman Brothers counterparty risk, and if they start defaulting on their derivatives contracts, delayed contagion could spread very quickly indeed.

It's not just hedge funds, either, which could end up being the vector by which crisis is spread. It could be a big insurance company, or it could be a series of failures of small and medium-sized banks. Or it could come out of left field entirely: the "shadow banking system" is now so big and so global that for all we know a series of bad decisions by a mid-level technocrat in Kazakhstan could precipitate cataclysm across America and the world.

If we've learned one thing this weekend, it's that regulators are playing catch-up, and they've pretty much run out of ammunition. I have a lot of respect for the New York Fed, but ultimately it's a sub-national arm of a single country's central bank: it has neither the ability nor the mandate to keep an eye on all the possible risks that the world's financial system poses. And neither does any other regulator.

So as Monday rolls past, we'll all be keeping our fingers crossed that the inevitable volatility doesn't metastasize into genuine chaos. But even if we survive Monday, and Tuesday, and Wednesday, it'll be a good while yet until we're really out of the woods.