Liaquat Ahamed's Lehman Question

Add economic historian Liaquat Ahamed to the ranks of those, like Paul Krugman, who think that monetary policy has at this point done all that it can do, and that the next important step will have to be fiscal. I was privileged to have lunch with Liaquat on Friday, and was the recipient of a fascinating disquisition on the kinds of global contagion which caused the Great Depression.

One of the things which interested me most was how incredibly global the causes of the Depression were; among them were the massive inflows of US funds into Germany between 1924 and 1928, followed by a sudden stop in 1929 and the collapse of Germany's banking system in 1931, with its attendant and enormous knock-on effects in the UK and US. If you think that the downside of globalization is a new thing, be sure to read Liaquat's book when it comes out in a couple of months: it will show you that history repeats itself much more often and more closely than you might think.

Liaquat also put his finger on a question which I have to admit has been troubling me as well.

According to its official balance sheet, Lehman Brothers had total stockholder equity, when it went bust, of about $26 billion: assets of about $639 billion minus liabilities of about $613 billion.

Lehman's shareholders have, of course, been wiped out; its assets, once they're liquidated and worked out, will go to its bondholders. Those bonds are trading at no more than about 10 cents on the dollar, which implies that the assets, far from being worth $639 billion, are in fact worth only about $60 billion.

Now I understand that things go at a discount when they're liquidated. But a $580 billion discount? That's beyond sense. There's something weird going on here, which I hope someone in the blogosphere will be able to explain to me.

Did Barclays and Nomura somehow snatch up the asset side of Lehman's balance sheet for pennies on the dollar, while leaving the liabilities behind? If not, what happened to that $639 billion in assets? Was it really worth only a tenth of that, implying fraud on an unprecedented level by Lehman's senior management? Is the market massively underpricing Lehman debt? Or is there something obvious which I'm missing here? Any answers would be gratefully received not only by me but also by Liaquat.

Update: We have some of the answer. A lot of Lehman's liabilities were secured, primarily in the form of repos and reverse repos. The unsecured liabilities were closer to $100 billion than to $600 billion. So if the unsecured liabilities are only worth 10 cents on the dollar, then that implies Lehman's assets were worth only $100 billion less than we thought, rather than $580 billion less than we thought. In a fire sale situation, that's conceivable.

I also spoke to a Wall Street analyst today, who told me about one phenomenon which helps explain the Lehman insolvency hole. Let's say that Lehman brothers was writing and buying credit protection on lots of credits such as, say, Ford. At any given point in time, its exposure to Ford defaulting was minimal, since every CDS that it had sold on such an event was offset by a CDS that it had bought.

But then Lehman defaulted -- and all the CDS that Lehman had sold on Ford were cancelled. The counterparties went out into the market, the Monday after Lehman's collapse, and got three quotes for what it would cost to replicate the credit protection that they had bought from Lehman. Under the terms of their CDS contract, the counterparties then became unsecured creditors (to the degree to which Lehman hadn't already put up collateral) for the lowest sum quoted -- a sum which, given what the markets were like that Monday, was incredibly high.

On the other hand, where Lehman had bought credit protection on Ford, nothing was cancelled: that CDS continued to sit on Lehman's balance sheet without anything special happening. So Lehman's liabilities exploded, since the bank now owed billions of dollars to counterparties where it had written credit protection. But nothing similar happened on the asset side of the balance sheet. Which would help explain why Lehman's debt is so cheap.