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Thoughts on the Lehman Bankrupcy

While I am not happy to see a historic company go bankrupt, and have vague but unspecific worries about some kind of general cascading financial problem, I am happy to see the government let Lehman go bankrupt without any sort of special intervention or bailout for a number of reasons:

  • Bailouts create awful incentives for other large companies managing their risk portfolios
  • I know many small business people who have gone bankrupt, and I once lost my job in a company bankruptcy.  There is no reason Lehman equity holders and managers should be immune from the same process just because their company is large and old. 
  • Lehman's management has failed to get a positive return from the assets in their care.  A bailout only keeps these assets under the same management.  A bankruptcy puts these assets in the hands of new parties who hopefully can do a better job with them. 
  • I strongly suspect that the hole in Lehman's balance sheet from underwater assets like certain mortgages is large compared to its equity but small compared to its total assets.  If this is true, equity holders will end up with nothing, but most creditors should come out close to whole when everything is unwound.

Like Megan McArdle, I found Obama's recent reaction to the Lehman bankruptcy to be wrong-headed but unsurprising.  Obama is blaming recent financial problems on an overly laissez faire approach by GWB in general (LOL,that's funny) and a lack of strong enforcement by the SEC in particular. 

But one has to ask, what laws were not enforced?  My sense is that these are all perfectly lawful portfolios of mortgages in which the one mistake was systematically being too generous in giving out credit.  Mr. Obama's party has always been a strong advocate of pushing banks to be more generous with credit, particularly to the poor, and of promoting home ownership as a national goal.  If anything, financial institutions are struggling because they were too aggressive in these goals.  McArdle writes:

This was not some criminal activity that the Bush administration should have been investigating more thoroughly; it was a thorough, massive, systemic mispricing of the risk attendant on lending to people with bad credit. (These are, mind you, the same people that five years ago the Democrats wanted to help enjoy the many booms of homeownership.) Lehman, Bear, Merrill and so forth did not sneakily lend these people money in the hope of putting one over on the American taxpayer while ruining their shareholders and getting the senior executives fired.  They got it wrong.  Badly wrong.  So did everyone else.

It appears from further Obama statements talking about lack of enforcement for predatory lending laws that the Democrats want to get back on the rollercoaster of whipsawing banks between charges of redlining (you are not lending enough to the poor) and predatory lending (you are lending too much to the poor).

Postscript:  While in retrospect there may turn out to have been laws broken, in situations like this, particularly when a management team is trying to head off a liquidity crisis, these tend to be of the reporting and disclosure ilk.  We saw back during the Enron failure that people tend to assume law-breaking of some sort to be the cause of a major bankrupcy or collapse, and to satisfy this notion the government aggresively pursued Enron executives.  But nothing for which Enron was prosecuted had anything to do with their failure -- all the violations were about disclosure and accounting methodologies.  The company would have still crashed, probably faster, without these violations.

Update:  More here

Posted on September 16, 2008 at 08:37 AM | Permalink


Actually, Bush & Co did make an effort to reign in the madness back in 2003, but got shot down by Democrats and certain lobbying groups. Link to a New York Times article about it here: http://query.nytimes.com/gst/fullpage.html?res=9E06E3D6123BF932A2575AC0A9659C8B63&sec=&spon=&pagewanted=print.

That's not to say they're blameless or anything.

Posted by: ErikTheRed | Sep 16, 2008 8:56:29 AM

Lehman's subsidiary Aurora Loan Services was a major wholesale lender and buyer of mortgage loans. They may have held onto or had to buy back some of this bad paper and that did them in.

Posted by: Franco | Sep 16, 2008 9:31:58 AM

The University of Arizona newspaper today has an article in it from the AP regarding the actions of the campaigns in response to this (both campaigns of course demagogued from various angles).

The article closes with the quote, "...[Obama and McCain] didn't emphasize that they are part of the Congress that has done little to head off the crisis." The implied judgment of failure here seems a little editorializing for a news article, and that bothers me. However, what bothers me more is the attitude that Congressional action was required to avoid this crisis. If only Congress had done something, such things wouldn't have happened.

[Off-topic note: Obama wants to ask us, from another AP article printed in the UA paper, "Can [we] afford to take a chance on someone who's voted against the minimum wage 19 times?" From those recent unemployment numbers, seems like we could afford that.]

Posted by: DKH | Sep 16, 2008 10:00:02 AM

good link erik.

this quote is absolutely priceless:

''These two entities -- Fannie Mae and Freddie Mac -- are not facing any kind of financial crisis,'' said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ''The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.''

Posted by: morganovich | Sep 16, 2008 10:25:51 AM

Fannie Mae and Freddie Mac are Barney Frank's personal slush fund. No way does he want to see them to go legit. He might actually have to go to work.

Posted by: Charlie B | Sep 16, 2008 10:59:21 AM

from my standpoint (as a hedge fund manager), allowing lehman to fail was an excellent idea. it was time to establish the end of the "greenspan put". funny how quickly merrill found a suitor in the wake of the lehman bust, no? this has reverberated through board rooms all over the US. you are not too big to fail. i suspect that many of the weak hands (AIG, wamu) are going to be scurrying for partners now. the notion of riding it out though a federal bailout has evaporated. i don;t think dick fuld ever really believed that they would let him fail. he turned down repeated offers because he thought he had a way out.

further, the fed holding rates steady today was an excellent move. greenspan would have pushed to cut. count on it. he is the one who taught wall st that he would backstop them on major market declines with accomodative (and timely) rate cuts. kudos to helicopter ben for not caving in to the debt market having priced in a cut.

it is my sincere hope that the rumors about backstopping a loan to AIG or taking it into conservatorship are false. i would hate to see this hard won credibility squandered.

the magnitude of current issues are the direct result of far too much accomodative policy since the mid 90's. banks and brokers need to have small failures. these impose discipline and prevent big failures. this is why hedge funds have ridden this out in much better shape - constant small failure and no bail outs. have there been failures, certainly, but that is to the good. that is a sign that the system is working and separating good operators from bad.

capitalism requires failure. from failure comes discipline and evolution. prevent it in the short term, and the imbalances build up in the long run. nothing can stop that.

fail small and frequently ought to be the fed and treasury mantra.

Posted by: morganovich | Sep 16, 2008 12:48:24 PM


You and I are in the same industry (except mine is a trading concern, not a hedge fund) and I agree with every word of your post.

Lehman is one of my favourite former employers where I still have friends and I take no pleasure in it's demise. But, you're right. Dick Fuld was betting a little too heavily that he'd be able to ride this out on the backs of taxpayers. It was nice to see the return of the old Paulson.

Posted by: Methinks | Sep 16, 2008 1:54:05 PM

spoke too soon. AIG just got a bailout.

So much for credibility.

Posted by: Methinks | Sep 16, 2008 5:23:55 PM

Wow, three Wall St. guys in a row. I think one thing you all are missing is the relaxation of the short sale rules. It encourages and allows people to create the perception of weakness, which is death to a company that needs continous access to capital. I think Lehman (and Bear) would still exist if they had never gone public. Over 11% of Lehman stock is was sold short. Almost 20% of Bear was. When your price is dropping you look weak and can't raise equity.

And, Coyote, Lehman had over 30 dollars in assets for every dollar in equity. A 3% writedown on assets means no more equity. Oops. Need more and can't get it equals bankruptcy.

Posted by: Scott | Sep 16, 2008 5:24:36 PM

Make that four.

This has been an unbelievable 2.5 (including Sun. afternoon) days. As methinks observes, AIG is not only getting an $85 billion bridge loan, but MarketWatch (and CNBC) is reporting that the Fed is going to take an 85% stake in the company.

In a way, that worse than bailing out Lehman.

The cascade is beginning: Primary Fund (money mkt fund) broke the buck via Lehman exposure.

Posted by: Mesa Econoguy | Sep 16, 2008 5:43:42 PM


I do computer systems. I have been a dilettante in a number of fields but I have worked with top executives in the S&L and banking industry. I have never been in the securities field but these guys are pretty knowledgeable about these things. If they weren't they wouldn't be where they are.

My conclusion over the years is that the root problem is the inability to properly assess risk in a portfolio.

This occurred during the S&L crisis with the repeal of Regulation Q and the changing of depreciation schedules. The current "crisis" stems not from the various things that led us here but the introduction of new kinds of portfolios of which we had no risk assessment experience.

Do I make any sense or have I been smoking too many funny cigarettes?


Posted by: Roy Lofquist | Sep 16, 2008 6:38:05 PM


it's an interesting question. certainly, you can make the argument that assessing the risk of a portfolio is difficult and that people can screw it up. all risk model have assumptions and we all know what assumption is the mother of... it's easy to screw up on liquidity assumptions or on presumptions about access to leverage and cost of capital, but i find this answer unpersuasive in terms of explaining the mess at the brokers and insurers. if this is the case, why did some banks do well? why did hedge and mutual funds fare so much better? it seems to me that there must be more to it.

i also find the "evil, malicious short seller" argument unpersuasive. they are just pricing assets. they are not causing the crisis, merely pointing it out. don't shoot the messenger.

my suspicion is that the real cost lies not in the inability to assess risk, but the lack of desire to. let me explain:

in a bull market, those who take risks tend to get rewarded. the problem is that as they progress (and potentially turn into bubbles) the risk reward diminishes. worse, overall reward tends to diminish as well. when returns start to drop, investors are left with a challenge: "how do i keep my returns up?" obviously, everyone can't outperform the market. so they lever up. if i am 200% long, my 5% return is now 10%! and in long bull markets free from nasty shocks, such a policy seems safe. what's more, you get rewarded for it. recall that dick fuld was the toast of new york in 2006-7.

investors want returns. employees want returns. this drives risk taking. and it becomes an arms race (and a prisoner's dilemma). the best analogy i have come up with is imagine you are in a car race. fog has settled on the course. you can see well enough to drive safely at 50mph. some guy passes you at 70. what do you do? if you chase him, you risk missing a turn. if you don;t, you risk losing the race. do not underestimate how quickly and loudly shareholders will howl for your blood if you are losing. they see the performance of other firms and demand that you match it. worse, you are managing hungry, aggressive people who are getting into markets you may not understand well and have big incentive to show outsized profits and grow their fiefdoms. they compete with other banks and with one another internally. you can tell them it's unsafe all you want. they may not care. or they may just think you are too dumb and old fashioned to compete anymore or that you don't understand.

bosses get replaced. more risk piles up. the big risk takers on the trading desk have gained power and share of the firms assets. a bubble magnifies this all out of proportion. at the top, everyone is way too long. but they have been making money hand over fist. they are confident in themselves and rarely see the turn coming. then things go wrong. the real professionals see this and cut losses quickly. the also rans wallow in cognitive dissonance. they are so sure they are smart and right that they ignore all the evidence that they are in real trouble. sometimes all the way to the bottom a la dick fuld.

bull markets always end that way and bear markets bottom when these guy's blood is in the streets. it's never going to change. trying to head it off for decades while inflating new bubbles to try to offset the popping of the previous one just leaves a huge, intractable mess when you finally run out of bubbles. it's like doing shots to prevent a hangover. eventually, it's going to catch up with you...

Posted by: morganovich | Sep 16, 2008 7:33:29 PM

I think one thing you all are missing is the relaxation of the short sale rules.

I think the thing your are missing is any actual knowledge of short sale rules and their effects.

The only "relaxation" of short sale rules is the tick price test ("offset" by Reg Sho). A tick is a penny. In liquid stocks, there's always a tick. In other words, the tick rule is useless. Of course, you don't have to sell the shares short to take a short position in a stock. you can buy puts. When you buy a put, the options market maker will sell the stock to hedge his short put position. The options market maker can and has always been able to sell the shares NAKED all day long as much as he wants and the tick rule never applied to him. Thus, when the SEC imposed it's "emergency" short sale restriction in July, the net effect was no real change in the short interest of the 19 stocks, but the liquidity got sucked right out of the stocks, raising transactions costs for anyone not savvy enough about finance to realize that the stock was trading much cheaper in the options market and they can take a long position by doing options combos.

Moreover, short sellers can't "create a perception of weakness". By definition, a buyer at any given price disagrees with the seller. If the short miscalculates and the market's opinion of the company is much higher than he thought, as the price decreases, buyers are happy to buy an ever increasing number of shares, driving the price back to the market's calculated fair value. Thus, a short can't permanently drive the stock down. A stock can only decline in value if the demand for it falls.

Have you ever noticed that it's the crappiest, least solvent companies that get heavily shorted? Are you honestly telling me that's a coincidence?

Posted by: Methinks | Sep 16, 2008 7:34:06 PM

hrm, AIG rejects an offer from Flowers & Co, supposedly because it gave Flowers a controlling equity stake, but accepts a similar offer from the Fed, that gives the Fed a controlling equity stake.

Was this about protecting shareholders or protecting management?

And, I'm waiting for Chuck Schumer to hold a press conference and demagogue New York investment bankers the way he does against Texas energy and oil companies. Surely some crime was committed, no?


Posted by: Jeff | Sep 17, 2008 5:56:37 AM

Oh, and I guess this is one last F*** Y** from Eliot Spitzer.


Posted by: Jeff | Sep 17, 2008 6:31:59 AM

Is the world going to end!?

Posted by: timboy | Sep 17, 2008 9:55:03 AM

"Methinks", your position doesn't make sense. You first state that the uptick rule had no effect, but then you say when they reversed it there was a dramatic effect on liquidity.

You also said that a stock can only drop if demand falls. Not true: a stock can drop if supply rises, which is exactly what happened when the uptick rule was relaxed. It led to an increase in liquidity, driven by the "new supply" available for sale after the rule was changed and you could short on any trade.

I'm curious what percent of short interest you think is represented by options market makers. Given hedge ratios, I'd guess not much.

Posted by: Scott | Sep 17, 2008 11:00:05 AM

your position doesn't make sense. You first state that the uptick rule had no effect, but then you say when they reversed it there was a dramatic effect on liquidity.

My position makes perfect sense. The SEC never reversed its position on the uptick rule. Since its repeal it was never reinstated. The "emergency" action in July temporarily changed the requirement from "locate" to "borrow".

You also said that a stock can only drop if demand falls. Not true: a stock can drop if supply rises, which is exactly what happened when the uptick rule was relaxed.

Where are you getting this misinformation? First of all, the uptick rule was repealed, not "relaxed" because it was dumb. Second, the naked short interest in the 19 stocks in question and in the stock market is as a whole did NOT increase over this past year, ACCORDING TO THE SEC. According to Cox, the move to change the rule from "locate" to "borrow" was prophylactic. I don't know where you got your rubbish information (my guess is from listening to the idiot brokers still left on the floor of the exchanges that CNBC and Fox love to interview), but it's horribly wrong.

I'm curious what percent of short interest you think is represented by options market makers. Given hedge ratios, I'd guess not much.

I have no idea and I don't care.

Posted by: Methinks | Sep 17, 2008 1:09:39 PM

No, to all of you. Lehman was obviously loaning money it didn't have. The company took on too much risk without any insurance. Why did a highly experienced company do such a thing? There must have been some new culture in the company that drove them to go for the huge volume of accounts. Maybe no one did anything illegal, but Lehman's debt investments seemed to go well beyond its equity. I would consider having regulation against such things.

Posted by: Frederic Rounds | Sep 17, 2008 2:52:11 PM

Methinks, but you said options market makers were never bound by the short sale uptick rule, which is true, but that therefore the uptick rule had no effect on the number of shares sold short, which is not a valid argument unless the overall short interest arose principally from delta-hedging puts, which it doesn't in individual stocks. I believe the implied short sale volume in individual stocks from put hedging is not a major component of short interest, but I can't get data on the whole market to support that, which is why I asked you.

With the rule change, I could now short on a flat tick, an uptick, or a downtick. If tick to tick movement is random, with the number of up, down, and flats equal, that means I can sell 50% more shares short than before, or get my short off in 2/3 the time.

And this has nothing to do with naked shorts. It's normal short sales that were impossible to execute before the uptick rule. Every short sale hits a bid, and if the number of bids doesn't go up, making short sales easier drives prices down. It doesn't matter if the rule was "dumb," it was the rule, and when they changed it they created a lot of downward pressure on stocks.

And no, this is not information from CNBC. I'm a fund manager.

Posted by: Scott | Sep 17, 2008 3:43:11 PM


Reread Morganovich's response to Roy. Twice. It's the best, most accurate, most honest explanation of what happened that I have ever seen. The answer to your question is right there in his post.

Posted by: Methinks | Sep 17, 2008 4:22:35 PM


Did you actually read my post? I never said options market makers were exempt from the tick rule. I said they were exempt from locating stock. The tick rule had no effect on anything because a tick is a penny and even when a stock is plunging, there's always an uptick. The ability to short without locates is far more valuable than eliminating the tick rule. The day that trading in eighths and quarters ended, the tick rule became utterly meaningless. You can't pass judgment on what I said until you actually read and understand what I said.

With the rule change, I could now short on a flat tick, an uptick, or a downtick. If tick to tick movement is random, with the number of up, down, and flats equal, that means I can sell 50% more shares short than before, or get my short off in 2/3 the time.

First of all, the rule was zero-uptick. You get around that by adjusting your size. Easy. Or buying puts and a whole bunch of other tricks I'm just not in the mood to divulge.

It doesn't matter if the rule was "dumb,"

I don't know how many different ways you need to be told this before you begin to comprehend, but the rule is DUMB because it DID NOT DO ANYTHING except create a lot of compliance busy work.

And no, this is not information from CNBC. I'm a fund manager.

It's normal short sales that were impossible to execute before the uptick rule.

I actually laughed out loud when I read that bit. That's not true. The SEC's own extensive research showed that this was not true. Any trader will tell you that's not true. The only exception is extremely thinly traded securities of tiny companies. There, the tick rule had the effect of creating massive rents for the specialist, sucking the liquidity out of already illiquid shares, raising transactions costs for retail investors (who are overrepresented in these itty bitty stocks because pros don't have the time to waste on a POS that trades 20K shares a day), and raising the cost of capital for the company.

and when they changed it they created a lot of downward pressure on stocks.

Prove it.

And no, this is not information from CNBC. I'm a fund manager.

And you don't understand all this? That worries me. Probably worries your investors more, though.

Posted by: Methinks | Sep 17, 2008 4:43:11 PM

and when they changed it they created a lot of downward pressure on stocks.

Actually, I can't stop laughing about that one. So it's NOT taking too much risk, levering every Tom Dick and Harry 100:1 in the purchase of their single largest asset at some tiny spread over LIBOR and then levering those loans 30:1 that put downward pressure on stocks? It's the tick rule!

I have to go read the pain in the ass new rule the SEC just released in response to ignorance like this.

Posted by: Methinks | Sep 17, 2008 4:49:40 PM


i think you may be under some misconceptions about how banks work and what equity means. all banks have investments exceeding their equity. it's the whole point of being a bank (unless you just intend to take deposits and put the money in a big pile and roll around in it like scrooge mcduck's vault).

the whole point of a bank is to let people borrow money that other people are not using. when you make a deposit, they pay you interest. where do you imagine that money comes from?

it comes from the bank lending that money to other people. they do this at a higher rate than they pay you. this is how banks make money.

what manner of regulation do you envision that would keep bank's equity at less than their exposure? i cannot imagine how this could be done without bringing the entire world economy to a halt. do you have any idea what borrowing costs would be under such a system?

Posted by: morganovich | Sep 17, 2008 6:23:40 PM

i apologize for the crass content, but i feel compelled to post a copy of this as it is one of the greatest wall street rants i have ever heard. (and deadly accurate)

I Need A Moment To Vent
Posted by Bess Levin, Sep 17, 2008, 5:37pm

Lloyd. John.

I am very disappointed in you. I though you were mensches. I thought you had pairs that hung as low as Russian Race horses. I thought you'd come out of this strong and long and down to get the friction on. Given your options today, which were a. stand up and take it like men or b. urinate sitting down like little girls, you chose b.

When the big bad short sellers came to blow your houses down today, you could've yelled through the window, "Huff and puff away, fuck sticks, unlike Lehman's house of straw, and Bear's trailer park of hemp, these bricks ain't comin' down." Instead, you caught the next train to Coxville to cry to your mama and clutch behind her legs while she wields a bat at the bullies.

You fuckers didn't want an actively regulated market when you were splicing and dicing toxic debt and selling this shit as if its shinola to unwitting third world countries who have difficulty with potable water (which I'm cool with, no playa hatas here). Then, the market bitch slaps you one down day after five years of offering up its fake breasts for you to snort the toxic lines of cocaine that is shit debt like Tony Montana and you get your undescended testicles in bind and go crying to the paradoxically named Chris Cox.

Christopher, please: live up to your uber-phallic name and dick slap these bitches back to the corner with their dunce caps.

There. I feel better.

Posted by: morganovich | Sep 17, 2008 6:30:51 PM

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