Will the US financial system collapse today, or maybe, over the next few days? I don’t think so — but I’m nowhere near certain. You see, Lehman Brothers Holdings Inc., a major investment bank, is apparently about to go under. And nobody knows what will happen next.
To understand the problem, you need to know that the old world of banking, in which institutions housed in big marble buildings accepted deposits and lent the money out to long-term clients, has largely vanished, replaced by what is widely called the “shadow banking system”.
Depository banks, the guys in the marble buildings, now play only a minor role in channelling funds from savers to borrowers; most of the business of finance is carried out through complex deals arranged by “non-depository” institutions, institutions such as the late lamented Bear Stearns Companies Inc. — and Lehman.
The new system was supposed to do a better job of spreading and reducing risk. But in the aftermath of the housing bust and the resulting mortgage crisis, it seems apparent that risk wasn’t so much reduced as hidden.
And as the unknown unknowns have turned into known unknowns, the system has been experiencing postmodern bank runs. These don’t look like the old-fashioned version: With few exceptions, we’re not talking about mobs of distraught depositors pounding on closed bank doors. Instead, we’re talking about frantic phone calls and mouse clicks, as financial players pull credit lines and try to unwind counterparty risk. The defences set up to prevent a return of those bank runs, mainly deposit insurance and access to credit lines with the US Fed, only protect the guys in the marble buildings, who aren’t at the heart of the current crisis. That creates the real possibility that 2008 could be 1931 revisited.
Policymakers are aware of the risks — before he was given responsibility for saving the world, Ben Bernanke was one of our leading experts on the Great Depression. So, over the past year the Fed and the treasury have orchestrated a series of ad hoc rescue plans. Special credit lines with unpronounceable acronyms were made available to non-depository institutions.
The Fed and the treasury brokered a deal that protected Bear’s counterparties — those on the other side of its deals — though not its stockholders. And just last week the treasury seized control of Fannie Mae and Freddie Mac, the giant government-sponsored mortgage lenders.
But the consequences of those rescues are making officials nervous. They’re taking big risks with taxpayer money. For example, today much of the Fed’s portfolio is tied up in loans backed by dubious collateral. Also, officials are worried that their rescue efforts will encourage even more risky behaviour in the future.
Which brings us to Lehman, that has suffered large realty-related losses and faces a crisis of confidence. Like many financial institutions, Lehman has a huge balance sheet — it owes vast sums, and is owed vast sums in return. Trying to liquidate that balance sheet quickly could lead to panic across the financial system.
That’s why government officials and private bankers have spent the weekend huddled at the New York Fed, trying to put together a deal that would save Lehman, or at least let it fail more slowly. But treasury secretary Henry Paulson was adamant he wouldn’t sweeten the deal by putting more public funds on the line.
The real answer to the current problem would, of course, have been to take preventive action before we reached this point. Well, that was six months ago. Where’s the mechanism? And so here we are, with Paulson apparently feeling that playing Russian roulette with the US financial system was his best option. Yikes.
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