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Lehman – Not TBTF after all

Posted by Mark Harrison on September 16, 2008

Lehman, the fourth biggest investment bank has gone into administration (or Chapter 11, as it’s called in the States.)

It’s among friends – Bear Stearns was bought by JP Morgan Chase earlier in the year, and the US Government effectively nationalised Fannie Mae and Freddie Mac (two large insurance companies for which we don’t really have a UK equivalent) last week, and Bank of America announced it was buying Merril Lynch on Sunday.

In the UK, we’ve only had one major failure – Northern Rock, though other, smaller banks, such as StreetCred, have fallen by the wayside.

Bizarre as it may sound, I actually see some GOOD news in the Lehman failure, because of the way that it’s been handled by the US Government.

When the earlier banks failed, then I’m afraid that the government tried to intervene in a way that saved the shareholders money, but cost the (US) taxpayers money. While I can see a moral justification for helping out those whose deposit accounts have been affected by the failure of a lender, I see little moral justification for jumping in to help shareholders – after all, the value of shares can go down as well as up, can’t it?

The doctrine that has led to intervention in the past is sometimes called TBTF – Too Big To Fail – the idea that some financial institutions were so large, that if they collapsed, there would be a domino effect, as other banks to whom they owed money suddenly took big hits, and risk across the system – or so-called “systemic” risk existed.

In the Lehman issue, the US Government has drawn a line in the sand, and basically said that it’s not going to bail out any more banks – shareholders will have to take the hit, not taxpayers (or, with the state of the US Government’s overdraft, the children of taxpayers, who will still be paying the interest when they are adults.)

The danger with constant bailouts is that it creates “moral hazard” – consider two situations.

  • A Director knows that if they do X, they might make £1,000,000, but might lose £1,000,000
  • A Director knows that if they do X, they might make £1,000,000, but might lose £1,000,000… but if it goes pear-shaped, the government will bail out 90% of their loss, so they only actually lose £100,00

In which situation will the manager take bigger risks? Obviously, taking some risks is required – companies would never get started without entrepreneurs willing to take risks, and no-one would get ANY mortgage unless banks were willing to take SOME mortgage risk, but generally, things work better when people, and companies, realise that actions have consequences, and they can’t expect to be bailed out.

Of course, the downside is that, in the short term, credit conditions are going to get tighter as a result of the Lehman failure… but the option isn’t a magic wand that sorts everything out, just a magic wand that saves a problem today by creating a bigger one next year. Deep recessions tend to be nasty, but not as nasty as long recessions…


One Response to “Lehman – Not TBTF after all”

  1. […] Comments Lehman – Not TBTF af… on Streetcred – another Northern …Martin on Gazundering is backNika on How to sell a […]

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