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News : US Economy Last Updated: Sep 17, 2013 - 10:41 AM

Lehman Fallout: Panic on Wall Street when barometers of stress hit World War II levels
By Michael Hennigan, Finfacts founder and editor
Sep 16, 2013 - 7:42 AM

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New York Stock Exchange, Wall Street, New York

In the aftermath of the collapse of the Lehman Brothers investment bank 5 years  ago yesterday, panic gripped Wall Street and barometers of stress hit World War II levels.

We reproduce below our story from September 18, 2008 and on that Thursday, Patrick Neary, the then Irish financial regulator, reassured a fretful nation on national television that Irish banks were "resilient" and had a "good shock absorption capacity."

There was of course nothing reassuring in the well-honed mantra from Dublin's Dame Street, the location of the Irish central bank. Even Irish politicians had years before dropped clichés such as "the thin end of the wedge" or "paramount importance," when they realised they were making fools of themselves.

Before September was out, Patrick Neary was in Government Buildings advising on how a feared collapse of the Irish banking system, could be averted.

In New York, within a month of the Lehman collapse, the Dow posted a record daily rise of 11%.

September 18, 2008:

Panic gripped Wall Street on Wednesday; investors rushed to safety pushing the yield on three-month Treasury bills to levels not seen since World War II; the two remaining independent investment banks Goldman Sachs and Morgan Stanley came under siege; corporate borrowing costs jumped and fears mounted about the unregulated credit-default swaps market on more than $62 trillion in debt.

The Dow fell 449.36 points, or 4.1%, to 10609.66, the index's lowest close since November 2005. The Vix - Chicago Board Options Exchange Volatility Index - a measure of future movements known as Wall Street’s index of fear, jumped 19.2% to 36.13 - - its highest level since 2002.

Investment bank Morgan Stanley fell 24% and its rival Goldman dropped almost 14%.

Gold for December delivery rose as much as $90.40, or 11.6% to $870.90 an ounce in after-hours trading on the New York Mercantile Exchange after rising $70 to close at $850.50 in the regular session. That was the biggest one-day price jump ever; gold's previous single-day record was a $64 gain on Jan. 29, 1980. In percentage terms, it was gold's largest one-day rise since 1999.

A day after the Federal government agreed to acquire 80% of insurance giant AIG in return for an $85 billion loan, at special government auction, demand was so high for Treasury bills that the Treasury Department sold $40 billion, far in excess what it required to cover the government's obligations.

Investors were eager to get three-month Treasury bills with virtually no yield and as the price was bid up, the yield fell - - it tumbled on three-month Treasury bills to 0.061% from 1.644% a week ago -- a level not seen since World War II.

US data firm CMA DataVision reported that the cost of insuring $10 million of Morgan Stanley debt against default for five years rose to $796,000 a year, up $40,000. Insurance policies on the debt, known as credit default swaps, were trading as if the firm had a "junk" status credit rating.

At the end of 2002, the notional value (the value of the underlying assets of these contracts) of the entire credit-default swaps market was just $2.19 trillion and about $144 billion a decade ago, but at the end of 2007, had rocketed to $62.17 trillion, according to the International Swaps and Derivatives Association.

As with the chain linking a subprime mortgage issued to a resident of Reno, Nevada and a municipality in northern Norway, the level of interconnectedness of CDS contracts is now what could be termed a known unknown.

The Wall Street Journal says that as of June 30, an AIG unit had written credit-default swaps on more than $446 billion in credit assets, including mortgage securities, corporate loans and complex structured products.

Lehman Brother was a big player in the market, but it was both a buyer and a seller, so its net exposure is relatively small as many contracts cancel one another out. AIG is primarily a seller of credit default swaps, meaning there are many players who are depending on AIG's ability to pay up on insurance policies.

Warren Buffett - Financial Weapons of Mass Destruction

Investor Warren Buffett's Berkshire Hathaway's principal business is insurance and in 2003 said: "In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal...there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives.”

Buffett wrote in his 2003 Letter to Shareholders:"When we began to liquidate Gen Re Securities in early 2002, it had 23,218 outstanding tickets with 884 counterparties (some having names I couldn’t pronounce, much less creditworthiness I could evaluate). Since then, the unit’s managers have been skillful and diligent in unwinding positions. Yet, at yearend – nearly two years later – we still had 7,580 tickets outstanding with 453 counterparties. (As the country song laments, 'How can I miss you if you won’t go away?')

If our derivatives experience – and the Freddie Mac shenanigans of mind-blowing size and audacity that were revealed last year – makes you suspicious of accounting in this arena, consider yourself wised up. No matter how financially sophisticated you are, you can’t possibly learn from reading the disclosure documents of a derivatives-intensive company what risks lurk in its positions. Indeed, the more you know about derivatives, the less you will feel you can learn from the disclosures normally proffered you. In Darwin’s words, 'Ignorance more frequently begets confidence than does knowledge.'"

Following are edited excerpts from the Berkshire Hathaway Annual Report for 2002.

I view derivatives as time bombs, both for the parties that deal in them and the economic system.

Basically these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. For example, if you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction, with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration, running sometimes to 20 or more years, and their value is often tied to several variables.

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counter-parties to them. But before a contract is settled, the counter-parties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands. Reported earnings on derivatives are often wildly overstated. That’s because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

The errors usually reflect the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid, in whole or part, on “earnings” calculated by mark-to-market accounting. But often there is no real market, and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counter-parties to use fanciful assumptions. The two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counter-parties. Imagine then that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company.

The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counter-parties tend to build up over time. A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. However under certain circumstances, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z.

In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.

Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants.

On a micro level, what they say is often true. I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.

The history of Lehman Brothers parallels the growth of the United States. The firm began as a general store in the American South. Henry Lehman, who came from  Germany, opened a shop in  Montgomery, Alabama in 1844. In 1850, he was joined by brothers Emanuel and Mayer, and they named the business Lehman Brothers. Cotton was the cash crop of the day and the Lehmans accepted it from farmers as currency to settle accounts. The firm  traded the cotton for cash or merchandise, becoming brokers of the crop. In 1858, they opened an office in New York, which was the commodity trading center of the country.

On top of that, these dealers are owed huge amounts by non-dealer counter-parties. Some of these counter-parties, are linked in ways that could cause them to run into a problem because of a single event, such as the implosion of the telecom industry. Linkage, when it suddenly surfaces, can trigger serious systemic problems.

Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term Capital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort.

In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM – a firm unknown to the general public and employing only a few hundred people – could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for weeks, was far from a worst-case scenario.

One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes.

Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Irish financial regulator; October 02, 2008:

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