North Carolina Product Liability Lawyer & Attorney : D. Hardison Wood : Toy Safety, Child Restraint, Car Seats

First, and no Paul Krugman was not the first person to coin this phrase, I am quite sure there were a lot of people betting that the Fed would "make Lehman-aid" and rescue the Wall Street icon from the disgrace of bankruptcy.  I was one of those people, but mostly for sentimental reasons.  Most were making that bet because they know that the new bankruptcy rules (mostly 2005) enforce harsh, indeed at places draconian, measures on financial companies that go bankrupt.  A good rundown on that is here.  And in short, no one knows what these measures will do because they've never been tested.  Why?  Because financial companies, especially major broker dealers, just don't go bankrupt.  Last one that did, Drexel, was almost 20 years ago and the 2005 amendments weren't there then.

To be sure, Lehman's bankruptcy will be ordered and well-regulated.  Thanks in large part to their hiring of super-debtor bankrupty all-stars Weil Gotshal and their talented staff of Harvey Miller (last guy to handle a major FIG bankruptcy - Drexel) as well as fellow Cardozo alum and former professor of mine, Gary Holtzer.  You can also bet that Ed Altman is going to be in this mix of various advisors as he's the guru of all gurus when it comes to restructuring.  However, just having good lawyers and good advice isn't going to eliminate the problem.  And the essence of the problem is this:

Lehman was at the near center of a byzantine thing called the "credit default swap market".  If you have no idea what that is, there is a decent description here.  The big worry in the market as it was created was what happens when a counter-party defaults?  Does the house of cards come tumbling down in a chain reaction?  This is the question of "systemic risk" and a good rundown on how that plague things is here.  Well, the ISDA (International Swaps and Derivatives Association) said in a report in 2007 (warning: pdf)that the market is just about sophisticated enough to deal with this.

It is possible, however, that credit derivatives have already evolved into a mature product and that future growth will resemble that of interest rate and other derivatives.  That is, products will become increasingly commoditized but will also become known by to a wider range of users.  The past ten years have seen credit evolving from a largely illiquid product into an increasingly tradable product, in which risks are managed the same way as other market risks.

It is this view of credit that is being challenged now.   It is, for lack of a better phrase, a true day of reckoning.  Yes there are optimistic predictions, as well as doom and gloom predictions.  Depending on your bent I'm positive you can found one account out there that will confirm your worst worries, or make you sleep better at night.  But one thing is for sure now, we are definitely going to find out.  When Paulson and Bernanke refused to put up more taxpayer dollars to save Lehman, they set in motion a series of events that will ultimately wind up answering the question.  I'm not saying that was good (more likely) or bad (less likely), just that it is.

And don't think for a minute they don't know this.  After all, the Fed's bailout of Bear Stearns and fire sale action earlier in the year was argued as a necessary because of Bear's role as a major counter-party in the CDS market.

The alternative would have been to let Bear slide into a Chapter 11 [sic] bankruptcy, which would have happened quickly. Among other things, Moody's, S&P, and Fitch all downgraded Bear on Friday, potentially forcing the firm to put up additional collateral to meet the requirements of a credit-default swap triggered by the downgrades—collateral it didn't have. Bear notionally holds $13 trillion in derivatives contracts, and even if credit-default swaps were only a small fraction of that, any sort of credit event would have been catastrophic for both Bear and its buyers, the latter of whom would find themselves holding guarantees from a firm that was not in a position to guarantee anything.

So, they had to let the Bear softly out to pasture cause otherwise the CDS market would collapse.  But if you haven't linked to the pdf from above, do it now, because in that very report, you see that Lehman is much more significant in this market than Bear ever was (charts at the end).  There has been lots of teeth gnashing about "moral hazard" and "Paulson gave them plenty of time to unwind" for Lehman but I think its clear that the Lehman bankruptcy was much more life altering for the CDS market than Bear Stearns could have been.  I suppose the more charitable view of Treasury's position is that the market had ample time to grow up between Bear and now.

And these CDS makrets are big, with a notional value of $62 trillion according to the BIS (Bank for International Settlements).  Keep in mind here that everyone is throwing a lot of numbers.  ISDA's chairman has said that the notional amount is just a nominal figure representing the underlying bonds being protected.  He further says that true exposure is about a factor of fifty less, i.e., how much people actually owe is 1/50th or so of the notional amount.  So with today's estimate of $62 trillion, there is owed approximately $1.2 trillion.  So that's the whole pie, how much of it goes into default  and how little is recovered is something we are soon going to witness.

I'll post a little more on this when I have the time.  But for now, I read the situation as pretty much a devastating indictment of the "see no evil hear no evil" approach to regulation we've had over the banking system for the past few decades.  I realize that view doesn't help fix the problem.  And honestly I don't have the foggiest clue about how to fix it, but I would just ask this simple favor as a taxpayer. 

If we are going to be bailing out any more of these entities, can we at the very least get some pretty serious oversight in exchange?  I mean, that seems fair enough doesn't it?  If you can't play by the rules and need our help, then shouldn't we be able to enforce rules on you until we trust that you'll continue following them on your own?

And maybe that's the real crux of the situation right now.  Trust.  It takes a long time to build, and once it is violated, even longer to get back.  As an attorney, trust is not only critical but ethically required in our enterprise.  Say what you want about attorneys, but to practice law long without trust is an oxymoron.  I don't think it would be a bad thing to inject some ethical standards into the world of high-finance right now.  I realize they don't have the time to be bothered, but for us taxpayers to trust them again, maybe that's what we need?