The current crisis in the US financial institutions is really worrying and is unprecedented in the modern history in terms of magnitude, complications, and immediate as well as future implications. Let me share a bit of information for us to ponder.

The recent failures of Lehman Brothers, Merrill Lynch and AIG centered around what is called as the “settlement risk” or “problems”. These banks or institutions failed in fulfilling their commitments to financial contracts – which then fail to be “settled”. The question is: How big is settlement risk right now?

An indicator one might look at is the number of “fails to deliver” and “fails to receive” reported by primary dealers in U.S. Treasury bonds. Last week, before Lehman was expected to file for bankruptcy, fails to deliver rose by $351 billion to $410 billion; fails to receive rose by $336 billion to $389 billion. Again, there have been bigger spikes in the past, but they haven’t happened at the same time as the bankruptcy of a primary dealer. Right now is the last time that anybody wants to be worrying about failed trades, because they can’t have any assurance that their counterparty will still exist by the time they’re all worked out.

Lehman Brothers has more than $600 billion in assets that will need to be liquidated as part of its bankruptcy. That’s an order of magnitude greater than any bankruptcy the world has ever seen: No one has a clue how to even get started on something so huge, let alone what the repercussions will be. Is there $600 billion in cash sitting on the sidelines of the global financial markets just waiting for an opportunity to snap up assets on the cheap? No. So as Lehman’s assets get liquidated, asset prices in general, and bond prices in particular, are likely to be under a great deal of pressure

In turn, that’s going to hurt other players in the global financial system, from hedge funds and sovereign wealth funds to small- and medium-sized regional banks. Anybody who’s leveraged and who marks their assets to market is at risk of margin calls and possible bankruptcy themselves, depending on the volatility and risk profile of those assets.

The upshot is a state of radical uncertainty: as Paul Krugman says, “nobody knows what will happen next.”… There is a very, very long list of things that could go horribly wrong from here on out. The liquidation of Lehman is one; the possible collapse of American International Group is another. Beyond that, there are countless hedge funds and other financial institutions which, collectively, present significant systemic risk.

But the biggest and most obvious risk of all is the one associated with Lehman’s own debt, which is now trading at less than 35 cents on the dollar. That’s a big loss for the institutions holding it—but it also means an unknowably huge loss for anybody who wrote credit protection on Lehman Brothers at any point over the past five years. Those sellers of credit protection are staring down the barrel of billions of dollars in claims, and they’re going to have to raise that money quick by selling anything they can get their hands on—and that might well include stocks.

In regards to AIG, last night the Federal Reserve bank announced that they will “bail out” AIG (the irony is that they refused to bail Lehman earlier), with an $85 billion bridge loan in return for control of the ailing insurance giant. Finally, everyone discovers there is a “loophole” in the Fed laws under Section 13(3) to allow bail outs. The last time this section was used was in 1929, during the Great Depression time. The Fed Board stated that “…. in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance. The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.”

Thinking of unthinkable has happened; risk premium has increased dramatically…the world should brace for tumultuous financial markets in the months to come, if not years…we should keep our watch and be kept informed.

Note: This article was circulated earlier by emails, on 17th September 2008

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