Lehman collapse means all bets for the financial system are now off
By Philip Aldrick, Banking Editor
Any bank harbouring hopes of an end to the credit crunch had a rude awakening today.
Lehman Brothers' bankruptcy has dealt the money markets another crippling blow, incapacitating them for who knows how long. Since the crunch struck last year, the markets have been in seizure. But, with the careful nursing by governments and central banks, they appeared to be on the slow road to recovery. No longer.
Fears about other banks' exposures to Lehman and renewed uncertainty as to where the crisis may strike next will freeze the wholesale markets up again. The crunch is back with a vengeance.
It's not hard to see why. Lehman's collapse into bankruptcy protection is the biggest corporate debt default in history and, in the complex interwoven world of modern banking, no one properly understands where the risks lie.
Wall Street's titans gathered on Sunday afternoon to start the process of working out their positions by sitting down with other banks and tracking the paths of these impenetrable credit structures. It will take months at the very least for them to establish their "naked" exposure.
Establishing those positions is vital. Last week, for example, David Wright, deputy head of the European Commission internal market unit, noted that regulators still didn't know the full size of global securitised product issuance.
"We have to believe the numbers, " he said. "If we can't, we can't restore confidence." Without confidence, banks will not secure wholesale market funding. As the largest user of the wholesale markets in the UK, HBOS' 30pc share price fall on the London Stock Exchange this morning appeared to reflect those concerns.
What little confidence the markets had restored in recent months has been knocked for six. According to experts, Lehman has $150bn of debt outstanding. By comparison, US telecoms group WorldCom - the largest debt default until today - had $23bn to $30bn (depending on whose estimates you use) when it went bust in 2002.
Lehman bonds and loans that were trading at 80 cents to 90 cents in the dollar last week on fears of collapse are this morning worth little more than 40 cents, according to credit market experts.
In other words, about $70bn of Lehman debt held by other institutions has been wiped out. The holders of that debt, therefore, are facing huge potential losses with untold ramifications of their own.
The scale of the potential crisis is exacerbated by the credit default swap (CDS) markets. CDS's are insurance contracts for holders of corporate debt that guarantee to pay back the loan in the event of the company's bankruptcy.
Most of these products are offered by other banks to low-risk institutions like pension funds. Sandy Chen, a banks analyst at Panmure Gordon, reckons this is "where the real stress will come from".
He estimates that the "CDS market as a whole had notional contracts worth four times greater than the underlying debts issued". By his calculations, which differ slightly to the credit analyst's above, that would make "$350bn in CDS's written on Lehman debts".
Even using a more optimistic valuation of 60 cents in the dollar for the value of the debt, he says this could cost the banks providing the insurance $140bn. By comparison, when the sub-prime crisis struck last year - tipping the markets into seizure - the initial cost was estimated at $200bn, though it has turned out to be multiples more.
Furthermore, Lehman's collapse will flood the market with assets for which there are very few buyers anyway. The banks are already having to writedown their positions on a quarterly basis, often because the valuation of these assets is declining.
With a flood of such securities now expected to deluge the market, prices will tumble further - necessitating more writedowns.
Central banks know it will be touch and go. Hence the $70bn liquidity pool provided by ten of the biggest investment banks for any one of them that needs to tap it.
Hence the decision by the US Federal Reserve to widen the set of assets eligible as collateral for Treasury loans to include all investment grade paper, and to almost double the size of these Treasury loans to $200bn.
Hence the extra £5bn of liquidity the Bank of England is providing the UK money markets.
As CDS contracts are called in and financial counterparties pull back from the money markets, the same funding crunch that did for Northern Rock and Bear Stearns will rear its head. Another even more opaque "unknown" is the "second order implication" for banks - the indirect effect as those banks badly damaged by Lehman start to reel.
As to the size of the counterparty risk - defined as other banks that have complex financial instruments held through Lehman - no analyst or credit market expert could hazard a guess as to the likely cost. Mr Chen said Lehman had $729bn of "notional derivatives contracts" that Lehman believed in May were worth $16.6bn.
Again, any losses will have to be punched into the complex, interlaced banking system to work out where the liabilities ultimately may lie.
At the very least, the collapse of Lehman is potentially as costly as the $200bn initial estimate of the US sub-prime mortgage fall out.
Given where that has left the world's banks - in terms of losses, writedowns, capital raisings and share price falls - there's every reason to be worried.
As Alan Greenspan, the former chairman of the Federal Reserve, said over the weekend: "We will see other major firms fail."
http://www.telegraph.co.uk/money/main.jhtml?MLC=/money/city_news/markets&view=DETAILS&xml=/money/2008/09/15/bcnbank115.xml&CMP=ILC-mostviewedbox
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