“Mischiefes feed / Like beasts, till they be fat, and then they bleed.”
So says the chief magistrate in Ben Jonson’s play Volpone after passing sentence on the avaricious characters of the piece. Many investors in Lehman Brothers might have been forgiven last week for sharing the magistrate’s sentiment after the firm filed for bankruptcy protection.
Despite discussions on who might be next on to the block, the bailout of Bear Stearns and more recently Fannie Mae and Freddie Mac had allowed markets to cling to the notion that these large institutions were somehow immune from collapse.
Speaking at the Financial Services Authority’s (FSA) asset management conference last week Paul Davies, deputy capital markets editor of the Financial Times, said “too big to fail” had given way to “too interconnected to fail” in recent times.
Both views, however, have been thoroughly undermined as market expectations of a last-minute deal to salvage the ailing Lehmans failed to materialise owing to the Federal Reserve’s refusal to underwrite potential liabilities on the firm’s books.
“People were expecting that there would be some kind of bail-out, a bit like they did with Bear Stearns,” says Keith Wade, chief economist at Schroders. “I guess what they’ve said is that the money is not available and the Fed is just going to try to manage the fallout.”
In the wake of this momentous decision the financial sector was spurred into action as Merrill Lynch was swallowed by Bank of America in a deal that valued the company at about $50 billion (£28 billion), only slightly more than the total value of assets written down by Merrills since the onset of the credit crunch.
Leigh Skene, a consultant with Lombard Street Associates, says the Fed’s decision not to intervene over Lehmans shows a determination to explode the “too big to fail” argument.
“The Lehman bit was expected as a lot of people expected them to let Lehman go as other bigger players were in trouble,” says Skene.
“Certainly the line in the sand has been drawn, and the immediate consequence was the sale of Merrill to Bank of America.”
The central bank was brought into sharp focus as a second panic gripped the market after American International Group (AIG), one of the world’s largest insurance groups, applied to the Fed for a $40 billion emergency loan. The Fed rebuffed the request, forcing the insurer to take the unprecedented step of drawing $20 billion from its subsidiaries to try to plug the holes in its balance sheet.
The moves played havoc with global stock indices, plunging Britain’s FTSE 100 index below the 5000 mark for the first time since June 2005. America’s Dow Jones fared little better. It fell 504 points in a day – the Dow’s worst day since the September 11 attacks in 2001 and the sixth largest fall since the index was created.
Speaking last Monday, Skene said that the Fed appeared to be moving to prevent a moral hazard being built up whereby there would be a presumption that risk taken on by large institutions was underwritten by government funds.
“What we’ve got now is the realisation that there is risk and the moral hazard game is being played out, although we’re not at the end yet,” he said. “I can’t conceive of the Fed opening its discount window to AIG as it would undo all of the good that it did over the weekend.”
The gravity of the situation, however, forced the central bank’s hand. AIG was downgraded by S&P, Moody’s and Fitch, threatening a potential call for the company to post an additional $13 billion in collateral, which it could ill afford to do. Faced with a potentially explosive situation, the Fed injected $85 billion last week in exchange for almost 80% of AIG, effectively nationalising the struggling insurance firm.
Almost simultaneously news emerged in Britain that Lloyds TSB had been given approval to enter into merger talks with Halifax Bank of Scotland (HBOS) as the plunge in the latter’s share price started to pose a serious threat. The government even promised to steamroller the deal past the anti-monopoly watchdogs to try to ensure its success.
The news was not universally welcomed by the financial services community. Robert Jenkins, chairman of F&C Asset Management and of the Investment Management Association, says the bailout sends the wrong message to financial organisations.
“There is no shortage of liquidity [in the market],” says Jenkins. “Capitalism will not succeed unless capitalists are allowed to fail.”
Of particular concern for Jenkins has been the apparent unwillingness of many financial firms to shed top management personnel even as they began to struggle for funding. Richard Fuld, chief executive officer of Lehman Brothers, refused to discuss a takeover offer from Korea Development Bank in August, saying the price undervalued the business despite its potentially crippling problems.
“The people that created the problems are not best placed to solve them,” says Jenkins. “I think the boards [of these companies] are not only doing the financial industry a disservice, they are doing their own companies a disservice.”
A more positive note, however, was sounded as 10 major banks committed to providing $7 billion each into a support fund to help ailing members of their industry. Participants include Bank of America, Barclays, Citigroup, Credit Suisse, Merrill Lynch, Morgan Stanley and UBS.
The decision has prompted hopes that the banking community are trying to resolve the funding problems facing the industry among themselves rather than looking to central banks to extend a limitless supply of capital.
In the meantime, it can only be hoped that bankers take the warning of Lehmans to heart and do not fall victim to over-optimism like the avaricious gentlemen of Jonson’s play. As the scheming manservant Mosca reports:”They will not see it; / Too much light blinds them, I think: each of them / Is so possest, and stuft with his own hopes, / That any thing, unto the contrary, / Never so true, or never so apparent, / Never so palpable, they will resist it.”