Life Since The Lehman's Collapse

This is a bit moot by now, but the fact that Lehman Brothers was "allowed" to fail probably triggered the massive panic and risk aversion which clouded all assets for the following 4-5 months. Lehman basically closed shop on 9th September 2008. Bespoke had a look at how global markets have performed since then.

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Saturday, October 25, 2008

Lehman Brothers, The Rosetta Stone

The 'Rosetta Stone' is an Ancient Egyptian artifact (حجر رشيد in Arabic) which was instrumental in advancing modern understanding of hieroglyphic writing.

Lehman Brothers' demise probably caused the "banking crisis of confidence", which brought about the present state of financial markets. The massive deleveraging by funds of all kinds, the downgrading of emerging markets' debts and currencies, the flight to USD and yen, the numerous injection of liquidity into the system by central banks, the guaranteeing of deposits to prevent bank runs, the notion that nothing has real value anymore... may all be traced to Lehman Brothers' bankruptcy, or rather Paulson's refusal to save the company. Lehman Brothers may be the Rosetta Stone which helps us better understand why things are the way they are now.

Though Lehman was the smallest investment bank when it failed — and regulators decided it was not too big to fail — its demise set off tremors throughout the financial system that reverberate to this day. The uncertainty surrounding its billions of dollars of transactions with banks and hedge funds exacerbated a crisis of confidence. That contributed to the freezing of credit markets that has forced governments around the globe to take steps to try to calm panicked markets, including guaranteeing bank deposits.
The list of creditors with material exposure to Lehman Brothers is long. There will be dozens of holders of senior notes, sub debt and junior sub debt, so you can’t make too much of the fact that it looks as though the Japanese banks were laid out. We’d need to see the signatories to the Trust Indentures of the three sets of Notes to see just how many financial institutions and debt funds were exposed to Lehman’s various debt pieces:

• $138 billion of senior notes, which have Citibank and BONY listed as indenture trustees
• $12 billion of subordinated debt, with BONY listed as indenture trustee
• $5 billion of junior subordinated debt, also with BONY as indenture trustee
• $463 million of bank debt provided by Japan’s AOZORA
• $289 billion of bank debt provided by Japan’s Mizuho Corporate Bank
• $275 million of bank debt provided by Citibank N.A.’s Hong Kong Branch
• $250 million of bank debt provided by BNP Paribas
• $231 million of bank debt provided by Japan’s Shinsei Bank
• $185 million of bank debt provided by Japan’s UFJ Bank
• $177 million of bank debt provided by Japan’s Sumitomo Mitsubishi
• $140 million L/C provided by Svenska Handelsbanken
• $93 million of bank debt provided by Japan’s Mizuho
• $93 million of bank debt provided by Canada’s ScotiaBank branch in Singapore via NYC
• $75 million of bank debt provided by Lloyds Bank

Paulson obviously did not appreciate Lehman's involvement. Lehman is a leveraged brokerage shop that was the counterparty to trades sized in billions, including interest rate swaps, commodity futures, corporate bonds, international equities and real estate loans, currency swaps, and private equities. The counterparty risk created fear and triggered domino selling. Banks refused to lend to one another fearing the other end to be infested with Lehman's positions. Insiders claim that it could take over a decade to fully unwind Lehman's positions.The scary bit is that Citigroup and Bank of NY may not be out of the woods yet as things stand.

What's more, Lehman was one of the largest prime brokers to international hedge funds. Lehman's bankruptcy immediately caused wholesale panic within the hedge fund industry as funds tried to close/transfer/pull their money out of their Lehman custodian. Today over $60 billion is still locked up in Lehman's London brokerage unit. Given the leveraging nature of hedge funds, the effect on global equity markets was catastrophic as trillions of dollars were wiped off global equity markets. If you were to leverage the $60 billion twenty times (about right) it comes to $1,200 billion worth of positions that needed to be unwound.

Maybe now we can get a better grip on why so many injections of liquidity and bailouts still failed to calm the markets. The injection of capital is more than sufficient, its just that those with fresh capital are not really lending, except to very solid names. Maybe Paulson would be better off addressing the root, i.e. unwind those institutions and creditors affected by Lehman's failure. The escalating domino effect from Lehman's failure is already cascading across the globe. I hope its not too late for Paulson and the global financial leaders to stem the tide.
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What the table shows is that investors have been discriminating. During the height of the panic, everything got sold down massively, even markets in Malaysia, Venezuela, Vietnam, Taiwan, etc... which had very little exposure to the subprime debacle. Yes, these markets should be sold down as a major financial crisis such as the subprime thingy would drastically affect global trade, global demand in particular. Many were fretting that everything gets sold down in a major crisis, even when the "real effects" may be not as severe in some far flung or more disciplined economies. Many were shrugging and throwing their hands in the air, not know why the selldown had to be so "wholesale" in nature.

This table shows clearly that investors do differentiate, and will punish accordingly over time. The right rewards and punishments for the right markets. This table should give us all a lot of comfort in that in the event of a major crisis, the kneejerk reaction would be risk aversion and a wholese-type sell down. It is during the initial first few weeks that those with tough stomachs will benefit in the long run. Yes, investors do differentiate, yes investors do appreciate the differences, yes investors do know the real culprits, yes they know the real effects on each economy and the resilience of each smaller economy, yes they do know that the same crisis affects everyone differently, yes they appreciate the fact that some economies are better managed and are more disciplined in their fiscal and monetary policies ... This is an important point because if all markets get sold down in a major crisis, then its pointless to look at specific sectors, specific stocks, specific countries ... as all will get whacked anyway. The table showed us that doing your homework counts, it pays to know more, it pays to understand more regions ... because if not, we might as well sack all analysts and just hire the few strategists to monitor and anticipate major financial crisis.


p/s photo: Keiko Kitagawa

Decoupling Of Markets Is Not A Myth

Decoupling - can the rest of the markets decouple from the US markets. That topic has been debated to death. The firm answer is that, yes markets have actually decoupled judging from the history of the last 8 years. However that seems to work only when we are in a flattish or bull market environment. The massive correction over the last 8-9 months have shown how all markets have recoupled during bad times. During the global bull market from '03 to '07, many pundits believed that developed and emerging markets outside of the US were strong enough to not catch a cold when the US sneezed. The BRIC countries of Brazil, Russia, India, and China were probably the most talked about countries when "decoupling" came up, but as we've all seen, these countries have in fact gotten hit much harder than the US during the downturn. A main pillar of the decoupling belief is the view that China and the other emerging market economies in Asia will maintain their impressive growth momentum despite a slowdown in the Western industrialized economies.

This couldn't be highlighted better than in the chart below that shows both the US and the BRIC countries as a percentage of world market cap since mid 2003. As global equity markets rallied across the board from '03 to '07, the US lost a huge amount of world market share, falling from about 45% to a low of 24%. At the same time, BRIC countries went from about 4% of world market cap to nearly 16%.

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Latest - Wow! Look at the yen/dollar rate go ... from 89.4 to 91.7 ...

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Once the credit crisis hit, however, US markets fell, but the rest of the world fell even harder. And as the chart shows, the US has been steadily gaining back market share over the last year or so, while the BRIC countries have fallen. When there are massive corrections, it looks like the BRIC countries and the rest have nowhere to run, especially when its a crisis with global effects.

Just because the markets recoupled during bad times does not debunk the decoupling theory. Its an indication that the theory needs to be refined and is not a one dimensional rule of thumb. Despite the US losing some of its pre-eminence in economic leadership, the aggregate demand by the US is still the engine of global trade. Yes, the dominance by US consumers may have been easing as a percentage over the last ten years, but its still the most significant demand factor today. Decoupling does not mean that an American recession will have no impact on developing countries. That would be daft. Such countries have become more integrated into the world economy (their exports have increased from just over 25% of their GDP in 1990 to almost 50% today). Sales to America will obviously weaken. The point is that their GDP-growth rates will slow by much less than in previous American downturns.

Globalisation has taken strong roots over the last 10-15 years, and that basically means more open economies to trade. BRIC countries have been able to build up wealth faster as they can run up greater surpluses and their companies can see strong profit growth, and thus the trickle down effect. Add in their huge requirement for infrastructure, its a potent mix. The recoupling during a bear market may only be in effect if its a "globalised event". If its a localised event, the decoupling theory may be able to hold up much better. But the key question now is whether any correction nowadays will be a localised event for the US. The answer is probably not.

Globalisation has in effect seen a surge in the freer flow of funds to invest in global assets. They could be index funds, commodity funds, hedge funds, private equity, etc... hence when US catches a cold, the likelihood of a domino effect is very likely. In fact, recent history has shown that when things are bad, even the good assets and performing assets will be used to cover the holes and anticipated drawdowns.

The first chart basically showed that in good times, emerging markets grew much faster as trade between themselves have grown to be a lot more important relative to the US. This shows that in good times decoupling theory works well and works better. During bad times, the flow on negative effects from the US would cloud the prospects of all countries, in particular this credit crisis which is global in nature as the deleveraging process hits all countries and almost all asset classes - be they good or bad.

The chart at the bottom proves once and for all that decoupling works well when things are going well, a reflection of the higher growth beta of emerging markets. But when things are bad, beware, its not a time to only look at how wonderful your local economy is doing.

p/s photos: Park Eun Kyung