As Lehman Brothers (LEH) turns into a single digit financial midget on its way to zero, as Washington Mutual (WM) works its way towards a buck, as Wachovia (WB) drops more than 80% over a year, as Fannie Mae (FNM) and Freddie Mac (FRE) become divisions of the United States of America, and are now priced in pennies — we need to reflect upon the ongoing lessons learned from all these interventions by Treasury, Congress and the Federal Reserve.
The lesson from the Bear Stearns’ bailout — $29 Billion in Federal Reserve bad paper guarantees — are quite stark:
• Go Big: Don’t just risk your company, risk the entire world of Finance. Modest incompetence is insufficient — if you merely destroy your own company, you won’t get rescued. You have to threaten to bring down the entire global financial system. The fear and disruption caused by a Bear collapse is why it was saved. (AIG has the right idea on this)
• If you cant Go Big, Go First: Had Lehman collapsed before Bear, then the same fear and loathing of the impact to the system might have worked to their advantage. But having been through this once before, the sting is somewhat lessened — especially for a smaller, lets interconnected firm like LEH. (First mover advantage!)
• Threaten your counter-parties: Bear Stearns had about 9 trillion in its derivatives book, of which 40% was held by JPMorgan (JPM). Some people have argued that the Bear bailout was actually a preventative rescue of JPMorgan. Its a good strategy if your goal is a bailout — risk bringing down someone much bigger than yourself.
• Risk an important part of the economy: If your book of derivatives is limited to some obscure and irrelevant portion of the economy, you will not get saved. On the other hand, if Mortgages are important, credit cards and auto loans are too. Securitized widget inventory is not. To use a dirty word, Lehman’s exposure is "contained."
• Balance Sheets Matter: Focus on the media, complain about short sellers, obsess about PR. These are the hallmarks of a failing strategy — and a grand waste of time. Why? Its call insolvency. ALL THAT MATTERS IS THE FIRMS’ BALANCE SHEET. Lehman’s liabilities exceed its assets, and they are now toast. Merrill Lynch got a lot of the junk off of its books, and got a takeover at 70% premium to its closing price. And Credit Suisse, who dumped much of its bad paper many quarters ago, is in a better tactical position than most of its peers.
• Unintended Consequences lurk everywhere: When the Fed opened up the liquidity spigots via its alphabet soup of lending facilities, the fear was of the inflationary impacts. But the bigger issue should have been Complacency. The Dick Fulds of the world said after Bear, these new facilities "put the liquidity issue to rest." Lehman got complacent once liquidity was no longer an issue — perhaps they acted to slowly to resolve their insolvency issue in time.
Unfortunately, Moral Hazard has created terrible lessons in 2008 — via Bear Stearns (BSC), Lehman (LEH), Fannie Mae (FNM) and Freddie Mac (FRE).