Déjà Vu All Over Again

8 August 2011/No Comments
By Nick Dunbar

Are we on the verge of another Lehman weekend?

The crisis of September 2008 unfolded in several stages: 1) a long bubble in subprime and credit markets in general, in which Lehman and other banks profited from by increasing their balance sheet leverage, 2) following a realisation that subprime was a haven of fraudulent lending, the bubble burst, leading investors to question whether the banks were sufficiently cushioned against write-downs in the assets they had taken on, 3) a expectation that the U.S. government, having bailed out Bear Stearns, would not let Lehman or other banks fail, 4) a loss of confidence as it became apparent that the government was not politically committed to bailing out banks, resulting in Lehman filing for bankruptcy, and 5) governments being forced to bail out other financial institutions after the consequences of letting Lehman fail became apparent.

Three years later, how similar is the situation today? Let’s go through the five stages of Lehman and look at the similarities: 1) like subprime in 2007, today there is the realization that a bubble in government spending and debt issuance took place over the last decade.

In my book I explain how financial instruments like CDOs made subprime appear perfectly safe investments with the help of triple-A credit ratings. Political instruments such as European monetary union and triple-A sovereign credit ratings did the same thing for over-spending governments. 2) Following the belated realisation in early 2010 that peripheral Eurozone countries like Greece had cooked their books, investors worried that they couldn’t support the enormous leverage they had taken on, selling their bonds, 3) following the initial problems with Greece and Ireland that led to the formation of a bailout fund, investors expected that the big Eurozone countries would not let peripheral nations fail. In the U.S., there was the expectation that political agreement was always possible on debt levels.

4) In 2008, banks were hit by contagion, and in 2010-11, the same thing has happened to sovereigns: Italy and Spain are now viewed as being as risky as Ireland and Portugal were a year ago. The political appetite for bailouts by countries such as Germany, or for U.S. taxpayers to bear the cost of increased debt has evaporated. That has resulted in a pre-Lehman like crisis of confidence. That is arguably where we are today. 5) This week, we are seeing European institutions being forced to bail out Italy and Spain, not least to support their banking systems, and the shock of the U.S. losing its AAA rating.

How do banks fit in to the current sovereign crisis? There is some good news: regulators forced them to bolster their balance sheets after 2008, so many of them are relatively stronger today than they were then. Unfortunately, the bad news is that regulations assumed that government bonds were effectively risk-free, so the banks own lots of them. Even worse, while sovereigns can postpone debt auctions and muddle through as they try to implement austerity programs, banks are funded by deposits and short-term creditors where a loss of confidence can trigger a sudden meltdown.

There is evidence that Italian banks are already experiencing a decline in non-domestic deposits, and the European Central Bank is supporting their balance sheets as it did with Irish, Greek and Portuguese banks ““ taking on their government bonds as collateral. Combined with the need to support peripheral EU governments as well, the potential size of this bailout could run into several trillion euros. In the U.S., the growing consensus that the private-label mortgage securitisation market was utterly fraudulent is raising concerns about the legal exposures of too-big-to-fail banks such as Bank of America. As in 2008, there is also the hidden network of derivatives contracts between the banks (and governments) which is supported by collateral, predominantly government bonds.

The bottom line is that the situation is easily as scary as 2008, possibly worse because the political commitment to international bailouts led by the U.S. has evaporated.

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