What If There's No Deal?

What if the Lehman Bros. deal falls through? It's a real outcome at this point. The Fed and the banks are running out of time. What if the worst happens? Let's start with this:

Cumberland Advisors Investment Chief David Kotok said Friday the stock market could plunge 1000 points if Lehman Brothers fails.

“If Lehman fails credit spreads change because they will reflect this new dynamic of the Fed is not always going to bail out,” Kotok said in an interview with CNBC. “And when credit spreads widen, stocks will get in trouble. They’re in trouble because of that risk.”

Let's continue with this:

If Lehman can't make good on some portion of its hundreds of billions of dollars in commitments, there is a risk of a domino effect throughout the financial system. And all of us, one way or another, are dependent on that system.

For the last 20 years, the idea of protecting the biggest financial firms from failure has centered in large part on the boom in so-called derivative securities such as credit default swaps -- a way for banks and investors to bet on, or hedge against, financial market moves.

The value of outstanding derivatives now is measured in the tens of trillions of dollars. Billionaire investor Warren Buffett has called derivatives "financial weapons of mass destruction" because of the market's size and complexity and the threat that one party's inability to honor its commitments could topple many others.

But some experts say that threat always has been overstated.

"I've heard this so many times," said Allan Meltzer, a veteran economist at Carnegie Mellon University in Pittsburgh. "I don't believe it."

The public's suspicions are correct, Meltzer asserted. In the case of Lehman, he said, it's natural that the investors who own the firm's stocks or bonds, or have other investments tied to Lehman, will say the company is too important to fail.

"The people who have the losses want help, so they tell you it's going to be a disaster," he said.

Janet Tavakoli, a Chicago-based consultant on derivative securities, says it may finally be time to find out just how well the derivatives market can stand up to a serious financial failure.

"It would be good to have a test case," she said.

And let's end with this:

It is now clear that we are again – as we were in mid- March at the time of the Bear Stearns collapse – an epsilon away from a generalized run on most of the shadow banking system, especially the other major independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley, Goldman Sachs). If Lehman does not find a buyer over the weekend and the counterparties of Lehman withdraw their credit lines on Monday (as they all will in the absence of a deal) you will have not only a collapse of Lehman but also the beginning of a run on the other independent broker dealers (Merrill Lynch first but also in sequence Goldman Sachs and Morgan Stanley and possibly even those broker dealers that are part of a larger commercial bank, I.e. JP Morgan and Citigroup). Then this run would lead to a massive systemic meltdown of the financial system. That is the reason why the Fed has convened in emergency meetings the heads of all major Wall Street firms on Friday and again today to convince them not to pull the plug on Lehman and maintain their exposure to this distressed broker dealer.

Are you willing to bet your portfolio on a deal?
You already have.

What we are facing now if the beginning of the unraveling and collapse of the entire shadow financial system, a system of institutions (broker dealers, hedge funds, private equity funds, SIVs, conduits, etc.) that look like banks (as they borrow short, are highly leveraged and lend and invest long and in illiquid ways) and thus are highly vulnerable to bank like runs; but unlike banks they are not properly regulated and supervised, they don’t have access to deposit insurance and don’t have access to the lender of last resort support of the central bank (with now only a small group of them having access to the limited and conditional and thus fragile support of the Fed). So no wonder that this shadow banking system is now collapsing. The entire conduits/SIV system has already collapsed with the roll-off of their ABCP financing; next is the collapse of the broker dealers (Bear, Lehman and soon enough the other ones) that rely mostly on unstable overnight repos and other very short term funding for their financing; next will be hundreds of poorly managed hedge funds that will face a tsunami of redemptions; and finally runs on money market funds that are not supported by a large financial institutions or other smaller member of the shadow banking system as well as highly leveraged and distressed private equity funds cannot be ruled out either.

Endgame for the global financial system, folks.

It's coming. If it's not Lehman, it will be one of the next insolvent brokerage banks. One will take down the system. It will take down the rest of the US economy with it.

The Second Great Depression? Could be.