The Real Reason Greece Is Like Lehman
by Justice Litle, Editor, Taipan Publishing Group
The 2008 crisis really got going when Lehman Brothers went bankrupt. That is a widely acknowledged piece of the puzzle.
But many do not realize exactly why the Lehman bankruptcy opened the floodgates. There is misunderstanding as to why the event caused disaster.
The same dynamic now applies to Greece. Then as now, the financial media aren't really reporting on this (because they don't really get it). There is talk of a "Lehman moment," without a good description of what makes it possible.
With more than $600 billion in assets involved, the Lehman bankruptcy was one of the largest in history. And yet, it was not the size of the bankruptcy that caused the problem. Before it happened, many thought a Lehman failure would be like a larger version of the Bear Stearns failure -- shocking, but not a mortal threat to the financial system itself.
In fact it is almost certain that Hank Paulson, the Treasury Secretary at the time, thought letting Lehman fail was the right thing to do. The Bush administration was taking huge amounts of criticism for being too friendly to Wall Street, and Paulson himself was being questioned as a Goldman Sachs alum. Letting a major investment bank fail would be seen as a sign of toughness, and the system could handle it. Or so Paulson seemed to think.
Of course, within 24 hours of Lehman's demise, Paulson and Bernanke realized they had made a terrifying mistake. The rescue of AIG (an instant $80-billion-plus lifeline, with more to follow) came almost immediately after.
Why did the authorities get it so wrong? What made the Lehman failure a disaster of catastrophic proportions?
To answer in a single word: "complexity." When Lehman failed, it was the tangle of complex aftershocks behind the scenes that triggered a massive heart attack for Wall Street.
Complexity is an inevitable byproduct of having multiple systems and lots of rules. Under periods of huge stress, the systems and rules can start slamming into each other, like cars in a pileup, with too much chaos for anyone to sort things out.
Another way to think about it is to picture the financial system as a giant plumbing network -- a profusion of valves and boilers and pipes. When pressure builds up in the wrong part of the system, pipes threaten to burst and boilers threaten to explode. If this happens fast enough, no human can stop it.
One of the unexpected results of the Lehman bankruptcy, for example, was a freezing of assets in London. British rules did not allow the withdrawing of assets from a company in liquidation. Those frozen assets in turn created a huge problem for all the hedge funds and money management firms that had accounts with Lehman.
In a true nightmare scenario, some funds not only had money locked up, they had open positions that they could not sell even as the market fell. Imagine if you were heavily long in your retirement account and your broker "locked you out" on the eve of a market crash, keeping you not only from accessing your cash, but forcing you to watch your losses mount. That was the equivalent position for many.
Lehman Brothers also had tens of thousands of derivative transactions with funds, banks and traders all up and down Wall Street. These "counterparties," in Wall Street lingo, had no idea where their trades were after Lehman went down. Would they get the money they were owed? Were the trades still open? Who had the risk? Where was it?
This wave of uncertainty led to a "deer in the headlights" reaction as everyone froze. Liquidity evaporated as all of a sudden every bank and every fund was not just frightened for its own life, but wondering who would be next to go down the tubes.
It was the runaway consequences of out-of-control complexity, unleashed by Lehman's failure, that brought the crisis to full bore. Which brings us back around to Greece...
The generally understood fear is that a Greek default could lead to a "domino chain" of other defaults. If Greece goes down, so does Portugal. Then Ireland, then Spain and so on, until it is "game over" for the eurozone.
That path of events could certainly unfold. But it is not the only way disaster could strike. What is frightening is that, as with Lehman, there are other ways the whole financial system could melt down -- thanks to our old friend complexity.
Take, for example, the "Credit Default Swap," or CDS. A credit default swap is a form of insurance against a debt obligation going bad. It was the indiscriminate selling of CDS that blew up AIG in the 2008 financial crisis.
AIG was happy to collect tiny premiums (pennies on the dollar) selling insurance on the subprime mortgage market, thinking it was "free money" because disaster would never happen. Wall Street banks, meanwhile, were dumping CDS obligations on AIG as fast as they could.
Now we have a repeat situation with European sovereign debt. Just as AIG sold CDS insurance on subprime, American banks have been selling hundreds of billions in default insurance to European banks, in the form of CDS on various periphery countries like Greece.
What this means, sadly, is that if Greece or another eurozone country defaults, American banks could blow up again too. Which means U.S. taxpayers would have to bail them out.
But it gets more complicated still...
Desperate to avoid the domino-chain scenario, France, Germany and the ECB (European Central Bank) are trying to engineer a "default without a default." They are hoping to pull a legal trick on the markets, by getting private creditors to "voluntarily" roll over their Greek debt -- or promise to buy more -- so that the conditions of a default are technically not triggered.
The trouble is, even if they succeed in this ruse, the financial system could blow up anyway. That is because, in the event of a "non-default default," the European banks that bought insurance from the American banks (in the form of CDS) would suddenly see their insurance deemed worthless -- canceled out by a legal trick.
That could cause investors to make a "run on the banks" that hold heavy loads of sovereign debt, just as Greek banks are already witnessing the beginning of a run. At the same time, American banks could see their troubles mount dramatically when their aggressive CDS sales to Europe -- making the same type of bet that AIG did -- come to light.
Last but not least in the horrific complexity department, there are the multiple parties that have to agree to a solution no matter what happens. Alongside the Greek government, one now must factor in the Greek populace. And France. And Germany. And the European Central Bank. And the International Monetary Fund. And the ratings agencies like Fitch and Moody's, who decide what a "default" is or isn't. And the ISDA, or International Swaps and Derivatives Association, which is the official ruling body when it comes to CDS claims -- deciding whether a CDS contract is payable or not.
With every step Europe takes, the situation seems to grow more complicated. And the stakes are getting bigger, not smaller.
The intercontinental snarl of complexity again puts the financial system at risk, because the wrong disagreement at the wrong time threatens to unleash new waves of chaos and confusion, which in turn could hurtle the American and European banking systems back into crisis.
Unfortunately there are no short-term resolutions (except in the form of blowup). Every time investors celebrate another episode of "kicking the can down the road," for example, the tangle just gets deeper. If Greece jumps through the proper hurdles to get its next bailout check next time, the stakes will be even higher in the following round -- the same ultimately applying to Portugal, Ireland and the like. Denial and delay simply build toward an even more explosive conclusion.