Bombshell: We Now Know What Set It Off (2008)

Karl Denninger
Market Ticker
Mar 15, 2010

The Jenner and Block report on Lehman has of course brought out many comments about Lehman and its management, along with what appears to be clear culpability of both management and government actors. I wrote about these factors and raised serious questions as well.

Today, however, I want to focus in a different direction.

It is rare that we learn the precise reasons behind a collapse in the markets. What set people off in 1987, for instance? We'll probably never know. Nor do we know what the precise cause was of the 1929 crash.

The Jenner and Block report, however, lays out something very disturbing: As early as July 31st it appears Citibank knew that Lehman in fact had no cash - nor any liquid collateral to post for repo transactions.

Repo transactions are what makes the world go 'round. They're the "oil" in the engine, so to speak. When two financial parties have various trades they're settling for one another (as Citi was for Lehman in the FX markets) the posting collateral to obtain short-term cash is how one secures the clearing of these trades. There's nothing magical about them, but without them the common, every day occurrence of transactions in the marketplace simply stops.

Specifically:

Contributing to the difficulty of finding collateral that was agreeable to bothparties was the fact that Fleming told Citi that Lehman repoed out for cash all of the marketable securities in its liquidity pool.

That one sentence right there says it all.

Now let's overlay a few things. First, the S&P 500 chart from the time in question:

It went on for a while, didn't it?

Now Lehman:

That went on for a little while too. About a month, to be exact.

Here's the problem - Lehman was functionally bankrupt at that particular instant in time. It was trying to post less than $4 billion in collateral and couldn't come up with anything acceptable.

Would you press a short bet knowing this? You damn sure would. Indeed, you'd be insane not to.

Let's consider the unfortunate reality of how this sort of circumstance develops:

This sort of circumstance happens when firms have huge amounts of securities that are marked at values that have no reasonable relationship to reality within the marketplace. The issue is not "liquidity", as anything that has an agreeable value in the market can be repo'd out for cash on a short-term basis.

Now consider this: What are the banks holding right now, and have the actions of government made another run at this problem more or less likely?

They have hundreds of billions of dollars of "illiquid" HELOC and other Second Line exposures on their balance sheets. Like Lehman, they're valuing most if not all of this in the 90s. But the market for them is literal pennies - any of these loans behind an underwater first is worth zero if the first stops paying and forecloses. Thus, the letter from Barney Frank.

The actions of early last year when FASB changed the rules are exactly backward. By allowing this trash to remain on balance sheets with fantasy marks FASB and our governmenthas set up a potential Lehman in every one of our large financial institutions.

These fantasy marks effectively remove this collateral from that which can be used for routine daily operational purposes. That in turn makes the available liquidity a smaller percentage of the firm's balance sheet, and drives it closer to insolvency.

Remember what Lehman did at earnings time: They made it appear that they had a smaller balance sheet than was real, and that they had more cash than really existed. Why? Because their liquidity looked larger as a percentage of the balance sheet than it really was, which was intended to lead the market to believe that they were "healthy."

Well, what are we doing here? By intentionally expanding asset valuations beyond true value we're doing the precise same thing!

Does this mean that we're going to get a blow-up tomorrow? Of course not. But it points to a severe danger - when one's assets are impaired - whether due to being "infrequently traded" or because you're carrying them well above a market price - you're asking for it. All it takes is for the securities you can pledge to be drained and you're doomed.

Now take a look back through the last few Tickers. I keep seeing evidence that the banks are not only holding things above reasonable recovery value in the HELOC space they're doing it everywhere else too, whether it be not foreclosing on homes, making bogus reports to credit bureaus about payments that are not being made or accepting ridiculously small payments that are a tiny fraction of even "interest only." Why? There's only one reason that makes sense - to claim (falsely) that their assets are worth more than they are - that they're "performing", "have collateral value of X" or "paying" when in fact they're not.

How long will it be before the next large financial institution goes to post a repo and has no good collateral?

I have no idea.

But this I do know: If it happens again "they" won't be able to stop the crash with promises and BS. In fact, they won't be able to stop it at all.

Washington should step in here right now and demand honest marks. If this means taking the big banks into receivership then it does.

I know nobody wants to talk about it any more, but we have to. If it's done now, in a controlled fashion, it will be expensive.

If we have another Lehman, we won't be able to cover it. The cost of a disorderly event will easily exceed $1.5 trillion for depositor claims alone, and we simply don't have the money and won't be able to raise it.

This can't be left alone folks. Valuations are not coming back any time soon on these loans. Not for years - maybe a decade or more.

We simply don't have that long before someone else has "an accident."

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Mar 13, 2010
Karl Denninger

source: http://market-ticker.denninger.net/archives/2076-Bombshell-We-Now-Know-What-Set-It-Off-2008.html

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