buying enough protection to limit your downside, by contrast, is simply prudent

From Reuters:

"Do CDSs cause more bankruptcies?

Post a comment (2)

Posted by: Felix Salmon

Tags: derivatives

Charles Davi has spent 1500 words replying in great detail to my blog entry about whether the CDS market has a deleterious effect on bankruptcy negotiations. He’s basically correct, as far as he goes, and indeed I did mix up an Event of Default with a Credit Event — my bad. But still I think he misses the bigger picture.

The problem, at heart, is this: debt negotiations are hard, arduous things. Nobody likes going through them — especially not big institutional bondholders, who can suddenly find themselves with 1% of their portfolio taking up 50% of their time. It’s something everybody wants to avoid if possible, especially since bondholders who engage in negotiations generally have to constrain themselves from trading in or out of the debt in question.

And so, at the margin, anything which makes it easier to ignore bond-restructuring negotiations is going to be jumped at by the creditors of any company. Given the choice between buying credit protection and entering into negotiations, most bondholders will happily buy the protection, even if it costs them a little bit more money.

I’m not for a minute positing the existence of protection buyers who actively seek to derail bond renegotiations so as to maximize the payout on their derivatives. Instead, I’m just saying that it becomes much harder for borrowers to renegotiate their bonds when the bondholders don’t particularly care what happens either way, because they’ve gone and bought themselves credit protection.

The problem with the originate-to-distribute model of mortgage lending was that the people who were meant to underwrite the loans couldn’t be bothered to, because they had no intention of holding on to them. Call it sheer laziness, if you like, if you don’t want to ascribe any malign intent, but the fact is that there’s an opportunity cost to getting dragged into long and boring procedures, and often a quick financial deal is much easier and cheaper than doing hundreds of hours of forensic and accounting homework.

I fear that the growth of the CDS market has made it altogether too easy for bond investors to simply rid themselves of troublesome considerations pertaining to companies in distress. Selling distressed bonds outright is extremely unpleasant; buying enough protection to limit your downside, by contrast, is simply prudent. Once you’ve done that, who can blame you for not getting bogged down in negotiations?

It’s far too early to say whether we’re going to see more bankruptcies as a result of this phenomenon, or even whether that’s necessarily a bad thing. But I do think it’s a legitimate concern."

Me:

A long time ago, about last September, when Lehman went bankrupt, I remember the words “hoisted”, “petard”, and “bankruptcy”, being used together quite a bit. The idea, as I remember it, was that bankruptcy had gotten way too hard, and bankruptcy should be made easier.

Whoa Nellie! Not so fast. Now we want bankruptcy to be harder. About the only thing that the two views have in common is a distaste for creditors, meaning people who lend companies money and have the audacity to want to get paid back and make money.

Talk about shooting yourself in the foot with a bazooka. How does it help us to market the buying of bonds as a flight to a haircut? Perhaps we should make the lending of money to companies more like charitable donations.

I favor a tax cut for investment. One way to do this is to get investors to want to buy corporate bonds. Mandating risk is not a good way to do that.I am seriously perplexed by these proposals.

Either people will stop buying bonds or they’ll demand much higher interest for their investment, meaning lower profits and wages.

What am I missing?

- Posted by Don the libertarian Democrat

"If everybody wants a bailout, that's a good indication that we're making some mistakes."

From James Hamilton on Econbrowser:

"Bailouts should be no fun( I SAID THIS ON SEPT. 22, 2007 )

If everybody wants a bailout, that's a good indication that we're making some mistakes.( TRUE )

Let's start with first principles-- why are we talking about huge potential transfers from the government to private companies in the first place? My starting point would be the observation that U.S. output is falling significantly below what America is capable of producing. The problem is not that labor and capital are physically incapable of producing more, but instead that certain key institutions have existing legal commitments that they are unable to fulfill. Foremost among these would be in the financial sector, where liabilities threaten to exceed the market value of assets, preventing the entire sector from functioning properly( TRUE ). But also prominent are other crucial industries, such as the domestic auto manufacturers with a very significant burden of debt and obligations to current and retired workers. We need an unambiguous resolution of this problem, allowing these institutions to return to productivity. The sooner those unpayable commitments can be resolved, the better off we're going to be.( TRUE )

How do you solve the problem of unpayable existing obligations of institutions that otherwise have the resources to make a productive contribution to total economic surplus? That of course is the function that our bankruptcy system is intended to provide. In a typical bankruptcy, the company's owners and senior management get wiped out, some crumbs are left for creditors and workers, and hopefully the most valuable underlying assets get reallocated to alternative productive use. But bankruptcy is a very clunky process with lots of deadweight costs in and of itself. We should have significant concerns in the present environment about the possibility of such costs leading to spillover effects, forcing other institutions into bankruptcy that otherwise might have remained solvent. There is a good case to be made for bringing the taxpayers in as a fifth player at the negotiating table along with owners, creditors, management, and workers. There are likely going to be instances in which a modest taxpayer contribution, in conjunction with substantial concessions from the other four parties, could end up preventing a much larger economic loss. I could easily believe that a judicious expenditure would leave the taxpayers as a group significantly better off than if we'd simply allowed the bankruptcy process to run its course.

The representative of the taxpayers in such negotiations would seem to have by far the strongest hand at the table. The threat point is to let the company go into bankruptcy, and the limit on what the taxpayers are willing to contribute should be the direct benefit to taxpayers (as opposed to benefits to the other four parties). If your company doesn't like our terms, fine, go your own way, and we'll prop up the next domino in line instead. If properly implemented, the taxpayers should leave the negotiating table pleased with the deal they achieved, and everybody else should leave battered, comforted only by the knowledge that, had they not made those concessions, things would have been even worse.

On the other hand, if everybody and their grandmother is lining up for a bailout, and pulling political strings ([1], [2]) to make sure they get it, I read that as prima facie evidence that the taxpayers' interests are not being properly represented."( I AGREE HERE )

I'm not sure that we allow banks to go bankrupt. Wouldn't that add a bank run to our problems?

having the government take over going enterprises will encourage investors to put their money in one of two places: mattresses or government bonds.

From James Surowiecki:

"What Does Insolvency Mean For a Bank?

John Hempton questionsPaul Krugman’s explanation of why banks like Citigroup are already effectively bankrupt, even though they’re still in business. Krugman says that as soon as a bank’s liabilities are bigger than its assets (that’s not technically true of Citigroup right now, but might very well be if Citigroup marked down its assets to their true market value), it’s “bust.” Hempton, by contrast, argues that it’s more complicated than this, for a simple reason: banks get a much bigger return on their assets (that is, their loans) than they have to pay for their liabilities (which include, among other things, their customers’ deposits). They earn, say, three per cent on their assets, while paying just one per cent on their liabilities, which means that as long as it can avoid a bank run, even a bank with bigger liabilities than assets can earn significant profits, profits that over time close the gap between assets and liabilities, so that after a few years, a supposedly “bust” bank can suddenly become solvent again, without any additional injections of capital. As Hempton points out, this is the way the biggest Japanese banks were able to return to solvency in the nineteen-nineties.

Now, this doesn’t mean that the current state of affairs is fine—the only reason a bank can avoid a bank run is because of myriad U.S. government guarantees( TRUE ). And as Hempton himself says, this math doesn’t say anything about whether we should take over technically insolvent banks. But Hempton’s analysis does speak to the fact that bank insolvency doesn’t always look like a typical corporate bankruptcy. Typically, when you think of a company being bankrupt, you think of it being unable to pay its bills or meet its payroll, being unable to get credit to order new inventory, and so on. Circuit City, for instance, is closing its doors because it literally doesn’t have the money to keep them open. But that’s obviously not the case with major banks, which have access to the Fed’s discount window (meaning it can borrow money to meet its obligations), and which are still generating significantly positive cash flow. They can be insolvent and still, in most respects, do business as usual.

Shutting a bank down is usually, then, in some sense a judgment call on the part of regulators. That’s O.K.: it’s an inevitable part of a fractional-reserve banking system with federal-deposit insurance. But many of the proposals for bank nationalization seem to imply that regulators should start declaring banks that are technically solvent (like Citigroup) insolvent, with the government getting to take all of the banks’ assets as a result of what regulators decide( A FAIR POINT ). (An alternative is what William Buiter proposed in Britain, which is having the government essentially pay to acquire the big banks( OK ).) This, at the very least, does seem like it creates room for political mischief( THAT'S OUR SYSTEM ). More important, having the government take over going( BUT NOT WITHOUT LARGE GOVERNMENT SUBSIDIES. THAT'S HARDLY GOING. ) enterprises will encourage investors to put their money in one of two places: mattresses or government bonds.( COME ON. THERE ARE THOUSANDS OF OTHER BANKS. BY THE WAY, BUSINESSES FAIL ALL THE TIME FOR ALL SORTS OF REASONS. DOES THAT ENCOURAGE PUTTING YOUR MONEY ELSEWHERE? )

Posted by James Surowiecki"

There are certainly problems with nationalization, but I submit that they are more manageable than the alternatives. That' all.

"But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed"

David Merkel on The Aleph Blog with a list:

"1) There are firsts for everything. Americans paid down debt for the first time, according to a Federal Reserve Study that started in 1952. America has always been a pro-debt and pro-debtor nation( SPENDER NATION ). It goes all the way back to the Pilgrims, who paid back the merchant adventurers who funded them at a rate of nearly 40%/yr over a 15-20 year period. But, the Pilgrims did extinguish the debt. Us, well, I’m amazed at the decrease, but we need more of that to restore normalcy to financial institutions.

2) Dropping to 45%, though, is the amount of aggregate home value funded by equity. With the decline in housing values, the fall in the ratio was inevitable. The low ratio puts downward pressure on home prices, because it means that more homes are underwater ( IT STILL HAS A GOOD SIDE ). Perverse, huh?

3) It’s a long interview, but Eric Hovde (my former boss) has a lot of important things to say regarding the financial sector. Few hedge funds focused on financials remained bearish on the sector, but Hovde’s funds survived to 2007-2008 where his bets paid off.

4) Is there a Treasury bubble? Yes, but it may persist for a while because of panic, central bank buying, buying from pension funds and endowments, mortgage hedging, and more( TRUE ).

5) Now these same low yields whack Treasury money funds. How many will close? How many will cut fees? How many will break the buck, and credit negative interest? An unintended consequence of monetary policy. Another unintended consequence reduces liquidity in the repo markets. Yet another unintended consequence is the reduction in investment from Japan and other nations that don’t want to hold dollars at low rates( WHO KNOWS? ).

6) Brave Ben Bernanke is fighting the Depression. If his theories are right( I AGREE WITH BERNANKE ) (and mine wrong), if he succeeds, he will face a difficult challenge in collapsing the Fed’s balance sheet as inflation re-emerges, without taking the wind out of the economy ( TRUE ). But if I’m right (or London Banker, or Tim Duy, or Stephanie Pomboy) things could be considerably ugly as the situation proves too big for the Fed and the US Government to handle( TRUE ).

7) Inflation is the lesser evil at this point.( I AGREE ) It would raise the value of collateral over the value of the loans, dealing purchasing power losses to those that made the bad loans, but not nominal losses.

8 ) I have said before that the Fed and Treasury are making it up as they go( TOO MUCH ), and Elizabeth Warren now confirms it for the Treasury. My Dad (turned 79 yesterday) used to say, “The hurrier I go, the behinder I get.” So it is for the TARP bailout( A HYBRID ). Policy made hastily rarely works. Spend more time, get it right. The market won’t die as you work it out.

9) But will AIG die, or the automakers?

• Sales are slow for assets at AIG. ( THEY WILL BE. BUYERS CAN TAKE THEIR TIME ) (no surprise valuations are crushed, and all likely buyers face lower P/Es and higher debt costs.)
• And who knows where the writeoffs end? As I said long before the failure of AIG, don’t trust the financial statements ( TRUE ). The palce was too complex, and the culture of fear inhibited objective financial reporting.
• GM’s suppliers are seeking cash. Just one of the costs of financial stress.( WOULDN'T YOU )
  
• Suppliers worry over a lack of demand if the automakers fail. They should retool for Japanese and European automakers. ( MAYBE )
  
• From Credit Slips, the important idea is that without a good business plan the automakers are toast anyway. I predict they will be back hat in hand in half a year even with a bailout( THEN WE CAN LET THEM FAIL ).
• A GM bankruptcy would take a long time, and a prepack would not get done before the cash runs out. Maybe, but I would still take it through bankruptcy, with the US Government as the DIP lender. ( THE BAILOUT NEEDS TO BE SEEN AS JUST THAT, BOTH FOR SOCIAL REASONS DEALING WITH PERCEPTIONS OF FINANCIAL TYPES BEING THE ONLY ONES SAVED, AND THE GOVERNMENT GUARANTEES ARE ESSENTIAL TO GETTING OUT OF THIS . THAT'S WHY INVESTORS ARE FLEEING AGENCIES FOR TRASURIES )
  

10) Even VCs are looking at the survivability of their portfolio holdings. Who can survive and become cash-flow positive in a tough environment. Who needs little additional funds?

11) Leveraged loans are attractive, but it is a situation of too many loans with too few native buyers. Watch the loan covenants, so that you can get good recoveries in a default. If you are an institutional investor, this is a place to play now that will deliver reliable returns net of defaults. For retail investors, the closed end funds typically employ too much leverage — it is possible that one could collapse before this crisis is over.

12) Residential mortgages continue to weaken along with property prices. Two examples: Alt-A loans and second mortgages.

13) I have a lot of respect for Dan Fuss. This is a tough time for anyone taking credit risk. That said, it could be a good time to take on credit risk now, if you have fresh money to deploy.

14) Two views of the crisis: one that focuses on structured finance, particularly CDOs, and one that focuses on macroeconomics. I favor the latter, but both have good things to say.

15) Michael Pettis is one of my favorite bloggers. He notes the weakness in China, and notes that the current economic situation is ripe for trade disputes. ( I'VE BLOGGED ABOUT THIS POST )

16) You can give the banks funds, but you can’t make them lend. Would you lend if you didn’t have a lot of creditworthy borrowers? ( YOU CAN MAKE THEM LEND )

17) The export boom is dead, for now. Fortunately, imports are falling faster, so the current account deficit is falling.

18) I blinked when I saw this Wall Street Journal Op-Ed. Sorry, but the secret to changing the residential real estate market is not lowering interest rates( IT'S A WAY THAT THEY CAN BE SEEN AS HELPING HOME OWNERS ), but writing-off portions of loan balances. Most delinquents can’t make even reduced payments, half re-default, and can’t refinance because the property is underwater. Yes, I know that the government is pressing to have Fannie and Freddie suck down more losses by letting underwater loans refinance, but if you’re going to do that, why not be more explicit and let the losses be realized today by resetting the loan’s principal balance to 80% of the property value, and giving the GSE a property appreciation right on any growth in the home value on sale, of say 150% of the amount written down?( THAT'S A POSSIBLE SOLUTION )

19) On commercial property, when do you extend on a loan vs foreclosing? In CMBS, if the special servicer has no bias, or if a healthy insurer/bank holds the loan on balance sheet, you extend when you are optimistic that this is just a short-term difficulty with the property, and you think that the property owner just needs a little more time in order to refinance the loan. More cynically, extensions can occur in CMBS because the juniormost surviving class directs the special servicer to extend because it maximizes the value that they will get out of their investment, because a foreclosure will wipe out a portion of their interests, since they are in the first loss position. With a less than healthy bank or insurer, the same procedure can happen if they feel they can’t take the loss now. (I know that in a extension/modification there should be some sort of writedown, but some financial entities find ways to avoid that.)

20) Time to go bungee jumping with the US Dollar? As Bespoke pointed out, the Dollar Index has just come off its biggest 6-day loss ever. Should we expect more as the US heads into a ZIRP [zero interest rate policy], with aggressive expansion of the Fed’s balance sheet, much of which might be eventually monetized? The best thing that can be said for the US Dollar is that it is already in ZIRP-land, and much of the rest of the rest of the world is being dragged there kicking and screaming ( TRUE ). As the interest rate differentials narrow in real terms, the US Dollar should improve.( TRUE )

But, there are complicating factors. Future growth or shrinkage of the demand for capital will have an impact, as will future inflation rates. Even if the whole world is in a global ZIRP, there will still be differences in the degree of easing, and how much easing the central bank allows to leak into the money supply ( TRUE ).

This is a mess, and over the next few years, expect to see a whole new set of metrics develop in order to evaluate monetary policies and currencies ( TRUE ). For now, put your macroeconomics books on the shelf, because they won’t be useful for some time ( TRUE ).

A good post.

"What did surprise him, though, was that Lehman’s collapse had been allowed to happen in the first place."

I know Felix Salmon has been on this, but I highly recommend this post on FT about the bankruptcy of Lehman in Britain:

"as the bank collapsed and his team took over the European leg of the biggest and most complex bankruptcy in history."

Wow. I didn't realize this.

"In many countries, bankruptcies are handled by lawyers, but in the UK, the lead roles go to accountants."

I didn't know this.

"if Lehman was a global enterprise in health, in bankruptcy each of its regional operations would face its own set of legal rights and responsibilities."

Fascinating.

"There are two basic forms of insolvency. The first and more common is cashflow insolvency. This is when a company finds itself unable to pay its debts as they fall due. The second is balance-sheet insolvency, in which liabilities outweigh assets. Lehman’s European operations fell into the first category."

Okay. It can't pay its bills.

"Like many global corporations, the bank swept all the cash from its regional operations back to New York each night and released the funds the next day. The Friday sweep had taken about $8bn out of London. Without cash, the business could not meet its financial obligations on Monday morning. A thriving business of more than 5,000 staff and investments worth billions of dollars was suddenly flat broke."

Unreal. $8 billion gone, never to return. Weird. See Felix Salmon here. Also here.

"Every day, Lehman dealt with thousands of companies, other banks and investment funds. Opening another day’s London trading therefore ran the risk of destabilising the world’s markets. Equally pressing, trading without the cash on hand to meet obligations – technically, trading when insolvent – is against the law."

Again. Unreal.

"There are more than 200 legal entities in the bank’s European operations. The PwC team needed to identify which pieces ran the whole business, which assets needed immediate protection and which would actually be insolvent as a result of a lack of cash. As the night wore on, the partners gradually began to realise the true scale of what they were taking on. Schwarzmann settled down to look at the standard group structure. “Wow,” he said, “that’s quite complicated.” Andrew Wright, Lehman’s European finance director, turned round and answered: ”That’s just the summary.”

These quotes are self-explanatory.

"At Lehman, that meant Lomas’s team had to act fast on a number of fronts – from dealing with more than 50 exchanges around the world to persuading the contracted canteen cooks to keep coming in. Harder still, they were starting from cold."

I think that this means that they had to take on this immense and complicated bankruptcy immediately. Wow.

"Immediate tasks included securing the IT operations, notifying the thousands of exchanges and other counterparties which the bank dealt with, assessing the risks involved in its open trades, starting the search for cash, figuring out the way each division operated, discussing sales of business units with potential bidders and talking with the staff. Then would come the detailed work – still ongoing – of unwinding the bank’s vast trading positions and unravelling exactly who was owed what and by whom."

Just think of this.

"Having run most of its accounts through its New York parent, Lehman Europe had few deposit accounts of its own. Nor could it set up any with another bank, since that bank was likely to be a creditor or debtor and could try to seize any money parked with it. In the end, the Bank of England came to the rescue. The bankrupt bank now has more than 60 accounts with the central bank, covering currencies ranging from US dollars to Chinese renminbi to Norwegian krona. It expects to open still more."

So, in essence, a business must be created in order to bankrupt itself.

"On average, the bank was responsible for 12 per cent of all trades on the London Stock Exchange. Its prime brokerage business, which serves hedge funds, was one of the biggest in London and held some $40bn of client assets."

12% of the LSE frozen.

"By Wednesday, Lomas and Team were in a position to tell staff that a $100m loan would cover their salaries. Now the focus could shift to trying to sell as much of the business as possible and trying to unwind its trading positions."

Good luck.

"For many Lehman traders, the need to unwind the company intelligently meant a new pay package with a hefty bonus component if they managed to strike deals that were advantageous to the Lehman estate. Pearson knows he might come in for outside criticism for doling out these bonuses, since all funds are now owed to the bank’s thousands of creditors. But he defends the move. “It’s exactly what I did at Enron, so I knew exactly how I wanted to handle this. You’ve got a bunch of people here who know these markets so well, and with the right piece of information they can make you – or lose you – hundreds of millions of dollars,” he says. “The last thing you can afford to do in these circumstances is be cheap, because if you’re cheap, you can ruin the ship for a hap’orth of tar.”

These employees, who are going to eventually be terminated, are in a pretty good bargaining position.

"The juddering halt caused by the bankruptcy meant that the previous three days’ trades were not fully settled. They weren’t even fully recorded in the bank’s systems. This wasn’t an unusual time-lag, but one not helped by the fact that trading volumes had simultaneously shot up because of market panic, caused in part by fears about Lehman’s health. The unsettled trades caused chaos in the markets as stock exchanges began to work through the deals to reach settlement. The securities traded by Lehman were simply left hanging during some of the most volatile days ever seen in the markets."

Unreal.

"Then there were the cancellations, where counterparties such as banks or hedge funds with whom Lehman had traded rushed to trigger legal clauses to extricate themselves from some deals. Thousands of e-mail cancellations hit the bank. Either for itself or its clients, the bank held billions in securities such as stocks, currencies, commodities, bonds and various derivatives. On Friday, Lehman traders went home comfortable they had protected their risk on these holdings. Monday brought the realisation that the broken deals meant many hedges were no longer in place: the bank now had a book of holdings at risk of being crushed by the wild market swings."

It's a snowball effect from hell.

"To begin unwinding the “book”, Pearson called on outside help and used other banks’ trading teams operating under confidentiality agreements. These teams conducted the sales so the market would not know they were Lehman positions. If dealers had known that a particular trade was linked to the stricken bank, they could have tried to profit by pushing the price down, knowing Lehman had to sell."

They had to pretend they were someone else in order to avoid getting hosed. Too much.

"In fact, some of these trades actually ended up making the bank hundreds of millions of pounds as the team rode the rollercoaster market moves. “We ended up catching both sides of the market,” says Pearson. “We decided to close out some long positions [assets held in the expectation that prices would rise] when the market went up. We had some short positions [designed to profit from price falls], too, and the market then went down.” He won’t give exact figures but says: “Some positions that we moved, we made gains that exceeded the entire earnings of one of the divisions last year.”

That's pretty funny.

"Then there were the client positions, where the bank held assets on behalf of its customers, or stored them with another bank. Since Lehman’s collapse, hedge funds and others have been issuing increasingly frantic calls for the return of their assets – to no avail. This has produced some high-profile victims such as Luqman Arnold, head of the Olivant fund, whose entire 2.78 per cent stake in UBS is held by Lehman.

Certain hedge funds have claimed they are at risk of collapse because of trapped assets, which they cannot trade nor effectively hedge against, but PwC has warned it will take months before they can be returned. Even six weeks into the bankruptcy, the administrators were waiting on some of the 97 banks holding Lehman assets to clarify just what they held."

Wow. You don't know what the worth is of what you have, and you can't do anything with it.

"It’s all complicated further by a process known as rehypothecation, which affects a substantial proportion of the hedge fund assets held by the bank. In these cases, the funds pledged collateral (usually stocks or other securities) in return for a loan, while agreeing to the bank’s putting that collateral back in the market to make extra profits. With the music stopped, the hedge funds owed Lehman money in exchange for the collateral. To honour that, Lehman must itself go back into the market and unwind deals in which it reused the assets, paying out cash to get them back."

Oh hell no. Not another bizarre term to understand.

Okay.
1) Hedge Fund gives assets to Lehman.
2) Lehman gives money to Hedge Fund
3) Lehman uses assets to make money from third party.

Now:
1) Lehman pays money to get assets back from third party.
2) Hedge Fund gives money back to Lehman for assets.

“There are so many trades that need to be closed and then evaluations validated and reconciled before we can say, ’are you a debtor or creditor’,” says Pearson. “You can’t form views without all the facts. The danger is if you form a view on two or three facts, that a fourth fact could fundamentally change your conclusion. And in a number of the positions that we’ve been looking at, we’ve discovered a fourth fact and we’ve gone from the situation being black to it being white in terms of the resolution.” He adds: “We don’t know if there’s a fifth fact, by the way, because this diligence exercise has never been done before.”

I'm sorry, but here I'm lost.

"Confusion began to clear in the following days. Pearson and Lomas used their contacts to find the $100m – unsecured – emergency funding. Pearson and Jervis began the work of unwinding the bank’s vast and complex trading positions. Schwarzmann pursued outside interest in the investment banking and trading teams and in the second week secured a deal – with Nomura, for just $2 in cash. That deal put the Japanese bank in charge of half the staff, while allowing PwC to keep working on unwinding Lehman’s trading book. The arrangement had two advantages: Lomas’s team retained, for the time being, the expertise it needed, and Nomura got a bargain on an established London-based investment bank.

It’s not clear how long this arrangement will last – nor is it clear how long the PwC administrators have until creditors get antsy enough to sue for their money. "

I guess this qualifies as a clearing.

"So far, only one hedge fund has gone to court to try to speed up the return of its assets. The judge told it to give Lomas and his team more time. This is likely to be the response most creditors receive for some time, not least because who owes what, and to whom, is still far from clear. The final goal is to get as much money to creditors as possible. Only when the lawsuits stop rolling in will Lomas and his team know they are done."

Good luck.

"In the end, is Lomas surprised by the scale and complexity of what he is now dealing with? He thinks carefully. Not in terms of complexity, no. What did surprise him, though, was that Lehman’s collapse had been allowed to happen in the first place. “I was surprised that it had gone down and that authorities elsewhere in the world hadn’t found a way to avoid it going down – precisely because I could anticipate the complexity that there would be here.

“Surely others had seen just how big and ugly this was going to be?”

I think that this makes perfect sense. Calling chaos theory. The uncertainty thrown into the markets must have been terrifying to some people. Letting this happen was a dreadful mistake. The government not stepping in was foolish, and we can see why. There are some market processes, involving legal and trading complexities, that can cause terrifying chaos as they are sorted out. The market can't handle this on its own, any more than it can handle it without courts.

This post by Felix Salmon seems wrong in retrospect.

Here's a post from Bronte Capital about this:

"The deleveraging of debt markets following the Lehman failure left everyone (maybe except Uncle Warren) hoarding cash. [It also ran the Federal Reserve out of balance sheet in a single day – something that I will come back to in a later post…]

Lehman’s failure cracked this market – and it did so because the UK lacked the basic depression era legislation (the 1934 Act) and had encouraged reckless leverage by reducing capital requirements to low levels.

It was the failures of London that made Paulson’s decision wrong. I didn’t see it at the time – and nor did he. However I have never been CEO of a broker-dealer – and Paulson has. So one bad mark for me and three for him. I keep score…"

What capital levels? They were broke?

"fear that the federal government's $143 billion attempt to rescue troubled insurance giant American International Group may not work"

Speaking of AIG, the Washington Post questions the bailout:

"A number of financial experts now fear that the federal government's $143 billion attempt to rescue troubled insurance giant American International Group may not work, and some argue that company shareholders and taxpayers would have been better served by a bankruptcy filing.

The Treasury Department leapt to keep AIG from going bankrupt on Sept. 16, and in the past seven weeks, AIG has drawn down $90 billion in federal bailout loans. But some key AIG players argue that bankruptcy would have offered more structure and greater protections during a time of intense market volatility."

One can certainly question the terms, which, although considered onerous, I believe should have been tougher, given the iffy nature of their outstanding investments. In other words, we've no idea of the actual cost. It's not wise to write an open check.

"What we see now are a lot of games by the government to keep these institutions going with a lot of cash," she said. "This is to fill holes in companies' balance sheets, and they're trying to hold at bay the charges that our financial system is insolvent."

The deal that the Treasury and the Federal Reserve Bank of New York pressed upon AIG was intended to stop any domino effect of financial institutions falling because of their business ties to AIG. The rescue allowed AIG to provide cash to huge banks and other players who had invested in rapidly souring mortgages insured by the company."

The cascade effect was certainly the issue.

"Early this year, investors had begun privately demanding that AIG pay off its billion-dollar guarantees. But in mid-September, when the demands for cash reached a public crescendo, AIG had to admit that it didn't have enough cash on hand to meet the obligations.

In the first weeks of its federal rescue, AIG has used the loan money to post collateral demanded by these firms, sources close to those deals say."

Lack of capital is the problem here.

"No one else benefits," former AIG chief executive and major shareholder Maurice R. "Hank" Greenberg wrote to AIG's current chief executive on Thursday. "Unless there is immediate change to the structure of the Federal loan, the American taxpayer will likely suffer a significant financial loss."

Another concern is that in this depressed market, AIG, and the taxpayers that now own 80 percent of the company, will lose coming and going.

The company may be forced to borrow additional federal funds for rising payouts to counterparties. Neither the government nor AIG is releasing information about the specific amounts paid to individual firms, but numerous credit experts say that the value of those mortgage assets is probably declining every week. That means AIG has to pay a higher price as part of its guarantees."

Okay. The iffy number keeps increasing. One example: As a house's value declines, the CDS would have to possibly pay more out when it's foreclosed or sold.

"AIG's Financial Products division is the primary villain in the company's free-fall. It made tens of billions of disastrously bad bets on mortgage investments but may not have carefully hedged those bets or properly estimated its risk. The company's rapid burn of $90 billion also suggests that it grossly undervalued its obligations to counterparties in a worst-case scenario."

This is the division I called AIG Crap.

"But AIG's external accountants warned that it was they who alerted management to the dispute, not AIG Financial Products, and that the division was not properly considering the market in its pricing.

Rutledge warns that because there has been no public disclosure of AIG's payments to counterparties, it is impossible to know whether the pricing it is using now is proper.

The Federal Reserve and its advisers have acknowledged privately that things are not going according to plan."

"If the company had filed for Chapter 11 bankruptcy protection, AIG could have frozen the crippling collateral calls, and shareholders would have had a chance at recovering some value from the company's 80 percent drop in stock price from earlier this year, said Lee Wolosky, a lawyer for AIG's largest shareholder, Starr International.

"AIG is nothing more than a pass-through being charged 14 percent interest," Wolosky said. "Company assets are eroding on a daily basis; asset sales have not begun and can only be at fire-sale prices in the current market. "

Here come the 'ifs'.

"But David Schiff of Schiff's Insurance Observer said he could not see how bankruptcy would have been a better solution.

"The point isn't to save AIG; it's to save the U.S. financial system. I think they were afraid to find out who else goes under if you let AIG fail," he said. "But right now, no one knows if this is going to work."

Well, there's the problem. Here, I'm a cock-eyed optimist. Not about AIG, but about saving the financial system.

It means bankruptcy has gotten harder

Here's when you it's tough. Via the WSJ by Jeffrey McCracken and Paul Glader:

"Credit has gotten so tight in recent weeks that companies contemplating a bankruptcy filing can't find the cash needed to get through the process...

"There is very little liquidity out there. It means bankruptcy has gotten harder. So, what does a company do? Good question. You can try to muddle by, but it's really not a good situation," said Barry Ridings, co-chairman of the investment-banking unit at Lazard Ltd."

You can't even go bankrupt.