Reenita's Wisdom

The failure of Lehman Brothers is seen as the last straw that broke the credit market. Did Paulson make a big mistake?

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In view of the current Wall Street crisis, America’s credibility as a bastion of free markets has come under the radar. The Fed’s recent bailout of AIG, Fannie and Freddie are perceived by many as a free market detour.

The government’s latest bailout news involves a plan to make the biggest intervention in the financial markets since the 1930s. Central to this plan would be a mechanism to bad assets off the balance sheets of financial companies or instead perhaps to create a federal insurance for investors in the money market funds. Additionally, the Securities and Exchange Commission is getting ready to propose a temporary ban on short selling financial stocks.

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I received an email from a friend in Hong Kong this morning:

Asia is watching in shock and wondering why if the problems are in the US, are the markets here selling off more dramatically.

It is back to fear tactics which immediately offset the fight or flight syndrome. In this case it is definitely all about flight. Asia in particular appears to be more volatile than other markets. It is based on sentiment according to Dan Parr, the Asia-Pacific head for BrandRapport, a consulting firm. Morgan Stanley might have released very positive third quarter earnings but nobody wants to believe that this is any indicator of their health. It is like withdrawing your bet from the fastest runner in the race because everybody else tells you that he’s surviving on steroids. Morgan and Goldman stock has come under such selling assault that their share price has gone down drastically. Investors are instead snapping up three-month Treasury bills with virtually no yield pushing gold to its biggest one-day gain in nearly 10 years. The only truly happy person must be the Indian housewife who has become rich overnight by virtue of her stridhan (gold jewelery inherited by an Indian woman at the time of her wedding).

My friend continues her email:

Also America’s credibility as bastion of free markets has fallen hard.

Indeed the Fed’s bail out of AIG, Fannie and Freddie are perceived by many as a free market detour. A free market economy refers to a system where the buyers and sellers are solely responsible for the choices they make. Free market gives the absolute power to prices to determine the allocation and distribution of goods and services. However, the notion of free market is mainly a theoretical concept as every country, even capitalist ones, places some restrictions on the ownership and exchange of commodities.

Whether the bailouts were a good idea or not remains to be seen. Some remained concerned about the depletion of the Fed’s resources, others remain incensed about the use of tax dollars. However one has to consider the the ripple effects of the failure of a Fannie, Freddie or AIG on the US and then global markets. Shockwaves in Asia are case in point. Personally, I am still annoyed that the Fed would not put up a paltry $4 billion to bail out Lehman Brothers. Had it done so, Morgan Stanley and Goldman Sachs might be having a better day. Not to mention the 15,000 Lehman employees who did not get bought by Barclays.

In a world where living by the credit card has been the shape of things for as long as I can remember, it is hard to grasp the fact that overnight funding markets have seized up sending shockwaves beyond the financial markets and into every household this side of the Big Waters. While the AIG crisis has been averted for now Morgan Stanley is not having a pleasant day in spite of great earnings in its last quarter. All eyes are on Morgan and Goldman Sachs, the two big I-banks left standing. Will they go next? Panic! Panic! Panic!

Investment Banking has always been the career with ‘cache.’ When I graduated from Williams College in 1993, most of my classmates had secured jobs with various Wall Street firms well before graduation day. Those of us who opted for other professions were considered ‘lower’ on the scale of common sense (don’t even think about people’s reactions when I tell them about my career path from Williams to advertising to Ayurvedic Medicine!).

Investment Bankers are the entrepreneurs of Wall Street: sure they take the risk but then look at the return that they bring and in a capitalistic society, who doesn’t respect the work of an entrepreneur? In the glory days of Wall Street, investment bankers were regarded to kings with ‘chocolate and champagne’ lifestyles…but not at the cost of the rest of society.  For as we all know, building solid business does wonders to boost the economy.

So where did the problem arise? How did we lead ourselves to this state of panic? Investment banks have financed themselves for the good times rather than bad. So they depend excessively on short-term funding and high leverage. While this might have generated high returns in good times (supporting large payouts for employees and shareholders), in bad times this kind of capital structure has come back to haunt the firms. Given Lehman’s collapse, the only choice for the remaining investment banks might just be acquisition by commercial banks with large, stable deposit bases. 2008 has seen it happen with Bear Sterns-J.P.Morgan, Merrill Lynch-Bank of America and now with Lehman Brothers-Barclays. All three deals create universal banks that are better positioned to weather market turmoil. Will this be the way for Morgan and Goldman? Or will they change their strategies to actually weather the storm of the credit crunch?

Much as ‘I-Banking’ might be a bad word right now, I will personally be sorry to see the collapse of an industry that has supported my household for all of my adult life. The Investment Banker has a unique personality and skill set that gives him/her a peculiarly stron apetite for risk and reward: a good friend left Lehman NY, just a month ago to build the next phase of her career in Asia. It is an awfully exciting time, I remember her saying as she fervently packed her life into a forty foot container headed to Hong Kong. There are deals happening in Asia almost round the clock. It’s like the very nascent phase of Wall Street! Alas, she went from Wall Street to the pavements of Hong Kong. Had she hung on a few weeks, she would have been saved by the clutches of Barclays!