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TOM PETRUNO / MARKET BEAT

If Lehman fails, would you feel it?

September 13, 2008|TOM PETRUNO

Wall Street now knows that investment banking titan Lehman Bros. Holdings Inc. could fail within days.

As frightening a thought as that is to financial market players, many also confess to having an intense curiosity about the potential outcomes: What would happen to the financial system? How bad would the fallout be?

Or would we find out that our worst fears were greatly exaggerated?

There also is a sense that a spectacular failure may be the cathartic event that is needed to move the nation's credit crisis closer to its final chapter.

"You get to a point where the dike is going to go no matter what," said Jeffrey Gundlach, chief investment officer at $127-billion-asset TCW Group, the Los Angeles parent of Trust Co. of the West.

Since at least the 1970s, however, the public has come to assume that some financial institutions were simply too big to fail. That view was underpinned by government policy that has been evident in spades this year.

In March, of course, the Federal Reserve stepped in with $30 billion to grease the sale of crumbling brokerage Bear Stearns Cos. to JPMorgan Chase & Co. And just last weekend the Treasury committed up to $200 billion of taxpayers' funds to guarantee the survival of mortgage giants Fannie Mae and Freddie Mac.

Now the government has said, no more. The Treasury and the Fed are said to be refusing to provide aid to potential buyers of loss-ridden Lehman, whose stock plummeted 77% this week as investors fled.

If this weekend the 158-year-old firm can't find a way to survive on its own and can't find a buyer, its collapse could be imminent.

Many Americans' sentiment on this is evident in the comments that deluge almost any investment website: "Let it fail!"

Lehman has been crippled by huge risks it took in the mortgage market. If foreclosure is the certain fate of millions of strapped homeowners, why should Lehman be spared?

The perennial argument for government aid is that the messy demise of Lehman could ravage the global financial system. Like mega-rivals Goldman Sachs Group, Merrill Lynch & Co. and Morgan Stanley, the firm is engaged in countless transactions, as a lender or borrower, with other brokerages and banks worldwide.

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.

If the collapse of Lehman is about to destroy the modern financial system, the stock market isn't expecting it. Most major indexes rose for the week even as Lehman's troubles deepened. The Dow Jones industrial average gained 1.8% in the five days, to close at 11,421.99 on Friday.

Still, no one doubts that a Lehman failure would be painful for the financial system and the economy. It could worsen the credit crunch in the near term by forcing on investors the realization that the government won't provide a backstop anymore for risk takers.

With many investors already shrinking from risk, the end of Lehman would instill even more discipline across financial markets, with the probable result that credit and capital markets would tighten further.

That could be devastating for other financial giants that the market perceives to be in weakened states, including Merrill Lynch & Co. and insurer American International Group.

But in a capitalist system, investors are supposed to be responsible for their own actions. That means they must have the right to fail as well as succeed -- no matter how indispensable they'd like us to think they are.

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tom.petruno@latimes.com

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