The financial world watched with bated breath as the drama of Lehman Brothers played out over the past week. That the reputed investment bank was in trouble was widely known, given the large second-quarter losses that it announced weeks ago. Its financial fragility notwithstanding, the precedent set by the US Federal Reserve in bailing out Bear Stearns a few months ago, reinforced by the US government’s nationalisation of Fannie Mae and Freddie Mac, did create expectations in the marketplace that a similar approach would be used for Lehman. Efforts by government agencies to broker an acquisition failed in the face of their refusal to protect the potential acquirer from Lehman’s liabilities. In short, over the course of the weekend, the US government changed the rules of the game, signalling that there were to be no further bail-outs, come what may. The new rules instantaneously changed market perceptions and, going by the response of Asian markets, which were the first to act upon the news, not only has confidence been shattered, the impact will be felt over a wide range of both asset classes and geographies. And, the meltdown is far from over. Merrill Lynch, another prominent investment bank, has been taken over by Bank of America at a significant discount to what it was worth a few months ago. The American International Group, one of the potential rescuers of Lehman, is also thought to be in trouble. The next few weeks promise to keep global markets in the grip of uncertainty; for instance, will there be repercussions now in Europe?
The refusal of the US government to step in and save Lehman, even in the form of providing guarantees to a potential acquirer, is not necessarily a wrong one. When it initiated the rescue of Bear Stearns, the Fed was strongly criticised by large numbers of people for the “moral hazard” problems that it was bound to create. Insolvent financial institutions, the critics said, must take what is coming to them; it is only when they are seen to be paying the full price for their misjudgments that others will act with the requisite amount of prudence. This argument was countered by the need to preserve the integrity of the system, in a scenario in which the failure of one large player could threaten the viability of many others, some for no fault of their own. But, when the Bear Stearns rescue was done, there were signals sent from the government that further bail-outs were unlikely. If the first one helped to solve the problem by restoring some confidence in the markets and thereby helping shore up the prices of distressed assets, that was well and good. For a while, it looked like this might happen; aided by favourable oil price movements, markets in the US and around the world were showing some signs of recovery. But it is now clear that the weaknesses are far more widely and deeply entrenched in the system for one rescue package to turn things around. The dam having been breached, as it were, the most likely outcome is a further downward spiral of asset prices, drawing more and more asset classes into it. Worse, the ability of the Fed or any other central bank to resist the spiral by pumping liquidity into the system is severely constrained by the still relatively uncomfortable inflation situation around the world.
