What lessons can be learned from the fall of Lehman Brothers? Is Lehman’s bankruptcy only a financial matter? How can an investment bank go bankrupt? What happens when it goes bankrupt? Why has Washington not intervened now if it did do so in the bankruptcies of Freddie Mac, Fannie Mae and Bear Stearns? Can more banks go bankrupt? Why is this crisis lasting so long? How did it all begin? What consequences can this have for the average citizen?

(From Phoenix, Arizona) AT SOUTHERN AVE AND RURAL ROAD, in the college town of Tempe, there is an attractive subsidiary of Washington Mutual, the biggest savings bank in the United States. WaMu, as it is called, is widely spread throughout the state of Arizona, and today there are quite a lot of people at this particular branch. They are construction workers, the large majority of them Mexicans, and almost all of them new clients that have chosen WaMu’s checking account because they see it as what it truly is: a bargain. WaMu does not charge for checkbooks or sent checks, and it has eliminated commissions that other banks still charge. Furthermore, if those clients buy online CDs they will also get a special rate of 4.25 percent, one percentage point above that offered by Citibank. This is, in a word, fantastic.

But the attractive and generous bank is a serious matter. There is only one reason for such generosity: WaMu needs money. Better yet, it needs a lot of money, a ton of money. The bank has had $7 billion of new capital pumped into it this year by new outside investors because of the sub-prime mortgage crisis, and it has been forced to fire 3,150 workers and close more than half of its 336 mortgage loan centers. After announcing its plan to raise $2.5 billion dollars in capital, it is now looking for a major partner.

But its new clients are not very informed about all of this, and it is more than likely that they will not save the bank from being subject to a quick sale. Instead, they, like half of the world, are wondering just what exactly is behind this giant mess and what in the world a sub-prime crisis actually is. Why will Joselo in A Coruña, Spain suffer the consequences if he has never heard of Bear Stearns, and how is it related to tomorrow’s increase in the price of tacu-tacu in Lima?

As a simple memorandum, Safe Democracy gives you this first attempt at making some sort of sense out of all of this information.

WHY DOES AN INVESTMENT BANK GO BANKRUPT, AND WHAT HAPPENS WHEN IT DOES?

The Lehman Brothers and Bear Sterns bankruptcies and the trouble that the insurance companies Fanny Mae and Freddy Mac are in, are a product of the unfolding of the mortgage crisis in the United States, to which a growing distrust by investors, and possibly (although it is difficult to prove) some short term speculative maneuvers have been added.

In the case of Lehman, a third of its assets lacked immediate liquidity and were thus condemned to be sold at a loss in view of the impending crisis. What’s more, seven out of every ten of the company’s dollars were being used for fixed rate mortgages in a market with growing costs and rates.

In a localized bankruptcy, those who are hurt are the bank clients, in general mid-to-large sized institutional and personal investors. There is usually no ripple effect. However, when the crisis is systemic, as in this case distrust grows and grows until it causes panic. From there we are only one step away from being pressured into taking actions due to the prospective of even grimmer times.

WHY HAS WASHINGTON NOT INTERVENED NOW IF IT DID IN THE FREDDIE MAC, FANNIE MAE AND BEAR STEARNS BANKRUPTCIES?

The principle by which Ben Bernanke‘s Federal Reserve is running can be summed up in this sentence: If the consumers and the economy will lose more by letting a bank go bankrupt instead of helping it, then it must be rescued.

“The added problem is that the loans in F&F’s portfolio represented more than half of the mortgage market in the United States” The second principle has to do with the so-called moral risk. The Fed, created in 1913, is a last-minute money lender, but it cannot and must not help all banks. If it were to do so, it would give the entire market the impression that reckless behavior is acceptable because Bernanke will finance the rescue from any dire situation with public funds (the issue is that no one really knows when the Fed considers a bank to be vital or strategic to the financial system, and when it does not).

A priori, rescues correspond to distinct banks and moments in time. Fannie and Freddie (F&F) were some of the government’s autarkic businesses that purchased loans for banks so that they could make more loans. Without them as reinsurers, banks would not be able to increase the money supply as much. The added problem is that the loans in F&F’s portfolio represented more than half of the mortgage market in the United States. “The investment bank model has been pulverized. Investors do not know what the banks’ balance sheets are hiding, and now this does not only apply to those banks that are in trouble”

In the case of Bear Stearns, the Fed aided JP Morgan Chase‘s purchase of the firm, since it was not able to receive the discount that Bernanke proposed to resolve financial turbulence. Besides, Bear was the first bank to be rescued, and it is possible that the Fed thus had a more lax, and perhaps less prepared, attitude. But when Lehman entered the picture, the Reserve had already made the decision not to rescue every bank (in fact, it has not made any more private rescues after Bearn).

Lehman, aside from being private and working with institutional clients and not municipal ones and SEMs, as is the case with AIG for example, did not have the insurance company’s impact either. There is a common lesson to be learned from the nationalization of AIG and the F&F affair. We are dealing with the nationalization of the biggest insurance company in the world, and its key market segment is corporative bonds. These promissory notes are used by businesses to assume debt, and AIG is in charge of ensuring that the buyer of that debt is repaid if the policy holder cannot pay. This type of insurance, technically called a Credit Default Swap, is negotiated in the market in order to generate financial gains. Their nonpayment, in these circumstances, would be the equivalent of falling into a black hole, since it would suck up the whole financial system.

IS THE COLLAPSE OF LEHMAN A PURELY FINANCIAL MATTER?

No. Lehman confirmed, as if it were necessary, the existence of a systemic crisis. The investment bank model has been pulverized. In broader terms, investors do not know what the banks’ balance sheets are hiding, and now this does not only apply to those banks that are in trouble.

Within this framework, some regulators have opted to not demand more information from the banks in order to reduce stress. This last decision is a complex and paradoxical one that is directly related to Lehman’s collapse. More information allows clients to make more informed decisions, which in the case of a bank in trouble could increase its slip-up due to capital outflow in search of funds. Within the context of a crisis, less information could also give a push to uncertainty and increase the possibility of capital outflow due to unfounded fears.

The regulators have opted for this second option in the belief that fewer banks in trouble would allow for greater damage to the system to be avoided, and it would help avoid a capital outflow from the banks that, hypothetically, could get better with time. It is a line of thought similar to the Fed’s, which presupposes that possible damage to an unknown number of citizens is preferable to potentially higher numbers.

The reasoning behind this decision has to do with a specific interpretation, that the market feed has already arrived, which is a sign that there are too many businesses that are either dead or on their last legs. On Thursday, the 18^th, at the last minute, the U.S. Securities and Exchange Commission announced that it would ban the short selling of financial stocks. This perverse move, which filled the pockets of speculators with short term buy-and-sell titles, was used especially aggressively with Lehman. In emergencies it works as a self-fulfilled prophecy: in light of the general belief that more banks can fall, speculative sales and a healthy dose of rumors (ill-intentioned or not) can push a potentially salvageable bank over the edge.

WHAT LESSONS CAN BE LEARNED FROM LEHMAN’S FALL?

The most profound lesson is the need to coordinate global measures to regulate the financial system, perhaps going beyond limiting itself to the mere scope of central banks. Federal Reserve always operates with national or multinational autonomy, as is the case in the European Union, and under grave circumstances, like the current crisis, they coordinate preventative actions with the goal of rescuing.

Given the global magnitude of the financial sector and the trans-nationalization of its assets, coordination that should include control of banks’ local behavior, acting as a type of United Nations General Council or, otherwise, as its Security Council, we should not throw out the idea of having more international relief funds available to save localized situations under the figure of loans against share capital. Greater regulation of the creation of financial instruments on the banks’ part is imperative.

CAN MORE BANKS GO BANKRUPT?

Yes. Washington Mutual, for example, is below the level of liquidity necessary, and it can go bankrupt. Also, the impact on banks like the monoline AMBAC and MGIA, which have one dollar in their portfolio for every 130 dollars lent, is still unknown. Avoiding that and other bankruptcies depends as much on how quickly their directors react as it does on the value at which they decide to sell, or (which in this case is the same) how much the buyers decide to pay.

“From this point on, the surviving banks will take greater care of their capital and their clients’ income, in an attempt to create a healthier and more conservative model” For the time being, the fall of three of the five biggest business banks in the United States (Bear, Lehman and Merrill) leaves Goldman Sachs and Morgan Stanley frantically bailing water from the ship. Financing costs are already high for them and their stocks are continuing to fall sharply. The whole world is anticipating their fall, and they have had to cover themselves. Morgan is closing a deal with Wachovia and the troubled WaMu is searching for a buyer partner.

What is clearly evident is that the business model for investment banks, which had run great risks, has collapsed. From this point on, the surviving banks will take greater care of their capital and their clients’ income, in an attempt to create a healthier and more conservative model.

It is rather curious, but what separates the dead from the living is a short lapse of no more than six months. At the beginning of the year (we don’t have to go back any further in time), Bank of America, Wachovia and HSBC, today among the most active searchers for buying opportunities with JP Morgan Chase, were labeled as banks with some difficulties. Wachovia had to be capitalized by its associates with nearly 4 billion dollars after losing more than $27 billion due to bad mortgages. HSBC wrote off $11 billion dollars and suffered a loss of $22.7 billion more for the same reason. A not-so-small advantage of this is that it was able to liquidate part of that loss through the favorable dollar/pound exchange rate.

HOW DID IT ALL BEGIN?

After the burst of the dot-com bubble and the September 11 terrorist attacks, the American economy did not emerge from the tough financial situation, and the world economy grew slowly. So the Fed decided to give liquidity to the market by lowering the reference rate to one percent. As a result, consumers had access to cheap loans. Many refinanced preexistent debt and got into more debt. Some bought second and third houses in order to increase their wealth and many others bought into the system, without much ability to pay, in order to also ask for money for houses.

The system fed back on itself: cheap credit raises the demand for loans, especially for difficult access assets, like houses, which began to increase in price. The demand for loans and houses did not stop and the system inflated; commercial banks put those loans in investment banks (like Bear, Lehman and Merrill), the credit was reinsured (in AIG, for example) and introduced in investment packages guaranteed by loans. Later, the investment banks sold them to their institutional clients, ranging from pension and university funds to private ones.

Four years ago, the capacity for growth declined, due in part to the double deficit of the United States government. The Fed decided to control the inflation that was driving up the cost of money, and it raised the reference rate all the way up to five percent last year. With that, the interest on the mortgage loans became very costly for many families and a lot of people discovered that it was cheaper to return their house (many of them were second houses) than to continue to pay their mortgages. The rest is recent history.

WHY IS THIS CRISIS LASTING FOR SO LONG?

That the crisis will not end until a turning point is reached is a truism. Very simply, it is still not known how many banks will fall, especially in the United States. Determining the end of the crisis today is uncertain, since it has come to be systemic. “It is difficult to know when and how investors’ confidence will return. Professionals gain it back it quicker; it takes families more time” Many analysts, before the latest announcements by the Fed and the United States Treasury, believed that we had reached the midway point.

It was initially predicted that the crisis would stop displaying the scope of its roots during the second half of 2008, but that speculation has been thrown out since, to a certain degree, no one knows how many banks are affected, and to what degree they are affected. The last hypothesis spoke of 2010, when it is hoped that the American economy will bounce back (its spending represents a fifth of the world’s consumption), but they were made before the proof of the week’s Lehman, Merrill and AIG tragic collapses. Up until then, stock markets like the United States’ were piling up losses above 25 percent. With values like that, many venture to say that the end of the tunnel is near, but the situation is still too turbulent.

In contrast, it is difficult to know when and how investors’ confidence will return. Professionals gain it back it quicker; it takes families more time (although it is also true that the optimism of American consumers, who generally operate in a herd, is capable of surprises).

HAVE WE ALREADY SEEN EVERYTHING, BEYOND THE BANKS?

No. The crisis has several dimensions. It began and it continues to be financial but it has already contaminated the economy, and as such GDP growth will slow down, be contained, and even turn negative in some regions. If the price of oil went from $145 a barrel in July to less than $100 today it is because there are already forecasts for a lower (35 percent lower) demand for it, due to the slowing down of activity. How long will the global economy be affected and what costs and for how long will the consumers pay? “Aside from paying or abandoning mortgages and facing the costs of personal bankruptcies, they also pay their credit card bills” These are questions that lack very precise answers; again, this is because it is still unknown just how far down the abyss goes.

For the moment, there is already higher inflation, and prices will not stop going up for quite some time, while the purchasing power of families’ salaries will fall and many families will have to rethink their expenses and hold on to their jobs. On this level, American families, whose consumption is equivalent to 70 percent of the country’s GDP, have not stopped processing all of the effects of the crisis. Aside from paying or abandoning mortgages and facing the costs of personal bankruptcies, they must also pay their credit card bills, which is where their general spending, including car tolls and health care payments, together with the onerous cost of education, has gone.

It still remains to be seen if the system has the ability to absorb the collapse quickly, something for which it has less than nine months, since a new mortgage plan will come in 2009, which is when the interest on the Alt-A and Option ARM mortgages will be updated. The first type are taken out by families who are presumably solvent but have not presented enough guarantees to take out the loans; the others are mortgages on which growing interest, but not capital, is paid.

HOW CAN IT BE FIXED?

The quickest way out of the financial crisis was the nationalization of the problematic banks; the second, with or without state help: consolidation. The first measure immediately sends the bill to the taxpayer, since it is financed with federal funds. The second will give it to the consumer, via more expensive credit, more demands for guarantees and less competition to reduce costs. “Within the framework of moderate inflation, freezing or adjusting their interest rates within a set range, is not irrational”

A reasonable option, which included the restructuring of the financial system, is not being explored. That is, the Bush Administration decided that the investors that invested in F&F, for example, would not pay for their risk. As such, instead of having them absorbing the collapse and contributing their own resources, the government sent a bill to every taxpayer.

The most liberal analysts are pulling their hair out over the nationalization. If F&F had fulfilled their reinsurance of private investment duties, their gains and losses would have been privatized, they say. The government’s interference implies that F&F are continuing to buy problematic mortgages with public money without sending the bill to the banks that sold them, or their greedy clients.

The banks, in turn, should rethink the renegotiation of their contracts. A reasonable solution is to increase the time allowed for payment of the debts. Within the framework of moderate inflation, freezing or adjusting their interest rates within a set range, is not irrational. Banks and clients must both assume responsibility for their decisions. This is about giving a good signal more than the reach of moral risk.

“Banks need money but you must be careful with the choices that you make. If you plan on making a long term investment with a bank, do not give it the bulk of your savings” The economy must finally be truthful about its value, in both the United States and the rest of the world. Without this necessary measure, bubbles will continue to arise and the American public sector’s deficit, which must already be added to its current $500 billion deficit a similar number derived from the rescues, will not be payable. The emission option will increase inflation and recreate another line of irresponsible consumers and bankers.

Outside of these options, there is still a serious doubt floating around in the market: has the Fed perhaps been able to stop the crisis by intervening in the market with maneuvering tactics? No, and for this reason it and the Treasury announced on Thursday that they were holding talks with Congress concerning a definitive solution to the crisis. It is speculated that it will be a giant agency like the Resolution Trust Corporation, a state bank that allowed the financial system to recover after the crisis in the 80s. In those times, the RTC acted as an ambulance, searching for the wounded by buying unpayable debts at a discount price from banks in order to clean out their portfolios.

The Economist points out that, in order to prosper, the RTC II’s ambulance should even combat the growing shock wave, which is a new event, since past experiences with bankrupt entities have been practiced once the crises have concluded, and the only thing remaining is to clean up the trash. Otherwise, it is a costly mechanism. On this point, the Fed and the Treasury will once again have to weigh the possible outcomes: which will inflict less harm?

WHAT CONSEQUENCES CAN IT HAVE FOR THE AVERAGE CITIZEN?

In such a financial crisis, if a citizen has funds in the banks that are in trouble, he or she should keep an eye on his or her accounts. In the United States, there is a guarantee for up to 100,000 dollars, provided by the Federal Deposit Insurance Corporation. In such an economic crisis, although it will vary by country, there will be more inflation, more employment can be found and salaries can be reduced. They are moments of basic buying and not out-of-control spending, sitting on the money (it is better if it is metallic) and studying each investment option with a short term perspective.

Banks need money but you must be careful with the choices that you make. If you plan on making a long term investment with a bank, do not give it the bulk of your savings.

Look at the anticipated withdrawal costs well and read the fine print in detail. Don’t be pressured to sign and don’t put too much faith in the “now or never” offers. If a bank offers too much interest for your money, reread the offer: more quick gains (and more services for free for which the bank previously did not hesitate to charge you) also imply more risks.