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Mark's Market Blog

10-11-08: Lehman was the First Domino

By Mark Lawrence

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Well, I must admit I was taken completely by surprise last week. I'm just starting to piece together what happened, I don't have a lot of confidence that I understand. I don't believe this was predicted by anyone, and I don't believe it's completely understood by anyone.

When the government decided to let Lehman brothers go into bankruptcy, that shook people up. Lehman was a big player in the CDS market (Credit Default Swap). A CDS is a sort of form of insurance - you buy some bonds, maybe you're a little nervous about them, so you write a contract with someone else that for a fee they will insure your bond against default. The trick is it's not really insurance, there are no rules to this game. Anyone can enter into either side of the contract; furthermore you don't need an insurable interest. You can't legally buy life insurance against me unless you have an insurable interest in my life, meaning you're my wife or child. But you can take out a CDS against my life. Hedge funds were taking out massive CDS's against mortgage backed bonds and making a fortune when the bonds defaulted, especially since the hedge fund didn't own the insured bonds. Lehman was writing a lot of these CDSs, and when they came due Lehman ran out of money. There are no reserve requirements to write a CDS, some people were insuring hundreds of millions of dollars worth of securities from a corporation that had a couple million in assets. Warren Buffet has called CDSs "weapons of financial mass destruction." This is one of the reasons banks aren't lending to each other right now, no one knows what toxic CDSs are out there or who holds them.

When Lehman went down, The Reserve, the number one money market manager in the world, went bankrupt. They held $750M of Lehman backed securities which were suddenly worth more or less nothing. They announced that they were paying $0.97 on the dollar. This is unheard of, money market accounts are considered completely safe and are a major source of funding for banks. People started drawing money out of money market funds and buying up government bonds. This is another source of funding problems for banks. The Fed and the FDIC immediately announced that they were backing all money market deposits; this was right on the edge of too little too late.

Finally, it turned out that European banks had also caught this disease, and the EU was burying their heads in the sand about it, issuing a statement after an emergency meeting about "coordinating closely as each country dealt with their problems in their own fashion." The EU bank problem quickly looked out of control, Germany had to do a $50B bank bailout last week, and Iceland is suddenly basically bankrupt - the Iceland government doesn't have enough money and credit to bail out their banks. And the Iceland banks didn't go for any of the mortgage backed junk bonds, they just got caught up in the general malaise.

Meanwhile, Wall Street and D.C. are convinced that we're falling into a recession of biblical proportion. The result of all this was unadulterated panic. I barely see us as in a recession, but this is the third largest drop in the stock market ever - Wall Street says we're on the edge of something like 12% unemployment. I don't see this: my Fed Ex and UPS drivers assure me that their business is brisk; I just bought a bunch of boxes from ULine, who probably sells half the cardboard boxes sold in the US, and they tell me that business is good for them; unemployment numbers sunk last week, we created slightly more jobs than we lost.

The history of the stock market is clear: when it spikes down like this, it spikes back up about 80% of the way in the next couple of weeks. These jolts are deep and narrow. I personally am down 25% for the last two weeks, but I expect to recover most, perhaps all of that quickly.

Or maybe I'm nuts and the world is really ending. Pictures at 11.

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