Wednesday, September 10, 2008

Financial Collapse

The lede to a New York Times story is:
Lehman’s fortunes dwindled further on Wednesday as the firm, staggered by the biggest loss in its 158-year history, fought to regain confidence among investors.

The firm survived the Great Depression! Why is it failing now? The narrative I know says that an enormous amount of worthless paper was pumped into the financial system; the corruption occurred because everyone made the "reasonable" assumption that house prices would go on increasing indefinitely. All that worthless stuff is mixed in with everything else through the obfuscation of complex derivative securities that are impossible to value with any reasonable degree of precision now. There is a crisis of confidence now, the money has stopped flowing freely, and Lehman is hit by that.

Of course, any insistence in the past that there be some rules around such "assets" that cannot be priced easily was dismissed as unwarranted interference in the free market.** Well, the free market is now exacting its toll. No matter how imprudent mortage-backed securities in this inflated housing market might be in the long or even medium term, competition dictates that these firms trade in such in the short term because there was money to be made. The only way to keep everyone from walking off the competitive cliff together is by external imposition of rules. But that flies in the face of the prevailing ideology. And so a 158-year old institution is on death watch.

** The social benefit of these derivative securities is supposed to be that they increase liquidity - they make tradable things that previously were difficult to trade; and that they help mitigate risk. Looks like that in this crisis, neither is true any more. Lehman's stuff could be gold-plated but the problem is that no one can reliably know what is in "the big shitpile" (a term I learned from Eschaton). They are no longer liquid and they've put the nation's world's financial system at risk.