The End of the Beginning

I really, really hope I get to eat my words here. I would love to think that the bankruptcy of Lehman Brothers is the beginning of the end – that reestablishing that there is real moral hazard risk out there [note: as originally written, this said the opposite of what I intended; moral hazard is what you get when you protect market participants from downside risk; I knew that, and was just not paying attention as I wrote] will sober everybody up, and we’ll see a number of other deals along the lines of BofA/Merrill that ends the liquidity crisis and establishes a bottom for the market. But I can’t make myself believe that.

It is the end of the beginning, though. Going into the weekend, market participants mostly assumed that some kind of deal would be worked out that kept Lehman operating pursuant to an acquisition, and that the Treasury would sweeten the deal in some fashion to make sure it happened, to protect the financial system from meltdown. Paul Krugman had the first line for his column already written. (“When life hands you Lehman, make Lehman aid.”) But Paulson didn’t blink, Lehman had to pay for its sins, and its counterparties weren’t bailed out for continuing to do business with Lehman long after the Bear Stearns collapse raised questions about the continued viability of the firm. Moral hazard is back has been addressed [note: same problem as in prior paragraph] in the market.

Which means market participants now have to take another look at the real risks they are running. What do you think they will find when they look?

The fact that Paulson – rightly – refused to blink at Barclays’ demands for a government backstop doesn’t mean this is the end of government intervention in the financial crisis. I fully expect that, by the end, there will be an RTC-style government entity created to buy up mortgages and mortgage-backed securities. Millions of Americans are going to be living in what amounts to government housing before this crisis is over.

Moreover, don’t think this is the end of the restructuring of the rest of the financial system. To me, this looks like the end of the independent investment bank. There will still be firms like Lazard that offer top-drawer advise for a top-drawer fee, but a year from now it’s hard for me to see a world in which there are two American investment banks that commit capital (Goldman and Morgan Stanley) and nothing else. That model appears to be dead. And what about insurance? If AIG gets a loan from the Fed, then the question of the nature of national insurance regulation becomes as topical as the question of the regulation of investment banks was after the collapse of Bear Stearns.

Right now, the Fed and the Treasury are focused on preventing the complete collapse of the financial system. They are fighting a four-alarm fire, and trying to keep the building from coming down. The renovation after the fire is going to take years. Anyone who confidently tells you they know what it’s going to look like once that process is done has been paying as little attention to the financial crisis as, say, Sarah Palin has been paying to foreign policy.

UPDATE: Fixed the first two paragraphs, in which I used “moral hazard” to mean pretty much the opposite of what it means. I’m so embarrassed . . .