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Could the Eurozone Crisis Cause Another Lehman Moment?

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Matt Stoller is a fellow at the Roosevelt Institute.  You can follow him on twitter at http://www.twitter.com/matthewstoller

The Lehman Brothers bankruptcy is perceived of as the 9/11 of the financial crisis, the moment where liquidity problems that had been bubbling since late 2006 turned into a full-fledged panic and then economic collapse. The question American elites are pondering is, will a Eurozone break-up, or even Greece leaving the Euro, cause another such moment? Ben Bernanke has argued that Greece leaving wouldn’t, since domestic banks have reduced their exposure to problem countries. Paul Krugman agrees, and in a recent interview on Bloomberg, laid out his case.

Question: How interdependent right now, how linked is Europe to the United States?

Paul Krugman: The sheer, the trade linkage, the thing people think well we export to Europe, that’s a lot smaller than people imagine. We only sell 2% of our GDP to Europe, so even a serious European recession, it hurts, obviously, it’s not a good thing, but it’s not that big a deal. The real concern for this side of the Atlantic is financial. Do we see a blowup in European financial markets that spreads worldwide the way ours did? And you know it’s, maybe I ate the wrong thing for breakfast or something, but I’m fairly optimistic that that won’t happen…. Between Mario Draghi and Ben Bernanke, that they can throw enough money at the banking system to keep this thing from being a financial meltdown. I can believe that and believe at the same time that Greece is going to be out of the Euro fairly soon and that there’s a risk that the whole Euro will break up. I don’t think we’re looking at a Lehman style event, which means the impact on the US economy will be fairly limited. Famous last words, knock on wood.

Yet, a key dynamic in the Lehman situation was ignorance – no one quite knew how bad the problem really was.  Similarly, no one knows how bad this Eurozone problem will get, or what the linkages are to American banks. It’s possible the linkages are very very significant. Remember that Bloomberg story from last November, in which JP Morgan and Goldman disclosed to shareholders they have sold credit protection on $5 trillion of global debt? They wouldn’t disclose many details, but that’s a fairly large amount of credit protection.

A few days after Krugman’s Bloomberg interview, we began to learn a bit more about what JP Morgan is betting on, that led to a few billion dollars in losses (so far). And it has a direct bearing on the transmission of Eurozone problems to the US.

The unit, the chief investment office (CIO), has been the biggest buyer of European mortgage-backed bonds and other complex debt securities such as collateralised loan obligations in all markets for three years, more than a dozen senior traders and credit experts have told the Financial Times.

So, apparently, aside from trillions in sold credit protection on global debt, the biggest American bank by revenue and profit is deep into speculative investments on European housing bonds. What could possibly go wrong? What’s interesting about JP Morgan’s losing bet in a relatively placid environment is how shocked people on Wall Street and in DC were. This is worrisome, because it implies that market actors simply do not know that there are still severe risks in the banking system, just as they did not understand shadow banking vulnerabilities in 2007-2008. They believed Bernanke’s PR about the “great moderation”, that financial risk had been diversified and effectively managed away.

The cult of personality around Dimon is similar a testament to elite ignorance of possible risks in the banking system. The Dimon story is that JP Morgan escaped the subprime debacle because of the CEO’s wonderful risk-management skills. But one possible reason JP Morgan escaped some of the housing damage is because JP Morgan’s MBS team just wasn’t very good at originating loans and issuing securities. Dimon’s one superb skill is PR, so he turned this weakness into a message of prudence. In 2007-2008, as the crisis unfolded and banks began cutting back on spending, the rumors were that Dimon stepped up and funded very significant amounts of lobbying and PR in DC. Thus, “fortress balance sheet”. And now, there are laudatory stories in the Wall Street Journal about how Dimon “couldn’t breath” after he learned of possible losses, and how he admitted the problem is taking decisive action. Of course, the more likely story is that JP Morgan isn’t well-managed and has risks and interdependencies we don’t understand.

With this in mind, let’s look at whether the Eurozone crisis could turn into a financial panic in the US.

Lehman was the light-switch to full-fledged panic mode during the financial crisis. Investors, over the past thirty years, had moved their deposited money from the regulated banking system covered by deposit insurance to the shadow banking system, where returns were higher but there was no government insurance. One key area where this took place was in money market funds, which held roughly $4 trillion. While technically money market funds are not insured, in reality investors saw them as safe liquid deposits. While they weren’t backed by government guarantees, they were backed by unassailable triple A rated assets, such as, well, Lehman Brothers bonds. So when Lehman blew up, there was the beginnings of a bank run-style panic in the money market funds. Most normal people have their savings in the regulated banking system, so they weren’t in trouble, but wealthy people, foundations, and corporations were in panic-mode. The Federal Reserve eventually stepped in and backstopped the money markets.

Lehman’s bankruptcy had a tremendous psychological impact on the political officials who forced the investment bank to file for bankruptcy, such as Tim Geithner and Ben Bernanke, as well as the entire economics and financial establishment. Subsequently, their attitude became so risk-averse in restricting banks or financial elites, lest they trigger another Lehman-style situation. It was very much a “9/11 changed everything” attitude, except with a financial shock in place of 9/11.

But the real question with Lehman was political, not technocratic. Would the government force the wealthy to pay for their use of the shadow banking system by allowing a run in the money markets, or nationalizing the money markets and forcing haircuts on money market accounts? Would the voters prevent bailouts with deep rage once they realized what was going on? When the government allowed Lehman to fail, the answers seemed like they verged on yes. But as soon as the markets realized, over the course of the next year, that the government would do everything possible to ensure that the shadow banking system would function, with an effective backstop, and that the voters were powerless to act, the panic subsided.

The question of the Eurozone’s impact on the US financial system is similar. If the Eurozone breaks up, or even if Greece defaults, it is not obvious who is exposed, or by how much. It’s not clear if the credit protection sold on European bonds would have to be paid out, because there is now no standard for sovereign defaults. There’s also counterparty risk. The number of bets internally at any of our banks is also an unknown. And then there are the unknown unknowns. That Wall Street is shocked by Dimon’s incompetence is in itself an indication that the environment is well-designed for panic.

As Krugman notes, the question on the Eurozone is whether governments, international institutions and central banks will throw enough money at the various national banking system to prevent defaults. Since there are swap lines between the Federal Reserve and the European Central Bank, the ECB can get as many dollars as it wants, in return for colored pieces of paper known as the Euro. American politicians could begin to get edgy on Federal Reserve exposure to the Eurozone. And ultimately, the ECB must be backed by Germany, so the question of what happens will come back to the German political establishment and the politics of austerity. Will Germany pick up the tab for Italian, Spanish, and Greek debt, which is really just a bailout for its own (and French) banks? Will the Greeks vote for anti-bailout parties in the upcoming election?

What I find most disturbing about the question of Eurozone is how little we still know about our own banking system, and how sanguine we are about the extent of American exposure to another financial panic. The assumption that our banks are now well-capitalized, that they have been effectively stress-tested, is, while not completely pervasive, still accepted by a shockingly large number of market actors. It should be pretty clear that our banks are large, rogue, and fragile, and that we just don’t know what they are exposed to, or how their exposures could impact the real economy. Dodd-Frank was a missed opportunity to restructure our banking system to make it more resilient and less able to transmit financial shocks. We may soon get another one. I don’t know if the European establishment is going to prevent the dissolution of the Eurozone or keep Greece in the Euro, but I’m not confident that we can avoid a panic if it does.

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27 comments

  1. Economic Maverick

    Great post

    Can we just come out and say that Market Actors are completely clueless, as they typically are in the financial sector? The Agents have all the information, and the Principals (of all types, using the term broadly) are totally clueless, and the broader “market” has no clue about the clueless-ness. It’s like several layers of information asymmetry magnified by several nested layers of clueslessness

  2. F Libertarians!

    Krugman’s comments are reminiscent of the 2006-2007 comments made by many alleged finance experts who, when interviewed on TV at the time when subprime mortgages began to default in 2006, said that those subprime mortgages defaults would be isolated events that would not affect the economy all that much because subprime mortgages only represented less than 5% of the entire mortgage market in the U.S. This past experience with economics and financial experts is one of the major reasons I sold my TV and stopped watching television.

    Does Krugman even know anything he is talking about? After all there is a $60 trillion nontransparent shadow derivatives market currently in existence that is unregulated and that no one – not any banker, finance expert, internal auditor, government regulator, or external auditor completely understands? Does anyone really know how much of this $60 trillion derivatives market has Eurozone debt or Eurozone securities that are linked somehow to that debt as an underlying? Krugman really has some gall to pretend like he has access to a magical crystal ball that would allow him to make such categorical assertions about the effect of a Eurozone break up.

    Personally, I believe that a Eurozone breakup will cause a major shock to the global economy as investors who have denominated their investments in Euros will lose confidence in the Euro and seek solace in the dollar or in gold. If Greece were to abandon the Euro, just imagine the panic among investors who would wonder if the Euro could remain a viable major currency in the long-term. What would happen to commerce and trade in Europe which is already faltering should European companies begin to share the same doubts? I really do not think that Draghi’s power to throw Euros at a potential Eurozone break up will matter all that much when the fear that Euros may someday possibly be worthless pieces of paper grips the world economy. And don’t forget about all of those derivatives bets that will need to be uwound. Of course, Bernanke could always violate the U.S. Constitution and bail out European and Asian bankers with U.S. dollars without Congressional approval but who really gives a sh*t about the U.S. Constitution nowadays as no one really follows it anymore? Of course, in the event of a global panic due to a Eurozone breakup, the rich and the banks and the CEOs and the richest 0.1% will again receive a bailout from the Fed while everyone else gets to enjoy misery on the breadlines. That reminds me. I should start hoarding camping gear. Tent city here we come!

  3. Min

    “And ultimately, the ECB must be backed by Germany, so the question of what happens will come back to the German political establishment and the politics of austerity. Will Germany pick up the tab for Italian, Spanish, and Greek debt, which is really just a bailout for its own (and French) banks?”

    What does it mean to say that the ECB must be backed by Germany? That the Germans are cheering the ECB on? I don’t think so. It sounds like the ECB relies for its funds upon Germany. Tilt! Euros come from the ECB, right?

  4. Jill

    Matt,

    Wasn’t Lehman in effect forced into bankruptcy by the US govt.? I am no expert on this topic, and I am asking a sincere question. “Inside Job” and other people I’ve heard seem to say they were pushed into it. This did not allow for an orderly bankruptcy, it froze the european markets and brought on an unnecssary aspect to the even larger crisis.

    Also, I don’t believe these are people who just keep making the same mistake over and over again. It seems deliberate to me. I would call it disaster capitalism as Naomi Klein speaks about.

    I don’t rule out the effect of drugs, specifically cocaine. Evidently most of these people take rather large daily doses of their “medicine”. This would account for some of the utterly reckless and bizarre behavior that we see in “elites”.

  5. Maju

    If EU collapses the biggest damage (after EU itself) will be to China and Russia? Most interesting! I feel that Krugman has it right this time, even if he seems blind about the implications. That explains it all the European aspect of the crisis and why the Anglosaxon media has been stirring the pot so vehemently – financial loses are just virtual loses, real loses are in the real economy of buying and selling real products.

    I understand from this that by blowing up EU, the USA wins in three different fronts at the same time: less (potential) competition from EU, China or Russia.

    That may well be the Plan Goldman Sachs (reverse Plan Marshall).

    1. Markar

      I think your theory is flawed. What do we manufacture that blowing up Europe would benefit us? The cascading cross defaults in the financial sector from an EU blowout would take the US down with it

    2. Maju

      I mean: Europe buys Chinese manufactures, Russian gas and has a strong currency that has (had?) some potential of shadowing the US dollar. What I mean is that if EU collapses, China and Russia also get affected, while the USA not much.

      The benefit is in the lack of exposure (except in the financial area, as Stoller says), lack of exposure in the real economy. The financial zone is more like the mechanism to control the real economy in the end, so IMO it’s not that important from a geostrategic long-run viewpoint.

      The benefit is in harming China and Russia (and to lesser extent EU, which is no real competitor yet but who knows?)

    3. mac

      I doubt that Krugman is or has been right about much of anything. The entire world would be better off If the NYT quit publishing him.

      1. Nathanael

        Krugman’s predictions have been uniformly correct since 2000.

        Run of good luck, but anyway.

        1. Nathanael

          This is as distinguished from Krugman’s analyses, which are sometimes right and sometimes not. He generally avoids making solid predictions except about the really clear stuff.

  6. pebird

    Lehman froze markets beyond those in which Lehman primarily participated. Because Lehman disrupted the financial flows, which once stopped are hard to restart. And it doesn’t take a large percentage to stop the whole shebang, especially when the entire system is leveraged to the sky.

    A similar thing will happen when the Eurozone blows up. Flows get disrupted and everyone pulls their chips off the table to count what they think they have. Who cares if the economy stops?

    So little Greece, upon which Germany has leveraged it’s mercantile strategy, can bring the Euro down, or at least create enough of a disruption to stop financial flows long enough for our double-dip crisis to begin.

    1. patrick

      Spot on. The danger in a Greek default or exit from the Euro Zone is that nobody knows what will be the impact on the financial system. Every bank will suspect that their counter parties are exposed to the financial fall out and will refuse to loan them money, just in case they can’t pay them back. So actual exposure to Greek debt isn’t the only issue. Perceived exposure, suspected exposure, will be just has toxic. American banks will refuse to deal with German and French banks because they might have Greek exposure. And so on until the credit market freezes and people in Iowa can’t get auto loans.

      I admire Paul Krugman but on this matter he’s no more knowledgeable than the man on the London omnibus. The fact is nobody knows about the impact of the interconnectedness of the financial markets, and despite getting a severe shock four years ago the ‘powers that be’ have not sought to find out. Santayana’s adage “those who do not remember the past are condemned to relive it” says it all.

    2. Glen

      Good analysis.

      Too bad the elites freaked out after Lehman and bailed out AIG. The correct answer was derivatives and dark markets are unregulated, so go fuck yourselves. We would have had a colossal financial implosion which would have been fixed after most of the banksters were hanging from lamp poles or in jail.

      Instead, we’re going to let the banksters fuck the whole world for the next twenty years or so – a whole lost generation just to save the very people that caused this mess.

  7. Dolomite

    “Similarly, no one knows how bad this Eurozone problem will get, or what the linkages are to American banks.”
    Aren’t American terr….Banksters exposed in the trillions?
    (Which is why they need to foreclose, unemploy and povertize the populace?)

  8. Winston

    “How interdependent right now, how linked is Europe to the United States?”

    Truthful answer – no one knows! Why? Unregulated, unseen and, therefore, opaque CDS. Just one inability to pay in a chain of CDS and the dominoes fall in that particular branch of CDS.

    My guess, based upon the risky games banks are KNOWN to continue to play, is that we are VERY much linked.

  9. jsmith

    “Lehman’s bankruptcy had a tremendous psychological impact on the political officials who forced the investment bank to file for bankruptcy, such as Tim Geithner and Ben Bernanke, as well as the entire economics and financial establishment.”

    Putting aside the inconvenient fact that some political officials knew about both events – 9/11 and Lehman – before they actually happened, let’s review the “psychological impact”, shall we?

    The whole “changed everything” meme in both instances was a propagandistic tool cooked up by the elite to further their sociopathic agendas – agendas that well predated both events.

    Hmmm, the creation of a police-state and the onset of the never-ending, MIC-aggrandizing War on Terror?

    Just scared politicians running around in a panic, huh?

    Funny, how the PATRIOT Act was just lying around, huh?

    Hmmm, the backstopping of the largest financial institutions on the planet by the world’s central banks and the consolidation of those banks leading to the implementation of world-wide austerity measures as the rights of sovereign nations are finally subjugated to the control of finance-backed technocrats?

    Just an accident I bet, right?

    Oops!

    The fact that the author basically takes both events at face value is yet another sad instance of how even the seemingly intelligent will fall hook, line and sinker for the horsesh*t that was peddled in both cases.

    One can argue in both instances whether LIHOP or MIHOP but one cant’ argue with the results.

    Even if both events – MAYBE – weren’t consciously choreographed, we may as well treat them as if they were as to not do so only hampers our abilities to deal with the consequent lawlessness and criminality.

    Does the author really believe that TPTB haven’t thought through the contingencies of a Greek exit and resulting panic and how they will further take advantage of the next “this changes everything” event?

    Funny, how “changing everything” always equates to the common person getting killed and stolen from while the elite are made more powerful and rich, huh?

    Ooh, I just can’t wait and see what’ll happen next!!

    1. SR6719

      jsmith: “The whole “changed everything” meme in both instances was a propagandistic tool cooked up by the elite to further their sociopathic agendas – agendas that well predated both events.”

      “Secrecy dominates this world, and first and foremost as the secret of domination. According to the spectacle, secrecy would only be a necessary exception to the rule of freely available, abundant information …..

      No one sees secrecy in its inaccessible purity and its functional universality. Everyone accepts that there are inevitably little areas of secrecy reserved for specialists; as regards things in general, many believe they are in on the secret …Their only role is to make domination more respectable, never to make it comprehensible. They are the privilege of front-row spectators who are stupid enough to believe they can understand something, not by making use of what is hidden from them, but by believing what is revealed!” – Guy Debord

    2. SR6719

      PS-

      Uh, just to be clear, I was actually agreeing with you in the citation above. I wasn’t including you as one of those front-row spectators stupid enough to believe what’s revealed to them by the media. Or who believe they can understand what’s happening based on that information.

  10. Lil'D

    One of the keys is to identify the quantity and holdings of assets that could transition from a state where they are trusted [without needing any due diligence. e.g. cash], to a state where the value can only be established with additional information [e.g. CDS...?].

    Gary Gorton (in “slapped by the invisible hand”) points out that when such transition occurs, asset becomes riskier and the rational response is flight to liquidity, which looks like a run on the bank.

    Bank runs, whether on Bailey Brothers Building and Loan, or on the “shadow banking system”, can be pretty brutal.

  11. John

    We seem to be teetering on the brink, if Greece leaves the Euro and returns to the Drachma it probably wouldn’t in itself be catastrophic as Greece makes up a very small percentage of the European economy. But it could cause a domino effect of panic that ripples from nation to nation…..

  12. guydetrop

    When Yves goes on vacation, by way of consolation, could we have more Matt Stoller , please.
    This post was excellent.

  13. sunny129

    Market Actors are NOT ONLY completely clueless, but pontificate that everything has been ‘stabalized’ by Ben, Geithner, Obama & Co.

    American sheeple has swallowed this ‘kool aid’ without asking any credible questions.

    Since the shadow banking remains opaque and unregulated there is no question that 2008 drama will be re-enacted but the question is the timing!

    Did any one dream about JPM announcing 2B loss, about a month ago? I think there are mini’black swans’ out there before the ‘big one’ emerges!

  14. freedomny

    “The cult of personality around Dimon is similar a testament to elite ignorance of possible risks in the banking system. The Dimon story is that JP Morgan escaped the subprime debacle because of the CEO’s wonderful risk-management skills.”

    Sorry – I’ve posted this before, so I am sure I sound like a broken record. But I have to find away to chip away (like Jamie the termite!) at this myth…and being repetitive, is the only way I know how.

    As an ex-Chase mortgage banker…Dimon just came to the party late and has an excellent PR machine. Right before they pulled back, there was a huge push, like never before in Chase’s history, for subprime and the sale of those loans.

    I just hate the media view of how Dimon has run this company. He crowed how the shares would trade so much higher, but then never fulfilled the promise. And he certainly doesn’t deserve his compensation. If the Board of Directors had a brain, they would get rid of him and put one of the many talented, and ethical, executives “still” working at Chase. The “bones” of that company are there…but if they don’t get rid of JD soon, it will be like a termite infestation.

    A toxic executive can ruin a company in no time at all. And JD’s managing style has been chewing on the pillars holding up that company for just a bit too long.

    Interesting, when I talk to my Republican ex-Chase co-workers, or even those still working there…well, the amount of disrespect…even “hate” against Dimon is truely astounding.

    But, anyone who read the book Last Man Standing, will understand that Jamie Dimon doesn’t “really” care about his customers, or even his employees. It seems that he only cares about himself…and his completely CLUELESS Board of Directors.

    1. Nathanael

      “A toxic executive can ruin a company in no time at all.”

      And that’s what’s happened to nearly the entire Fortune 500.

      1. Nathanael

        .. which goes to show that the elimination of corporate governance and oversight was a very, very bad thing. We need FDR’s SEC back, at a *minimum*, and we probably need even stronger oversight, such as they have in Germany.

        1. freedomny

          Guy at work, who is a BIG Republican…we often “debate” amicably, actually said the other day that we need an FDR leadership “moment” against the TBTF banks.

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