Arnold Kling  

Hurricane Lehman Update 4:30 EST

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Kind of a mixed day on Wall Street. Dow down 500. Indexes down about 4-1/2 percent. The market stayed open.

Right now, it feels to me like the second round of our fantasy baseball auction.

Our league, the Friends of Freddie, auctions off players in two rounds. In the first round, players who had decent playing time the previous season are auctioned off in a set order. In the second round, owners take turns nominating the remaining players, the prospects and suspects.

The first round is fairly efficient. Rarely do I pick up a player for less than 90 percent of what I think of as fair value. By the second round, a lot of owners have either filled their rosters, run out of money, or don't think the scraps are worth fighting over. As a result, I think that if you put your mind to it you can pick up some decent bargains in the second round. Instead of paying 90-100 percent of fair value, you can pay 50-70 percent of fair value.

My guess is that those banks and money managers that have capital to deploy these days are feeling like it's the second round. There has got to be a lot of stuff out there that is selling for way less than fair value.

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COMMENTS (7 to date)
E. Barandiaran writes:

You're too optimistic about the time it will take to find stuff that is on sale for far less than fair value. Between 1981 and 1999, I was paid a lot to advise on how to solve financial crises and I can tell you that it's too early to know what fair value is. And as I said earlier today in a comment to one of your posts, pay attention to the prospect of a McCain victory.

Barkley Rosser writes:

And according to Calculated Risk, a soaring TED. Not good at all.

Snark writes:

Looks like a Class 5+ is headed our way. Nouriel "Houdini" Roubini is predicting the worst crisis since the Great Depression.

Lauren writes:

Hi, Arnold.

I'm not seeing this drop in the prices of stocks as analogous in any way to fantasy baseball. I see it as something very real, fundamental, and deep.

For the first time in many years, the Fed has taken a transparent stand that reduces their committing taxpayers as the ultimate buyers, supporters, or lenders of last resort of some stock-traded companies that in the past the Fed deemed too big to fail.

What stock prices are worth today is maybe their first unsubsidized real value in years, as a consequence.

By not guaranteeing Lehman Brothers and letting it fail, the Fed finally took a stand that many people--taxpayers--have been waiting to figure out. There is finally a level of company that, no matter how big it may look to the public eye, the taxpayer cannot afford to bail out. Some companies finally are not too big to fail. The Fed couldn't keep up buying out companies at the taxpayer's expense. There is now a bottom line.

The stock market has of course fallen with this news because other companies traded on the stock market were hoping they might be included in some dozens or maybe hundreds of additional companies of the top 500 or 1000 implicitly to be deemed "too big to fail". Yes, there are other factors interacting with some companies dependent on or working with Lehman, as a financial company. But the dramatic stock price fall is not about just Lehman-related companies. It's about the expectation based on what the Fed has done. It's finally drawn a line in the sand. That's a good thing! It helps us as consumers, taxpayers, mutual fund owners, stock owners, mortgage payers, bank depositors, and lenders sort things out.

Taxpayers are gaining exactly as much and maybe even more in tandem every time the Fed says no to buying up or supporting a big-shot company with taxpayer money. Every time the Fed takes strength and doesn't commit taxpayer money to backing more private companies, the rest of America gains. The value of stocks won't reflect it because income tax reductions are not part of stock values. Consumer confidence may be one measured value that may reflect it, but maybe not even that.

For the record: Many local banks that were reorganized after the 1970s and 1980s are, I think, doing pretty well. They deserve credit for doing great in their lending practices. They actually didn't sell all their loans to Freddie Mac or Fannie Mae. They looked at their borrowers and have evaluated their borrowers. In the 1970s they were called S&Ls, and they nearly failed. Now those who survived are looking like the thoughtful and perspicatious.


Bob writes:


If you think about individual firms instead of the stock market as a whole, it's more like Arnold's analogy. It does not benefit healthy firms to have the unhealthy firms bailed out.

Willem writes:

Only one day later, and there's already a new firm that's 'too big to fail'.

I thank the US government for letting US citizens pay to mitigate worldwide risks, but wow, anyone predicting US government owning Bear, Freddie, Fanny and AIG a year ago would have been ridiculed.

Lauren writes:

Willem wrote:

Only one day later, and there's already a new firm that's 'too big to fail'.

Right. And the U.S. stock markets rose the moment the news broke. That's exactly consistent with the model I'm suggesting: that the stock market is trying to figure out where the new bottom line is for Fed bailouts. Lehman was too small, but AIG is apparently large enough; so the line in the sand is somewhere in between. Companies above the possible line have increased value.

Maybe for the moment "small" and "large" also involve interconnected and international. Or maybe "insurance industry" is the key! Certainly "financial industry" is a path in. The incentive is for more companies to include interconnectivity and internationality and insurance and financial instruments in their future plans, as they grow. Maybe then they can be considered in that no-longer elite class of "too big to fail."

I retract the part of my response above where I said the Fed was finally being transparent. We have one new piece of information--a company (Lehman) that, no matter how large it is, is too small to be rescued by the Fed. There is still a lot of confusion.

I also find it interesting that some pundits seem baffled at how the stock market can plummet, and yet we are not clearly in a recession; and how they are baffled at how even consumers, while worried, have not shut down the way they commonly do during a recession. I'm not seeing any inconsistency at all. The taxpayer benefits when the Fed stands tall and refuses to bail out firms just because they are large or interconnected.

An $85 billion dollar "loan" to AIG looks pretty much like an additional $85 billion in taxes. It's pipe-dreaming to think that AIG can repay it without even more help. If they couldn't raise even half of that on the market, that's a clear indicator that the market thinks they aren't good for it.

The role of lender of last resort was originally conceived as a short-term role the Fed could engage in at no cost to the taxpayer. The concept was that sometimes a bank is fundamentally solvent but because of rumors or insufficient information, the depositors might panic needlessly, creating a negative bubble. The Fed's role was to print money instantly and lend it to the bank--which was fundamentally solvent!--and with the likely restoration of confidence, the Fed would be repaid. The term "lender of last resort" was never intended to mean "Hey, if you can't find anyone to lend to you and you are about to go out of business, we at the Fed are here to lend to you! Especially if you happen to be involved with the banking industry in some way. Come on in!"

The stock market is not identical to "The Economy". It's just one measure of one piece of the economy. When the Fed bails out a big company, it hurts the economy because it hurts the taxpayer. To think the taxpayer--some of whom are stock market participants--doesn't understand it, is either complete hubris or complete denial of the contributions of the rational expectations model revolution of the 1970s and 1980s, or the efficient market model of previous decades, or even the classical model of the 19th century.

But I digress.

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