Wednesday, September 10, 2008

Doing the Lehman limbo, or how low can financials go

Even the prime minister of Thailand could hardly have conspired to cook this mess up. Combine a consumer credit bubble driven by home mortgages and a loss of faith in securitization markets, add in a flawed set of mark to market accounting rules abetted by a sprinkle of potential criminal liability, and then throw in a heaping portion of unfettered short selling. Turn up the heat, it's the Lehman limbo.

We are back in crisis mode for financials, a situation that seems to come around every three months at the moment. The Fannie and Freddie takeovers were necessary but it set an alarmist tone that rocked the entire market, well beyond the financials. Searching for liquidity some hedge funds and lots of individual investors were selling indiscriminately yesterday.

Other than the obvious fact that the market is going through the pain of deflating a credit bubble, there are two things that are exacerbating, or exaggerating hopefully, this downward spiral in equities. First, the mark to market accounting rules did not anticipate a situation in which markets for certain securities and contracts, that definitely have some value, would not exist in a credit seizure environment. This is an unrelenting negative trigger during these crises, and was discussed here at ENS ad nauseum in a March 18 post. Second, also previously discussed somewhere here, is the lack of restrictions on short selling, notably the elimination of the uptick rule in July 2007. This rule was put in place in 1938 to deal with times when liquidity dried up and the market was subject to severe declines or outright manipulation. In 2007 the SEC and others decided that U.S. markets had become more sophisticated and therefore more stable and this rule was not necessary and was hindering the free market mechanism. My conspiratorial mind suggests that this was no accident but who knows. It seems clear that now is the time to put the uptick rule back in place, immediately and not just for two weeks.

This week we find out if Lehman can go low, make it under, and stand back up. Who's next in line.

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