Wednesday, September 24, 2008

Capitalism in action

So what really happened? A bunch of mid-level managers -- trusting the mid-level managers at ratings agencies -- lent Lehman money, only to have it vanish.

Then their bosses said, for a few days, "hey, we can't trust the ratings agencies, so let's hold off and not lend people money for a bit".

Then the ratings agencies, as a public relations move, to prove that they had spine, lowered AIG's credit rating one notch, but that slight change in credit rating triggered unanticipated contractual obligations that would have created a self-fulfilling prophecy that would have forced AIG into bankruptcy.

At this point, nobody wanted to lend money to the two most powerful institutions in America, Goldman Sachs and Morgan Stanley -- particularly because the ratings agencies had shown themselves to be not only incompetent, but capricious (i.e., but GS and MS had unhedgable risk of a ratings agency event that might have also driven them into bankruptcy).

Since Paulson's social life is intimately bound up with Goldman, he had to find a way to save them (which is not a bad thing -- it is a very strange civilization where a twenty eight year old CFA at a ratings agency can bring down trillion dollar companies with the stroke of a pen). So he offered insurance to money market funds, basically saying that they could keep the difference between the risk premium and the par value. I have yet to see how this insurance will be priced (i.e., if you build on the eastern side of a mountain, you should have a lower premium than someone who builds on a sand bar), and whether the premiums will correlate with the risk premium determined by the market -- or whether the existence of the fund will undermine the market mechanism and get rid of the risk premium.

With Warren Buffett's bet on the new Goldman bank, it is tempting to say that Paulson and Bernake's dire financial crisis will be averted by market forces. Five days ago, it looked as though Goldman might collapse because the regular banks and money markets were unwilling to provide short-term liquidity. Now, even without a bailout, Goldman Bank will thrive as it takes business from the regular banks. "Oh, you guys are going to behave in economically irrational behavior and leave food on the table? Well doesn't capitalism dictate that economically rational parties step up to the plate?"


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