The solution to this debt crisis may lie three years in the past

 

Stephen Foley
Thursday 15 September 2011 00:00
Comments

With Europe's sovereign debt crisis threatening to become a banking crisis, the Continent's leaders must look across an ocean to the West and three years into the past for lessons on how to react.

One lesson of 2008 stands out above all: check the plumbing.

It was in the early morning of 15 September, three years ago today, that the US investment banking giant Lehman Brothers filed for bankruptcy. In the following 72 hours, almost every area of the credit markets succumbed to dysfunction, panic or complete shutdown.

This is what investors and traders mean when they say that they fear Europe's "Lehman moment". Whether the trigger is a declaration by Greece that it will walk away from its debts, or the failure of a French bank stuffed to the gills with dodgy sovereign debt, the only thing certain is that the consequences are unpredictable.

The first area of concern now, as it was in 2008, is credit default swaps, large bets on the credit markets made between banks.

The threatened disappearance of a bank that is party to hundreds of billions of dollars of these bets is hugely disruptive, which is why Lehman's counterparties demanded more and more collateral from it during its last days, speeding its decline. Such counterparty risk – the fear that your trading partner might not be there tomorrow – is why interbank lending, the grease in the financial system, dried up in 2008 and is wearing thin again now.

After the bankruptcy, two unexpected things happened. First, hedge funds found themselves unable to get at money locked up in Lehman subsidiaries in Europe, forcing many to sell assets elsewhere, depressing markets everywhere. Second, and most worrying, a US money market fund turned out to have lost money on Lehman debt.

Money market funds invest in super-safe assets such as very short-term debt and are used by firms to borrow working capital to pay wages; ordinary Americans use these funds like bank accounts. The run that developed threatened to end with workers being unpaid and cash machines stopping working.

In the US, the Fed is closely watching money market funds' exposure to French bank debt. In Europe, the ECB is examining other liquidity issues, such as whether banks have enough assets to pay back the money they have borrowed in currencies outside the euro, mainly the dollar.

It is this stuff, deep down in the financial pipes, which matters – as Lehman proved three years ago.

Register for free to continue reading

Registration is a free and easy way to support our truly independent journalism

By registering, you will also enjoy limited access to Premium articles, exclusive newsletters, commenting, and virtual events with our leading journalists

Please enter a valid email
Please enter a valid email
Must be at least 6 characters, include an upper and lower case character and a number
Must be at least 6 characters, include an upper and lower case character and a number
Must be at least 6 characters, include an upper and lower case character and a number
Please enter your first name
Special characters aren’t allowed
Please enter a name between 1 and 40 characters
Please enter your last name
Special characters aren’t allowed
Please enter a name between 1 and 40 characters
You must be over 18 years old to register
You must be over 18 years old to register
Opt-out-policy
You can opt-out at any time by signing in to your account to manage your preferences. Each email has a link to unsubscribe.

By clicking ‘Create my account’ you confirm that your data has been entered correctly and you have read and agree to our Terms of use, Cookie policy and Privacy notice.

This site is protected by reCAPTCHA and the Google Privacy policy and Terms of service apply.

Already have an account? sign in

By clicking ‘Register’ you confirm that your data has been entered correctly and you have read and agree to our Terms of use, Cookie policy and Privacy notice.

This site is protected by reCAPTCHA and the Google Privacy policy and Terms of service apply.

Register for free to continue reading

Registration is a free and easy way to support our truly independent journalism

By registering, you will also enjoy limited access to Premium articles, exclusive newsletters, commenting, and virtual events with our leading journalists

Already have an account? sign in

By clicking ‘Register’ you confirm that your data has been entered correctly and you have read and agree to our Terms of use, Cookie policy and Privacy notice.

This site is protected by reCAPTCHA and the Google Privacy policy and Terms of service apply.

Join our new commenting forum

Join thought-provoking conversations, follow other Independent readers and see their replies

Comments

Thank you for registering

Please refresh the page or navigate to another page on the site to be automatically logged inPlease refresh your browser to be logged in