Yep, It Was Really That Bad

TPM Reader MH makes the case that Lehman’s collapse was really that bad and we can’t let it happen again …

The problem that the Lehman Brother’s bankruptcy exposed is that, in these complex derivative investments, it’s not always clear where the counterparty risk lies.  These transactions are non-traditional in structure and so its often not clear how bankruptcy rules will apply to them. There’s very little relevant case law and these transactions just weren’t designed with much thought toward this contingency (no one imaged that these large couterparties could ever fail).  Things don’t fit neatly into statutory boxes, so it’s not clear what the bankruptcy court will do and who will end up getting their money back.  So when Lehman went bankrupt, everyone had to try to assess the degree to which they were exposed to the potential bankruptcy of other major counterparties.  And that’s really hard to do with any accuracy.  That’s why everything froze up.  No one could get an accurate assessment of their own exposure.

The fear people have now–and justifiably so, I think–is that the only thing keeping the financial system functioning at all right now is the assumption that the major governments of the world will not allow any other major counterparties to default.  If even one of them is allowed to fail, that assumption immediately goes out the window and suddenly everyone will have to assume that any major counterparty could fail at any moment.  If that happens, everything will grind to a hault again.