Echoes Of Lehman: World Awaits Another High-Stakes Weekend

By Katy Burne, Liz Moyer and Javier E. David

As European officials meet in Luxembourg Sunday in a two-day bid to halt a spiralling Greek debt crisis, unsettling parallels can be found with a weekend gathering of U.S. officials three years ago.

As is now etched into popular memory, the frantic deal-making at the Federal Reserve Bank of New York on Sept. 14-15, 2008, failed to prevent the troubles of another single borrower, Lehman Brothers, from throwing the entire world’s financial markets into turmoil. Could the same happen again? Might the struggle to save Greece suffer from the same failure of best intentions?

There are key differences: First, Greece is a sovereign debtor, Lehman was a private entity. Second, Greece’s troubles have been publicized far and wide for over a year, whereas evidence of the U.S. investment bank’s mounting problems spread in just a matter of months before its collapse, after which “the Fed quickly and decisively took Lehman into bankruptcy,” as Otis Casey, credit analyst at Markit in New York, puts it.

But the similarities shouldn’t be ignored: the magnitude of creditors’ exposure, the lack of political support for a bailout, and the international contagion risk posed by an otherwise small individual debtor.

“It’s about the flap of a butterfly wing leading to tidal wave or a big hurricane,” said David Gilmore, a partner at FX Analytics in Connecticut. “Greece is small as an economy and its fiscal deficit is small relative to the euro-zone economy. The problem gets much bigger because Greek debt is held by a lot of the banks.”

In 2008, the cast included officials from the U.S. Treasury and the New York Fed, as well as bankers. This time, the protagonists are mostly policymakers from the purse-string-holding governments of Germany and France, the International Monetary Fund, and the European Central Bank. Bankers aren’t in the room, but they perhaps deserve to be. It is their holdings of Greek and other countries’ sovereign bonds that are at stake.

And now, as with then, politics is getting the way.

After a series of interventions to rescue failing institutions through the summer of 2008, the willingness in Washington to put taxpayer dollars behind a Lehman rescue was extremely low going into the Sept. 14 weekend.

Then, the political pressure was felt by Treasury Secretary Hank Paulson, who worried about being labeled “Mr. Bailout.” This time, it is borne by German Chancellor Angela Merkel, whose minority government confronts a parliament that’s reluctant to add to the EUR110 billion already promised to Greece if private creditors don’t share the burden.

That has put Merkel in conflict with the ECB, which warns that a non-voluntary restructuring of private-sector debt could unleash contagion-selling in other troubled sovereigns’ debt markets and threaten the European financial system. While the Fed had no open conflict with the Treasury in 2008, it harbored similar fears of a viral impact from a Lehman default–especially the New York Fed, which oversees financial markets. In this sense, ECB President Jean-Claude Trichet is in a similar position to then-New York Fed President Timothy Geithner, now U.S. Treasury Secretary.

Right now, there’s another wild card in Greek politics, where Prime Minister George Papandreou is desperately trying to shore up popular support for his government, with no guarantee he’ll have the mandate needed to deliver the austerity measures the IMF demands to keep payments flowing. The equivalent character in the Lehman case was the investment bank’s CEO, Dick Fuld, and his failing efforts to keep his shareholders and employees happy. The key difference is that by the time Sept. 14 came around, Lehman’s management had no power at all. Greece, by comparison, is still a sovereign nation.

Nor are this weekend’s negotiations quite as do-or-die as those in Lehman’s case, when it was understood that a decision not to bail out the bank would automatically result in its bankruptcy. The Europeans have until mid-July before Greece would miss payments on its bonds if it doesn’t receive a scheduled EUR12 billion disbursement from the IMF.

Nonetheless, if euro-zone authorities can’t resolve their differences by Monday, clearing the way for the IMF to release those funds, traders say waves of selling could hit the euro and the debt markets of the “peripheral” countries. If so, the mechanics of meltdown would be very different from the Lehman case.

Unlike Lehman, a Greek-triggered disaster “wouldn’t manifest itself through the commercial paper market and a freezing up of credit, because in Europe much of the lending is interbank, not through credit markets,” says Alessio de Longis, portfolio manager of the Oppenheimer Currency Opportunities Fund. Rather, “the worst-case scenario [would be] fire sales of Portuguese, Greek, Irish and Spanish assets. As banks get into the mission of reducing balance sheets, they won’t do any more loans and the rest of the lending will freeze up as well.”

To avoid such a death spiral, officials are working on a controlled solution that would in theory keep German politicians happy but also protect fragile debtors like Spain, Ireland and Portugal: a “soft restructuring” in which private creditors commit to swap their old bonds for new securities with longer maturities.

However, ratings agencies say participation must be truly voluntary to avoid them calling a “default event,” a ruling that would block the ECB from receiving Greek debt as collateral from that country’s liquidity-starved banks. And it’s not clear whether enough of Greece’s far-flung creditors would voluntarily accept such a deal to make it worth it.

Separately, there’s a debate over how to prevent payments on Greek credit default swaps from setting off their own contagion effect. Much hinges on whether a regional committee of the International Swaps and Derivatives Association deems the sort of restructuring envisaged a “credit event.”

This evokes memories of the failed effort to prevent CDS contracts from sowing chaos in 2008. In fact, many believe the lessons from those events will steer European officials into writing another check for Greece once their two-day meeting ends on Monday.

“Given that it is unlikely that anyone in Europe wants to undertake a Lehman’s like experiment with an E.U. sovereign, one would think that there would be some flexibility and a negotiated agreement by the EU/ECB/IMF to keep Greece afloat,” said Gary Jenkins, head of fixed income at Evolution Securities in London.