Dealing with the shock

There is no need to speculate about Lehman any more; it has gone. Here is my quick list of post-Lehman issues.

A rate cute?

Will the Fed cut rates again? There is some speculation that Bernanke might make another panic-stricken response to another financial crisis. However, would it matter much if the Fed did knock off another 25 to 50 basis points off rates?

The situation is too far gone. Previous rate cuts actually did more harm than good. It spooked markets; and created a general atmosphere of fear that hasn't dissipated. Previous rate cuts did nothing to revive the US economy and actually contributed to higher inflationary pressures.

Cheap money didn't save Lehman and it won't save Washington Mutual.

Where is the consistency?

Why did the US authorities bail out Bear Stearns, but throw Lehman to the wolves? It is possible to cobble together an unconvincing story about Bear presenting more systemic risk that Lehman. Nevertheless, decision-making at the Fed does seem arbitrary.

Previously, the thinking was that the Fed would come to the rescue if a major bank were in trouble. Now, we know that is not true. However, no one knows the criteria for a bail-out. Risk premia will rise accordingly.

Who is next ?

There are some fairly obvious names out there. Next weekend could be just as hairy as the last one.

What about the UK banking system?

The UK housing bubble was far larger than anything experienced in the US. UK household are far more indebted; and there was much more buy-to-let speculation here than across the Atlantic.

Around 20 percent of the UK labour force work in finance or related activities. When the banking crash really takes off here, the economic fallout will be directly on GDP.

When the crash really takes off; things will be worse here than in the States.

The fire sale

The Lehman experience taught other banks one very harsh lesson. Rebuild capital now; because if you don't, bankruptcy is a really possibility. Since further capital injections from investors now seem highly unlikely, banks have only one other option; sell assets. The simple laws of supply and demand are about to take over. If everyone is selling, then prices must come down.

Mark-to-market accounting will make things worse. As bank-held assets fall in value; bank balance sheets will suffer. Since banks have only the slimmest of capital, the fire sale could put many banks into technical insolvency.

Is there a way out of this mess?

Yes, but it is painful. The US banking sector needs to be restructured. Bad assets need to be separated from good ones. The quicker this is done, the better. The simplest way of doing this would be to set a minimum capital adequacy standard. Any bank falling below this limit would be automatically nationalized; the share holders wiped out and all bank assets written down. Once the bank is cleaned up, it is privatized via an IPO type sale.