03 May 2009

How the failure of Lehman Bros is like SARS, and swine flu

FT Alphaville » Blog Archive » How the failure of Lehman Bros is like SARS, and swine flu
How the failure of Lehman Bros is like SARS, and swine flu
Posted by Tracy Alloway on Apr 28 12:18.

It’s not great timing, given the the outbreak of swine flu, but it is, nevertheless, the theme of the latest publication from the Bank of England.

From a transcript of a speech (with charts) by Andrew Haldane, executive director of the BoE’s Financial Stability unit:

On 16 November 2002, the first official case of Severe Acute Respiratory Syndrome (SARS) was recorded in Guangdong Province, China. Panic ensued. Uncertainty about its causes and contagious consequences brought many neighbouring economies across Asia to a standstill. Hotel occupancy rates in Hong Kong fell from over 80% to less than 15%, while among Beijing’s 5-star hotels occupancy rates fell below 2%.

Media and modern communications fed this frenzy and transmitted it across borders. In North America, parents kept their children from school in Toronto, longshoreman refused to unload a ship in Tacoma due to concerns about its crew and there was a boycott of large numbers of Chinese restaurants across the United States. Dr David Baltimore, Nobel prize winner in medicine, commented: “People clearly have reacted to it with a level of fear that is incommensurate with the size of the problem”.

The macroeconomic impact of the SARS outbreak will never be known with any certainty. But it is estimated to stand at anything up to $100 billion in 2003 prices. Across Asia, growth rates were reduced by SARS by between 1 and 4 percentage points. Yet in the final reckoning, morbidity and mortality rates were, by epidemiological standards, modest. Only around 8000 people were infected and fewer than 1000 died.

On 15 September 2008, Lehman Brothers filed for Chapter 11 bankruptcy in a New York courtroom in the United States. Panic ensued. Uncertainty about its causes and contagious consequences brought many financial markets and institutions to a standstill. The market for Credit Default Swaps (CDS) froze, as Lehman was believed to be counterparty to around $5 trillion of CDS contracts.

Media and modern communications fed this frenzy and transmitted it across markets. Banks hoarded liquidity for fear of lending to infected banks, causing gridlock in term money markets, spreads on lower-rated companies’ bonds spiked and there was an effective boycott of the remaining large US investment banks. Professor Paul 3 Krugman, Nobel prize winner in economics, commented: “Letting Lehman fail basically brought the entire world capital market down.”

The macroeconomic impact of Lehman Brothers’ failure will never be known with any certainty. IMF forecasts of global growth for 2009 have been revised down by over 5 percentage points since Lehman’s failure. Yet in the final reckoning, the direct losses from Lehman’s failure seem likely to be relatively modest. Net payouts on Lehman’s CDS contracts amounted to only around $5 billion.

These similarities are striking. An external event strikes. Fear grips the system which, in consequence, seizes. The resulting collateral damage is wide and deep. Yet the triggering event is, with hindsight, found to have been rather modest. The flap of a butterfly’s wing in New York or Guangdong generates a hurricane for the world economy. The dynamics appear chaotic, mathematically and metaphorically.

Haldane continues with the pandemic theme right through to his conclusion:

Through history, there are many examples of human flight on an enormous scale to avoid the effects of pestilence and plague. From yellow fever and cholera in the 19th century to polio and influenza in the 20th. In these cases, human flight fed contagion and contagion fed human catastrophe. The 21st century offered a different model. During the SARS epidemic, human flight was prohibited and contagion contained.

In the present financial crisis the flight is of capital, not humans. Yet the scale and contagious consequences may be no less damaging. This financial epidemic may endure in the memories long after SARS has been forgotten. But in halting the spread of future financial epidemics, it is important that the lessons from SARS and from other non-financial networks are not forgotten.

No comments:

Post a Comment