Letting Lehman Collapse Was Right Move

It’s been an extraordinary weekend on Wall Street and the latest events in the financial crisis will probably affect us all.
Lehman Brothers’ move to Chapter 11 -- roughly equivalent to administration in the UK -- is extraordinary in itself. Lehman is (or was) the fourth largest investment bank in the world after all. But on top of that, you have an emergency takeover of Merrill Lynch and insurance giant AIG in deep trouble, too.
Today’s news makes it even clearer that the days of cheap credit and surging property prices are over. Stability will eventually return but I may not see ‘irrational exuberance’ again in my lifetime.

Today’s markets

Shares in London have fallen across the board this morning and we’ll probably see a similar picture this afternoon on Wall Street. As I write, the FTSE 100 is down 185 points at 5,232 while mortgage bank HBOS (LSE: HBOS) has slumped 52p to 229p.
Other financial fallers include Royal Bank of Scotland (LSE: RBS), down 21p at 212p, and Barclays (LSE: BARC), which has dropped 36p to 314p.
I can understand why investors are selling out. Lehman had big positions in derivatives markets and we don’t know which banks are exposed to those positions. Lehman’s positions will now have to be unwound in very difficult markets and other assets may be sold at ‘fire sale’ prices, too.
There’s a risk of a domino effect across the financial sector as asset values fall further.

Beyond shares

Sadly I fear Lehman’s collapse will even affect those of us without a share portfolio. For starters, the economy will be hit as bankers lose jobs and confidence suffers.
And the mortgage market could be hit as well. In recent weeks we had seen tentative signs of a revival with rate cuts on some mortgages. I reckon we’ll see that trend go into reverse as lenders once again find it harder to raise finance.
On the plus side, central banks such as the Bank of England may start to cut interest rates more quickly than had been expected. Central bankers will know that further bank failures could lead to deflation -- where retail prices fall. The obvious way to avert deflation is to cut interest rates.

What now?

The most important advice I can give is: ‘Don’t Panic!’ We’ll get through this crisis in the end. If you can focus on the long term, now is probably a good time to drip money into the stock market. The good old index-tracker fund will do nicely.
However, I would stress that any stock-market investments should really be for the long term. I mean ten years or longer. Drip feeding your cash in every month is a good approach, as it means you can 'average down' at lower prices if the market falls further.
The one area I’d avoid is bank shares. Sure, they look cheap at first glance -- if you believe analyst forecasts, HBOS is trading on a price/earnings ratio of just 4 for this year.
Trouble is, it’s very hard to ascertain the true health of the loan book and there’s a real risk of further fund raisings in this sector. Possibly even a Lehman-style collapse. I’m steering clear of the lot for now.

Hank got it right

But in spite of all the gloom, I am pleased about one thing. US Treasury Secretary, Hank Paulson, made the right call. We’ve seen government bail-outs of Fannie, Freddie, Bear Stearns, and Northern Rock, but it’s been different for Lehman. Paulson has let Lehman go to the wall.
That was the right decision because bankers had to learn that the government wouldn’t always rescue them when they took on too much risk. If bankers never learned that lesson we’d see another bubble all too soon.
The biggest risk for all of us now is deflation. Let’s hope that central bankers and governments can inject enough cash into the system to stop that happening.

* - Article from Motley Fool