China’s ‘Lehman Moment’

William Pesek

The 1972 classic “The Godfather” cemented the director’s place among history’s greatest auteurs. It should also earn him a place in the pantheon of financial seers.

Francis Ford Coppola set a pivotal sit-down between Don Corleone and the other heads of U.S. mafia families in the New York Federal Reserve building in lower Manhattan. In 1998, the imposing neo-Renaissance building would host another dramatic meeting of powerful and secretive families: Wall Street’s oldest firms. Bankers gathered to cobble together a deal to save a shadowy hedge fund run by John Meriwether - the ironically named Long-Term Capital Management LP.

This was Wall Street’s original too-big-to-fail moment, and it’s one that nations like China should be learning from now.

Observers hunted for analogies in recent days as China mulled whether to bail out a 3 billion yuan ($496 million) trust product distributed by its biggest lender, or to let it default. Some viewed this as China’s “Lehman moment”: They feared a collapse would spark an unraveling within China to rival that which followed the 2008 bankruptcy of one of Wall Street’s most familiar names. But now that Industrial and Commercial Bank of China. has signaled that investors can recoup their funds, I think this is China’s “Meriwether moment,” meaning that Beijing will regret saving this single investment in the years ahead.

Up until LTCM’s implosion in September 1998, Meriwether was an almost godlike figure thought to be impervious to the whims of markets or the laws of economics. From his perch in Greenwich, Connecticut, the former Salomon Brothers honcho and his band of Nobel winners appeared to have found the Holy Grail of trading profits.

Yet their fabled models turned out to be no match for Thailand’s currency collapse in July 1997 and Russia’s September 1998 default. Back then, as in China now, those arguing for a bailout spoke of systemic risk, credit markets seizing up and deals too complex to fathom or to unwind safely. LTCM was at the core of the U.S. version of the shadow-banking crisis China is now hurtling toward.

If only the Fed had let the market forces that then-Chairman Alan Greenspan claimed to hold so dear mete out justice. Sure, letting LTCM collapse would have slammed markets and risk premiums. But once the dust settled, traders would have understood where the risks and boundaries lay in markets from bonds to derivatives. If LTCM had been allowed to fail, banks never would have built up the kind of leverage that Lehman Brothers did, necessitating yet another sit-down at the New York Fed.

This purging process was partly what British authorities had in mind four years earlier when Nick Leeson’s trades crashed Barings. By deciding instead to pitch in $3.7 billion to save LTCM, Wall Street bankers opened the door to today’s culture of giant public bailouts.

Moral hazard has become as much an underlying feature of finance as Libor. Wall Street banks strike me as nothing less than America’s own “chaebol.” Like the huge, family-run conglomerates that dominate South Korea, they roll in profits, influence and hubris when times are good. When things go awry, they pull everything else down with them.

This is the choice that China faces. There were valid arguments for why ICBC, the trust issuer and the Shanxi provincial government should bail out investors. Although a reckoning is due for China’s shadow-banking cabal, President Xi Jinping also knows full-blown monetary and banking crises in Asia don’t generally end well for autocratic regimes. Why risk precipitating a run on banks so close to the Lunar New Year holiday?

Yet the case against a bailout was more compelling. Xi’s government arguably has the financial and political firepower to avoid a panic and forestall any calls on microblogging sites for regime change. If Xi doesn’t take a stand soon, risk will only build, and China’s reckoning could make Lehman’s look orderly by comparison.

A crucial reason China’s runaway credit growth is so hard to slow is the belief that banks and big investments will always be protected. Even state-owned enterprises assume they are too systemically important - or too politically connected - to fail.

That gets us back to Coppola’s mafia masterpiece. Every few years, the mob carries out a purge - a very public one that makes headlines and sends a message about boundaries and accountability. If only bankers had exercised such discipline at their 1998 New York Fed sit-down. Lehman wouldn’t have happened, and Washington wouldn’t be so beholden to its chaebol. China has an opportunity to craft a better ending for its financial drama. Sooner rather than later, Xi should take it.

*The author is a Bloomberg View columnist.

By William Pesek