A September To Remember: Does Evergrande Feel Like Lehman?

As Evergrande missed its bond coupon yesterday and edged ever so closely to the precipice of default, the media was chockfull of contrasts and analogies with the Lehman Brothers crisis of 2008. It occurred to me, and this is where my math wizardry served me so well in twenty years of hedge fund investing, that Lehman filed almost exactly thirteen years ago. Thirteen years! I could not help but wonder: do traders today have the foggiest idea what the Lehman reference is truly about?

Let me enlighten you, young reader, at the risk of aging myself but with the reward of perhaps picking you up as a Twitter follower. Because I was there in 2008, sweating it as a portfolio manager, and lived to tell the tale in my book, Damsel in Distressed, as follows.

We found ourselves way out on a limb in underestimating and underpricing risk, and happily going about our business until such time as it could no longer be ignored. I remember the exact day that happened for me. It was Sunday, September 14, 2008. The Canyon senior managers had been invited to a beautiful party for the daughter of one of the partners. The event was held on a vast beachfront property in Malibu owned by Larry Ellison of Oracle ORCL , who has since turned it into a high-end commercial development anchored by a Nobu restaurant (let me abuse of my author power here to complain that I am never able to secure a reservation). It was a picture-perfect day and they had set up, as one does, multiple dance floors and bars, entertainers, dancers, white leather furniture, ice sculptures, and a splendid buffet. Hundreds of dressed-up guests with their spouses and children were determined to have a jolly time. Except the news never stops. Financial stories roll in before and after market hours, including Sundays. No matter the day or time, a market of something is open somewhere—Asia, Europe, currency exchange, futures. Before the end of the party, an ominous headline hit the screens of our Blackberries: Lehman Brothers to file a disorderly bankruptcy Monday morning. A bankruptcy is generally a well planned process that a company can—no, is expected to —survive by optimizing its assets and reducing its debt load under the protection of the court. A “disorderly” bankruptcy is rare and extreme; it is financial chaos. George Soros later described it in rigorous medical terms. “Allowing Lehman to fail,” he said, caused “a cardiac arrest of the financial system.” I wondered if the party planners had arranged for defibrillators. I marveled at the ice sculpture melting away and disintegrating in the hot afternoon sun. It was exactly what the market would do on Monday. Lehman was the liquidity provider for many funds and countless companies, a critical piece of the Wall Street maze in which all the players were hopelessly intertwined. We, like every hedge fund, used Lehman as a counterparty, or a trading partner. We had not been only sitting on pending trades where we had sold them stocks, bonds and loans, but also ongoing contracts, credit and interest rate swaps, warehousing lines, you name it. So when Lehman’s stock started falling, from $65 per share at the beginning of 2008 to $12 in July, and rumors of a potential insolvency could be validated by an even cursory analysis of the cash balance, it became clear that left to its own fate, Lehman would unravel. We didn’t need to wait and find out if a white knight would come to the rescue, all hands were on deck. A colleague redirected our business throughout July and August, diligently unwinding the strings that connected us to Lehman, so that when they filed, we had virtually no exposure. But he pointed out that given the speed at which one investment bank after another could melt toward bankruptcy— first Bear Stearns, then Lehman, then Morgan Stanley MS , Merrill Lynch, and Goldman Sachs GS —he would run out of possible counterparties before Christmas. Still, at the beginning of September, with Lehman’s stock still hanging around $10 per share, market participants firmly expected the government to step in and arrange for a hasty merger between Lehman and a healthier financial institution, with a tidy fulfillment of its obligations to follow. I recalled Long-Term Capital in 1998, the hedge fund that was forced into a sale by the Fed to avoid a frenzied unravelling of billions of intertwined borrowings and lending around the globe. This time was different. Simply put, government officials and Wall Street bankers ran out of time—or goodwill. The simple fact that Lehman could fail—was allowed to fail—meant that any bank could fail. There was no safe haven anymore in investment banks or commercial banks. Panic spread throughout the financial market, even among institutions and investments with no interconnection with Lehman at all. The cornerstone of our financial system is that banks lend liberally and cheaply to each other and to financial players all over the world. When the ability to move capital suddenly and entirely dried up, a liquidity crisis of such scale and depth ensued that it ground the economy to a complete halt. No more money flowing through the veins of the planet’s financial system—an economic heart attack.

It seems to me that the Chinese government has both the will and the time to prevent financial chaos. The will, because real estate and tangential industries represent as much as 30% of the country GDP. The time, not only because of the Garcia Marquez quality of the Evergrande chronicle but also because of the wide-reaching authority of the government. Already, it appears that the Chinese housing regulator has taken control of the company’s bank accounts and is directing its proceeds.

So the question is how much of a liquidity squeeze will cessation of payment by Evergrande cause among its creditors? Naturally, many US and European banks have rushed to reassure investors that, in their shop, Evergrande never was. Grand, that is. But would anyone expect players with a large exposure to come forward publicly? The size and intermingling of that pool is key and will not come to light until and unless it must. Because for financial players, a large default can become a game of Jenga. Thirteen years ago, once the Lehman piece was taken away, the whole thing came crashing down.