Its business was selling insurance and, when it saw a seriously mispriced risk, it went to town insuring it, in the belief that diversifying risk reduces it.It expected to make a fortune in the long run but it was destroyed in short order. What would have happened if the uptick rule on shorting shares had been kept, in effect, but “naked” short-selling (where the vendor has not borrowed the stock in advance) and speculating in CDS had both been outlawed?By the next day Hank Paulson, then US Treasury secretary, had to reverse himself and come to the rescue of AIG. Lehman was one of the main market-makers in commercial paper and a large issuer of these short-term obligations to boot.
The issuance of stock is closely regulated by authorities such as the Securities and Exchange Commission; why not the issuance of derivatives and other synthetic instruments?
The role of reflexivity and the asymmetries identified earlier ought to prompt a rejection of the efficient market hypothesis and a thorough reconsideration of the regulatory regime.
Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is dependent on confidence and trust.
That means that “bear raids” to drive down the share prices of these institutions can be self-validating.
The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds.
When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract. That can be clearly seen in US and UK government bonds, whose actual price is much higher than that implied by CDS.
The bankruptcy of Lehman might have been avoided but what would have happened to the asset super-bubble? My guess is that the bubble would have been deflated more slowly, with less catastrophic results, but that the after-effects would have lingered longer.
It would have resembled more the Japanese experience than what is happening now. Undoubtedly it gives markets greater depth and continuity, making them more resilient, but it is not without dangers.
The asymmetry serves to discourage the short-selling of stocks.
The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds.
(Being long means owning a stock, being short means selling a stock one does not own.) Being long has unlimited potential on the upside but limited exposure on the downside. The asymmetry manifests itself in the following way: losing on a long position reduces one’s risk exposure while losing on a short position increases it.