Why we should not forget Lehman in evaluating the likely course of the Greek default

The parallels between what happened in the US with the bankruptcy of Lehman Brothers a little over three years ago and the coming default by Greece should not be ignored. Indeed, this may be the best guide to what will follow, not the rhetoric of self-interested politicans with a poor grasp of economics.

Outgoing ECB President Jean-Claude Trichet has been touring America in recent months highlighting the similarities between the actual performance of the eurozone and US over the past few years. The housing crashes of Florida and Nevada, for example, have their parallels in Spain and Ireland, though the EU has created far more jobs that the USA.

Lehman sacrifice

Three years ago the US authorities concluded that Lehman was a sacrifice worth making to purge the system of its debts and allow the bad to fail so that the good could survive. It was a decision that very quicky went awry with the contagion of the global financial system dramatically magnifying the impact of the failure of one Wall Street bank.

That is the problem when balance sheets are overstretched and gazillions of derivatives have spread financial risk so widely that nobody really knows where it lies. Do the Europeans contemplating a massive bank refinancing really know how big this needs to be? Or will their largesse fall short and leave the system terribly exposed when Greece is allowed to default?

The EU works by compromise, and compromises have a habit of being half solutions. Nevermind that the French and German leaders stand united, they still have the 15 others in the eurozone to carry with them. A Greek default could be like the Trojan horse entering Troy – a complete disaster.

So the possibility of history repeating itself all over again with the Greek default is only too obvious. The lessons of Lehman have likely not been learnt or more dangerously people will assume that they have been when they have been compromised in the process of reaching an agreement among 17 nations.

Now then, what followed the Lehman failure? First a slump in equities, then a rally until the year-end and then a crash into the lows of March 2009, and then a long rally that only began to fall apart this spring. The real economy was already into a recession before Lehman but it deepened into the worst post-war recession and financial crisis. Precious metals tracked the stock market down but bounced back much quicker and then some.

Historical paralllel

This very recent historical precedent sets investors up for another very rough ride, and the problem naturally is that this pattern will not be exactly repeated, throwing up big losses for those who try. What will equities be worth if the world tumbles back into recession, led by the eurozone and UK, and perhaps China whose real estate boom seems to be finally coming unhinged?

You could argue that the eurozone is about to push the button on the money presses so buy stocks, they can only go up. But what if the real banking crisis post-Greek default mirrors Lehman and more and more money is required.

Do the Europeans have the stomach for it? How bad will the crisis have to get to force them to spend even more? We are back with a world economy desperately trying to inflate its way out of a debt disaster but that will take some years and come at the cost of future growth.

As the ArabianMoney investment newsletter pointed out to subscribers over the summer there will be pockets of opportunity amid this chaos but the general rule for most traditional investment classes will be to avoid them or die with them.