How to protect yourself from the Lehman collapse

As markets take a hammering following the collapse of Lehman Brothers, John Stepek examines how to protect yourself from the fallout - and finds that one investment in particular remains an attractive choice amid the carnage…

Chancellor Alistair Darling might permit himself a rueful little chuckle this morning.

A mere couple of weeks after the pundits lined up to shoot him down over his claim that Britain was facing the worst economic conditions in 60 years, the papers are now full of comparisons to 1929.

Of course, he won't be laughing for long. After all, the collapse of Lehman will just leave him with yet more headaches, and doubtless there's still plenty of drama to come on both sides of the Atlantic.

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But forget him how does all of this affect you?

There will be a whole new round of disruption to interbank lending

Stock markets around the world took a hammering yesterday, unsurprisingly. The Dow Jones ended below 11,000, slumping 504 points. The FTSE 100 was off 212 points at 5,204.

This isn't over. Lehman Brothers is gone, Merrill Lynch has been sold off, but the impact will be felt throughout the markets for a long time. No one is entirely sure what will happen as Lehman's liabilities are unwound. That means a whole new round of disruption to interbank lending as banks become more afraid to lend to each other again. So forget about mortgages getting any cheaper any time soon.

As Philip Aldrick points out in The Telegraph, there's the debt that Lehman actually has outstanding (around $150bn, about five times that of telecoms group WorldCom, which was until now the biggest debt default in history). The debt is still worth something Lehman itself clearly has some valuable assets so we're not talking about a loss of that entire $150bn. But whatever it's worth, it'll be a lot less than its face value.

Then there's the credit default swaps (CDS) issue to worry about. CDSs are basically a type of insurance written on corporate debt, guaranteeing payment of the debt in the event of a company going bankrupt. Sandy Chen at Panmure Gordon reckons there was about $350bn in CDSs written on Lehman debt. Again, because the debt is worth something, we're not looking at an entire $350bn but using an "optimistic" 60 cents in the dollar, that's still $140bn the banks writing the insurance will have to pay out.

Then of course, as Lehman sells off its dodgy assets, the market price of these will fall further, which will also mean that other banks have to take further writedowns on their own dodgy portfolios. All in all, it looks a bit like the subprime meltdown all over again.

Then there's the small matter of insurance giant AIG, which is struggling to raise emergency funds as I write this. As Kenneth Lewis, chief executive of Bank of America told CNBC, "I don't know of a major bank that doesn't have some significant exposure to AIG." A collapse would "be a much bigger problem than most that we've looked at." We'll have more on this story on the website later today.

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So what does all this mean for you?

Unsurprisingly, the main losers in the UK amid the sea of red the only risers were utility stocks were the banks. HBOS was the top faller, down 17.5%, with Royal Bank of Scotland and Barclays close behind. As the three British banks most exposed to toxic' assets, they've been hit hardest.

Now we've been warning readers away from investing in banks for a long time, so hopefully most MoneyWeek readers will have avoided taking a hit from their share prices collapsing. As for concerns about another Northern Rock - on this point, we've already suggested, along with every other newspaper, that it's a good idea to make sure you only have a maximum of £35,000 saved with each individual bank. That's the limit covered by the Financial Services Compensation Scheme.

That's not to say that anything is going to happen to any of the high street banks that would imperil people's savings. If Northern Rock was deemed too big to fail, the government can hardly pull a Lehman Brothers on a genuinely important bank like HBOS, for example. But it's always better to be safe than sorry.

As for the rest of your portfolio - something interesting happened yesterday amid all the carnage. The oil price took a dive. This could be put down to Hurricane Ike being less disruptive than feared, or to increased fears about the state of global growth. But I'd argue that it's yet more proof that much of the recent surge above $100 a barrel was due to a flood of speculative money, which is now being yanked out of the markets. We suggested selling out of oil at the start of August and I wouldn't be looking to buy back in again yet.

The real value of gold insurance against financial disaster

At the same time, the gold price moved higher. Gold as my colleague Dominic Frisby has pointed out has had an awful time recently, partly down to the dollar rally and some thoroughly misplaced optimism about the US economy. But events like yesterday's demonstrate the key reason for holding gold as insurance against financial disaster.

In a recent edition of his Gloom, Boom and Doom newsletter, Marc Faber argued: "I am not a great believer in insurance policies, but since I think that sooner or later the entire financial system will blow up I want to make sure that I shall still be left with some assets that are mine (physical gold in a safe deposit box not in the US)."

Now that's a very downbeat way to look at things. But the point is that the more that things like the Lehman collapse happen, the more people start to wonder if Mr Faber is right. That'll drive demand for gold higher, regardless of whether a total financial collapse happens or not. And if it does, well, there are worse things to be holding than gold.

So I'd suggest you keep holding on to your gold. You can find out more in our current issue, where Dominic has more on why physical demand has been rocketing. If you're not already a subscriber, you can get your first three issues free by clicking here.

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John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.