What lessons have we learnt from that crisis which finished off a prominent financial organisation and wiped off $10 trillion from the markets in a matter of months?
The 2010 documentary Inside Job, which won an Oscar for its examination of corruption in the financial services industry in the US that led to the crash of 2008, signs off with a damning indictment:
“For decades the American financial system was stable and safe. But then something changed. The financial industry turned its back on society, corrupted our political system and plunged the world economy into crisis. At enormous cost, we've avoided disaster and are recovering. But the men and institutions that caused the crisis are still in power and that needs to change. They will tell us that we need them and that what they do is too complicated for us to understand. They will tell us it won't happen again. They will spend billions fighting reform. It won't be easy.”
While the public attitude towards investment banking and such financial institutions has changed a fair bit - in that nobody trusts them anymore - the general attitude towards banking has remained largely unchanged. We do not debate the industry. It could be that talking numbers and statistics in debates isn’t sexy, so they’re never the subject of serious debate beyond one or two evenings of prime time cacophony.
Tomorrow is 10 years to the day since the collapse of Lehman Brothers, the most prominent casualty of the financial bloodbath in 2008. We’re taking a look at the 2008 financial crisis that has shaped our attitudes towards financial institutions and governments, and has shaped our cynicism in all things financial. We will also see what lessons can be learnt so a similar crisis doesn’t explode again.
Let’s refresh that memory about the 2008 financial crisis.
On September 15, 2008, Lehman Brothers, a global financial services firm that was founded in 1850, became the largest bankruptcy case in US history.
Lehman had more than $639 billion in assets, but it came to light that the firm also had over $619 billion in debt. The company’s 26,200 employees were watching, first in mild discomfort, then bemusement, and later in no small amount of shock as the fourth-largest US investment bank declared Chapter 11 bankruptcy.
When Lehman shut shop, it ended a 158-year-old business that had been a marquee name in financial services around the world. It was the fourth biggest investment bank behind Goldman Sachs, Morgan Stanley and Merrill Lynch.
A few months prior, in April, Henry Paulson, then US secretary of the treasury, met the CEO of Lehman Brothers, Richard Fuld, at a dinner. Paulson told Fuld that he was “worried about a lot of things”. Andrew Ross Sorkin recounts this meeting in his book Too Big To Fail.
Paulson told Fuld he was “anxious about the staggering amount of leverage—the amount of debt to equity—that investment banks were still using to juice their returns”.
Paulson was right. Lehman Brothers was leveraged at 30.7 to 1 at that point. Merrill Lynch was at 26.9 to 1. While leverage increases returns when the going is good, it causes huge problems when things are no so good. Hedge fund manager David Einhorn believed that Lehman Brothers had an actual leverage as high as 44:1. Einhorn explained that even a 1 percent fall in the value of the investments of Lehman would wipe out half its equity and push the leverage to almost 80 times.
Ok, let’s ‘de-jargon’ that. Vivek Kaul helps with an example from his book Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System. Say a firm has $1 of its own money. That one dollar is its equity. It borrows 44 USD and invests 45 in total.
Say the investment falls in value by 1 percent. This means a loss of 45 cents. Now, this loss has to be adjusted against the firm’s equity of $1. After this adjustment, the firm has only $0.55 of its own money left. Further, it has that loan of $44. What this means is, the firm’s leverage is now 80 - because the loan amount is 80 times the money the firm has. Ergo, Lehman was structured pretty riskily.
A mere 2 percent fall in the value of its investments would have wiped out its equity, or its capital in the business, entirely. It was this leverage which came back to haunt Lehman a few months later.
The main culprit in Lehman’s demise was - you’ve heard this phrase before- subprime mortgage. Investopedia.com defines a subprime mortgage as a type of loan granted to individuals with poor credit scores who, due to poor credit histories, would not normally qualify for mortgages or loans. Subprime borrowers present higher risk for lenders, so subprime mortgages usually charge interest rates above the prime lending rate.
In 2003 and 2004, a US housing boom was underway. We now know that was really a bubble, but Lehman had acquired five mortgage lenders, including subprime lender BNC Mortgage and Aurora Loan Services, which specialized in Alt-A loans. These are loans made to borrowers without full documentation. Lehman's acquisitions initially seemed to be smart decisions.
Record revenues from Lehman's real estate businesses enabled revenues in the capital markets unit to rise 56 percent between 2004 and 2006. That was a faster rate of growth than other businesses in investment banking or asset management. Many mocked Lehman, saying it was not really a bank anymore, but a real estate hedge fund.
Lehman then securitized mortgages worth $146 billion in 2006, a 10 percent increase from 2005. Securitize means converting an asset, especially a loan, into marketable securities, usually to raise cash by selling them to other investors. The investment bank reported record profits in 2005, 2006 and 2007. In 2007, net income was $4.2 billion on revenues of $19.3 billion.
In February 2007, Lehman’s stock reached a high of $86.18, giving it a market capitalization of nearly $60 billion. However, around this time, cracks were appearing in the American housing market. Defaults on subprime mortgages rose to a seven-year high.
In March, one day after the stock saw its biggest one-day drop in five years after concerns that rising defaults would affect Lehman's profitability, the firm reported record revenues and profit for its fiscal first quarter. Lehman's CFO had said that the risks posed by rising home delinquencies were well contained and would have little impact on the firm's earnings.
He also famously declared that he did not foresee problems in the subprime market spreading to the rest of the housing market or hurting the U.S. economy. Despite his assurances, a credit crisis erupted in August 2007 after the failure of two Bear Stearns hedge funds.
At the same time, Lehman's stock fell sharply. In response, the company eliminated 2,500 mortgage-related jobs and shut down its BNC Mortgage unit. It also closed the offices of Aurora in three states. Even as the correction in the U.S. housing market gained momentum, Lehman continued to be a major player in the mortgage market.
In that year, Lehman Brothers underwrote more mortgage-backed securities than any other firm. Consequently, it accumulated an $85 billion portfolio. This was four times its shareholders' equity. In Q4 of 2007, Lehman's stock bounced back as global equity markets reached new highs and prices for fixed-income assets staged a temporary rebound. But Lehman did not grab this opportunity to trim its extremely large mortgage portfolio. On hindsight, ignoring this was the crossing of the rubicon.
Lehman’s stock again began declining as hedge fund managers started questioning the valuation of its mortgage portfolio. In early June of 2008, the company announced a second-quarter loss of $2.8 billion, and reported that it had raised another $6 billion from investors.
It also claimed that it had reduced its exposure to residential and commercial mortgages by 20 percent, and cut down leverage from a factor of 32 to about 25. However, these measures were too little, too late. Lehman's stock fell 77 percent in the first week of September, amid plummeting equity markets worldwide.
Lehman CEO Fuld's plan to keep the firm independent by selling a part of its asset management unit and spinning off commercial real estate assets was questioned by investors. The investment bank had also pinned its hopes on the Korea Development Bank acquiring a stake in Lehman. Those plans were put on hold by the government-owned South Korean Bank.
That was the straw that broke the camel’s back. It led to a 45 percent drop in Lehman’s stock and a 66 percent spike in credit-default swaps on the company's debt. Credit default swaps are a type of insurance against default risk by a particular company, where the buyer of protection is compensated for any loss emanating from a credit event. In this case, the particular company was Lehman Brothers.
Lehman reported losses of $3.9 billion, including a write-down of $5.6 billion, and restructured its businesses. On the very same day, Moody's Investor Service announced that it was reviewing Lehman's credit ratings, adding that Lehman would have to sell a majority stake to a strategic partner in order to avoid a ratings downgrade. That led to the company’s stock tanking 42 percent in value.
By the end of that week, Lehman was left with only $1 billion in cash. The company was in talks with Barclay’s and Bank of America for a takeover, but there was to be no reprieve. The following Monday, on September 15 2008, Lehman Brothers declared bankruptcy, resulting in the stock diving 93 percent.
Former chief of the Federal Reserve Ben Bernanke and former US Treasury Secretary Timothy Geithner said Lehman was insolvent and brushed aside any chance of a bailout. Given Lehman’s size, the bank’s collapse sent shock waves around the world.
The bankruptcy led to more than $46 billion of its market value being wiped out. Its collapse also precipitated the purchase of Merrill Lynch by Bank of America in an emergency deal that was announced on the same Monday. Well, we now have an idea when the phrase too big to fail became part of popular lexicon.
We know the rest of the story that unfolded. Bloomberg recalls it in brief, saying that within days, the fallout crippled America’s largest insurer AIG, triggered a run on money-market funds, and accelerated a cash crunch that would ultimately destroy millions of jobs.
Only after pledging trillions of dollars to prop up the financial system, and spending hundreds of billions more on fiscal stimulus, did the US government manage to prevent the worst economic disaster since the 1930s from becoming the worst recession ever.
Bloomberg observed that the repercussions of that mess endure even today. In the United States alone, an estimated $1.4 trillion in annual economic output will never be recovered — a loss that has weighed most heavily on the poorer sections of society. The cost of shoring up economies has left governments deeper in debt than at any point since World War II. It depleted the financial resources central banks will need to fight the next recession.
Bloomberg goes one step further, claiming that the populism that has gripped the developed world, and that made Donald Trump President, can be traced to the way the crisis undermined confidence in governments.
Another 2013 article recalled that the US Fed initiated an unprecedented monetary policy. Its quantitative easing, or QE program involving the monthly purchase of immense piles of bonds not only reversed the largest-ever plunge in America’s GDP, it also sowed the seeds of what would become a 105-month long expansion. The immediate result was that interest rates and inflation remained below levels preceding every recession since 1955.
The US government bailed out many companies - Bank of America, Citibank, insurance company AIG, mortgage originators Fannie Mae and Freddie Mac, carmakers General Motors and Chrysler.
So what lessons have we learnt from that crisis which finished off a prominent financial organisation and wiped off $10 trillion from the markets in a matter of months?
Aditya Chakrabortty writes in The Guardian, “Long before today’s polarised politics and angry mobs, it was the powerful who could not brook dissent. The result was first financial crash, then political crisis, ultimately breeding this decade’s extremism.”
He talks about how Raghuram Rajan, the IMF chief in 2005, was mocked for warning about trouble brewing. He reminds us of speeches by Gordon Brown and David Cameron that painted low regulation of the financial industry as a virtue.
He writes “Brown believed that London’s success demonstrated the miracles of “light-touch regulation, a competitive tax environment … open to competition and to new ideas”. In Cameron’s mouth that became: “Low tax. Less regulation … Openness. Innovation.” Chakrabortty is blistering in his criticism of the two former British Prime Ministers. He writes, “They sound like a pair of cockatoos in the same cage.”
That is one lesson dissenters want to bring our attention to - that finance and politics are too closely intertwined, so no substantive changes have been made. Chakrabortty says that most British government reports on banking after the crash are dominated by bankers. Instead, he hopes for an economy where the finance sector is smaller and is less voracious for faster and higher returns.
Jared Bernstein, Economic Adviser to Vice President Joe Biden in the Obama administration, writes in the Washington Post, “...the clearest lesson of Lehman is not simply that we must regulate financial markets, which is true, nor is it that we must always preserve private credit flows by fully bailing out irresponsible lenders, which contributes to inequality and economic unfairness. It is that it takes both monetary and fiscal policy working together to get back to full employment. Restored credit flows alone won’t get people back to work. That’s pure supply-side thinking.”
He also adds, “In a lesson learned from the disaster seven years ago, Dodd-Frank includes procedures for the demise of insolvent banks formerly deemed ‘too big to fail.’”
Bernstein also sounds a cautionary note: “...the need to end the unfair treatment of lenders and recognize that credit is but half the battle when demand collapses are lessons we’ve not yet learned.”
American senator, and possible 2020 presidential candidate, Elizabeth Warren said she does not necessarily see a better financial system today. She merely believes the US is in a different place. She said parts of the system have improved in her country - like the Dodd-Frank financial reforms and Consumer Financial Protection Bureau, a watchdog she helped create after the 2008 crisis.
There are many such opinions floating about. After all, it has been 10 years since the spectacular end of Lehman Brothers. But the best comment on this probably came from the Queen of England, who had famously asked, “Why did no one see this coming?”
Which is, of course, not entirely accurate. As we’ve seen, the guys who tried to warn about impending doom were brushed aside. For being doomsayers. And there lies another lesson. As David Dodwell states plainly in his column for the South China Morning Post, “...our experts’ ability to see a crash coming has always been appalling.” He also talks about an unexplored bailout option in 2008 - bailing out the families that defaulted on their mortgages.
Wait, what? Bailing out families? 7.8 million people in USA lost their homes following the 2008 crash. Isn’t that a naive point of view? A Financial Times article showed that many of the houses sold in foreclosure auctions across the US were snapped up at ridiculous prices by private equity firms.
Dodwell writes that Stephen Schwarzman, the head of Blackstone, now holds a portfolio of 80,000 homes, making his firm one of America’s biggest private landlords. Dodwell wagers that inequality would not have become the inflamed issue it is today if the victims of the crash had been supported as earnestly as banking institutions were.
Vivek Kaul is a bit pessimistic about lessons having being learnt. He writes in Mint, “The global financial and trading systems, as they have evolved, are at the heart of this crisis, and there is really no way to solve this.
These systems will keep creating problems in the form of asset bubbles of different kinds…(it) also played a part in creating the Japanese stock market bubble of the late 1980s, the South Asian bubble of the 90s, and the dot-com bubble of the 1990s and early 2000s. Until a global challenger to the US dollar comes along, this system will keep throwing up other bubbles. And that should worry us.”
Meanwhile, Warren Buffett, the legendary investor of Berkshire Hathaway, said, “I describe it as an economic Pearl Harbor. It was something we hadn’t seen before. Even the 1929 panic was nothing like this. I mean, the system stopped.
“Buffet knows what he’s talking about. He had been approached by Lehman’s CEO Dick Fuld for emergency capital, but those discussions fell through. He was also approached by other investment banks desperate for capital. His $5 billion investment in Goldman Sachs saved the firm, and earned him billions.
Buffet gives credit to the Bush government and Hank Paulson for preventing a second Great Depression. He said, “When they realized the gravity of what was happening, we were having a run on the United States, maybe a run on the world, they stepped up.”
What is his advice after all these years? He said, “Humans will continue to behave foolishly and sometimes en masse. And that doesn’t change. We get smarter, but we don’t get wiser." Melancholic musings from the Oracle of Omaha there. What’s he not telling us?
Mohamed El-Erian, chief economic adviser at Allianz SE, and author of the books The Only Game in Town and When Markets Collide, says there have been three accomplishments since 2008 - Firstly, we have a safer banking system, thanks to stronger capital buffers, more responsible approaches to balance sheets and better liquidity management.
Second, there is now a more robust payments and settlement system. Third, we now have smarter international cooperation, with steps like improved harmonization of regulation and supervision, more timely and comprehensive information-sharing, and a greater focus on the challenges of monitoring internationally active banks.
The areas where we’ve failed to make any progress, according to El-Erian, are a still-elusive inclusive growth and misaligned internal incentives like pockets of improper risk-taking or excessive short-termism in compensation payouts.
He also highlights some unintended consequences - the market structure that emerged from the financial crisis involves significantly larger institutions, particularly US-based entities. Meaning, the big have gotten bigger. He says this change in market structure is connected to another phenomenon: the morphing and migration of risk to non-banks.
Another consequence, according to him, is reduced policy flexibility. Interest rates are still at zero or lower in many parts of the advanced world outside the US, and debt levels are significantly higher than before the global financial crisis. El-Erian observes that even if there is sufficient political will, the ability to manage crises and to recover may be diminished compared to 10 years ago.
We could go on and on about lessons from the financial crisis of 2008. As Ken Rogoff noted, “The global economy never ceases to be uncertain and unpredictable … It took economic historians seven decades to unpack the Great Depression. It is safe to assume that historians will have much more to say about the 2008 financial crisis in the years and decades to come.”
Meanwhile, some former Lehman Brothers staffers are planning a party to mark 10 years of the bank’s demise. Reports say an emailed invite to the event read, “One of the best things about Lehman was the people. What better way to celebrate the tenth anniversary than getting everyone from former MDs to former analysts back together again!”Somebody give them a gold medal for empathy.