Sunday is the five year anniversary of the bankruptcy of Lehman. So what have we learnt?
1 – Bank executives lie…
…they also got paid huge amounts, weren’t as smart as they thought they were and those that ended up at the top tended to be deeply flawed individuals…
On Sept 10 in a conference call with investors, days before Lehman collapsed, Dick Fuld clearly stated to his shareholders that “no new capital was needed” and that “real estate and investments were properly valued”. Yet only five days later, Lehman filed for bankruptcy.
At a congressional Committee just a few weeks later, Dick Fuld was defiant. He stood by his “no new capital was needed” statement: “no sir, we did not mislead investors”. And he added that “we (made) disclosures that we believed were accurate”. If no new capital was needed why did Lehman go bust five days later? And if he didn’t know the financial position of Lehman what was he doing as CEO?
As part of the Congressional Committee hearings, Dick Fuld was allowed to make a presentation before he was questioned. These are his exact words as to the cause of Lehman’s demise:
“Naked short sellers targeted financial institutions and spread rumours and false information. The impact of this market manipulation became self-fulfilling as short sellers drove down the stock prices of financial firms. The ratings agencies lowered their ratings because lower stock prices made it harder to raise capital and (it) reduced financial flexibility. The downgrades in turn caused lenders and counter parties to reduce credit lines and then demand more collateral which increased liquidity pressures. At Lehman Bros the crisis in confidence that permeated the markets lead to an extraordinary run on the bank. In the end despite all of our efforts we were overwhelmed.”
There are two facts about this statement that I find fascinating. Firstly the downfall of Lehman, according to Mr Fuld, is due to the naked short sellers spreading false rumour and misinformation. It is not that it was too highly leveraged, too risky and that he had missed the speculative property bubble completely. And secondly Lehman was” hoisted with its own petard” – it was injured by the device (short selling) that it had used frequently and very profitably to injure others. Investment banks have made fortunes from shorting financial instruments – bonds of indebted governments, shares of troubled companies etc. But then short selling was used against the very financial firms that had so championed and defended its use. A delicious irony.
Despite Dick Fuld’s best attempts to obscure his compensation, the Congressional Committee calculated he was paid at least $480mn in the period from 2000 to when Lehman went bust in 2008. Even for the credit boom times, he was getting massive sums. Such high levels of compensation reinforced his sense of his own financial genius and infallibility. And that explains why he found the demise of Lehman so difficult – it challenged his view of his own brilliance. It’s also why he blames others and not his own shortcomings. Some of his statements defy belief and confirm he was living in a different reality. He stated that “(past) decisions were both prudent and appropriate”. That is an extraordinary level of arrogance and conceit for a man presiding over the largest bankruptcy in America’s corporate history.
Those that made it to the top in the rapacious and immoral times are not likely to admit their failures. We learnt not to expect Mea Culpa from the arrogant bank execs of the boom times.
I was going to write that credit booms bring out the worst in people. But I changed my mind – they just bring the worst of people to the top.
2 – Credit truly is the lifeblood of the economy…
We have all heard the saying, but it was only post Lehman we got to truly understand what it meant. The economic fall-out from allowing one American investment bank to go bust reverberated loudly around the world. Credit markets became paralysed as all now wondered who would be next to go under. Economies – not just America – fell off a cliff. And the scale of the fall is extraordinary. Years later after much data revision and analysis, we now know that the economies contracted rapidly. The deep freeze in the credit markets may now have thawed – thanks to central bank actions – but there is still a sharp frost in the air. Years later and credit markets are far from functioning normally.
3 – Reported bank profits are guesses at best and almost useless in a financial crisis
Time and time again a bank would tell us “all was well”, “this is the last of the losses” only for the executives to have to admit in just weeks or months to further red ink. Bank balance sheets had become enormous – so large that no one knew the quality of the loans and assets hidden within. And markets were disintegrating so quickly that the accountants couldn’t keep up with the speed that losses were appearing.
A financial instrument is only worth what someone will pay for it. And in deeply troubled times, that price can be a long way from where it is valued on a bank’s balance sheet. Lehman reminded us of a whole bunch of risks that we used to ignore – liquidity risk, funding risk, credit risk etc. It has also taught us to be extremely sceptical about bank’s reported accounts.
4 – Asset price bubbles occur relatively frequently (and at the time few spot them)
History books have been dug out to read. Reinehart and Rogoff’s History of financial Crises became one of the most popular financial books , translated into 20 languages. And as we all delved into history, what became obvious so quickly is that asset price bubbles are all too frequent. There is something in human nature that ensures we all want to believe in Get Rich Quick Schemes, be they property (Ireland, Spain UK), the stock market (1920s America) or tulip bulbs (seventeenth century Amsterdam). And asset price bubbles always cause banking crises, because the banks lend to finance the purchase of the latest fad.
The problem is that whilst the party is ongoing, no one wants to leave. It makes sense to keep on dancing until the very end by which time there are no cabs left to take you home and you’re left stuck at the party nursing a hangover.
5 – Financial stocks are cheap for a reason
On most measures – PE, price to sales, price to assets etc, banks trade much cheaper than other industries and the market. The collapse of Lehman and all the others reminds us why – banking is a poor quality business and profits can change into losses remarkably quickly.
Please see lessons 1 to 4 above as to why caution is needed in investing in bank shares.
6 – We never learn the lessons of the past…
In 1931, the Austrian bank Creditanstalt – the oldest and largest in the country – went bust because it used short term borrowings to fund long term loans. It faced a liquidity crisis when foreigners stopped lending to it. At the same time Lazards was the first British bank to fall after a “rogue trader” made a large and unauthorised bet which went wrong. The failure of banks in the current crisis is remarkably similar. The funding and liquidity crisis at RBS and JPMorgan’s $6bn whale like loss mirror the situations above. And these are not the only parallels. History gives us hundreds of examples of the same behaviour repeated time and time again in the financial industry. It is a deeply depressing thought that the human race (or at least the part of it that works in banking) cannot learn any lessons from history.
Asset price bubbles, credit booms, banking collapses. It’s all been seen so many times before. And so why were we not better prepared? And despite all the current regulatory reform to ensure this never happens again, I’ve got to bet that it will.
7 – Risk Management is a misnomer….
The management of risk has appeared to be anything but, and not just at Lehman. The model to estimate the potential losses for JP Morgan’s whale trader was changed just to reduce the apparent risk and enable him to continue trading. We discovered that so many black box quant funds had models that were utterly useless in predicting losses in turbulent times. The reputation of the whole risk management profession has taken a beating in this crisis.
But basic risks were also badly understood. Classic economic theory explains the benefits of diversification – don’t put all your eggs in one basket. And yet that is what many employees at Lehman did. Their source of income – their job – was dependent on the firm’s success (even more so as Lehman paid bonuses). But then on top of that, Lehman staff also had far too much exposure to the bank through their investments – Lehman stock. And so, when Lehman went under, they lost not only their jobs but also all their savings. And yet most employees at Lehman should have realised they needed to spread their (nest) eggs wider.
8 – Regulatory capture is not a theoretical concept…
Financial firms had so much money and power, they persuaded politicians and regulators to leave them alone. Such regulatory capture is not unusual but in the financial industry it caused global devastation.
The Nobel prize winning economist George Stigler first came up with the term. It describes a regulator that is supposed to act in the public’s interest but ends up acting in ways that benefit the industry that it is supposed to be controlling. Or in laymen’s terms, these regulators are “captured” by their industries – the gamekeeper turns to poaching if you like.
In retrospect just the lack of limits to leverage and the low capital requirements created a disaster waiting to happen. And that is without all the slicing and dicing allowed, credit rating agency failures etc.
Weak regulation was highly beneficial to the banks short term but it has come at great economic cost to the countries those banks are supposed to serve. Also the failure of weak regulation of the past now ensures much stricter regulation in the future. Short term the banks and executives benefitted but in the long term the operating environment will be a lot tougher.
9 – Allowing Lehman fail was the wrong decision…
If I was Hank Paulson what would I have done? I don’t know, but the devastation in the credit markets was truly terrible and I think that Mr Paulson had no idea it would be that bad. However I am also firmly against creating moral hazard – if bank executives know the government will always bail them out, then they will take massive risks. Tails I win, heads you lose, is not a great way for the banking and financial industries to be run.
However what needs to be done now is to create a way for banks to fail without destroying the system. And the new concept of a bank’s “living will” attempts to do so. Regulators are trying to make our banks safer for the future, restricting “too big to fail” andsplitting investment and traditional banking apart.
However any criticism of Paulson has to be tempered by the remembrance of the environment – September 2008 was a crazy time. Just one week before the collapse of Lehman, Freddie Mac and Fannie Mae were effectively nationalised and bailed out by the state. On 16th September, the day after Lehman’s bankruptcy, the Federal Reserve had to lend $85bn to AIG. To try and understand what was happening and the implications of it was extremely difficult at the time.
10 – In a crisis it is a select few who hold immense power… (so hope they’re your friends)
That fateful weekend when Lehman was disintegrating, there were only a very small number of key decision makers. The top three were (at the time) Treasury Secretary Hank Paulson, New York Fed Chair Tim Geithner and Fed Reserve Chairman Ben Bernanke. None were elected by the people.
In March 2008, six months previously the same players had decided to save the smaller Bear Sterns and so most expected Lehman to be rescued too. And yet it wasn’t. Predicting the moves of the powerful is a dangerous game.
During the weekend Barclays interest in Lehman firmed up. But the UK regulator (widely thought to be Mervyn King) scuppered the deal. Barclays did go on to buy the bits of Lehman it wanted for a token amount but only once it had gone bust. Mervyn King’s decision though instantly ensured creditors didn’t get paid hundreds of billions, shareholders were wiped out entirely and many lost their jobs. The power of the few was strongly demonstrated in the collapse of Lehman.
Reportedly Dick Fuld blames Hank Paulson for not saving his bank. Paulson was ex Goldman and Fuld was a Lehman lifer. When there are only a few players making massive decisions, then the lesson to be learnt is make sure they’re your friends.
Lehman will be used as a case study for years to come. Already there are plenty of academic articles about the demise of the bank. My favourite? Mark Stein at the University of Leicester: “When Does Narcissistic Leadership Become Problematic? Dick Fuld at Lehman Brothers”.