Lehman Brothers collapsed a year ago on September 15, 2008. The formal filing of bankruptcy was in essence a formality; it had been terminal for months. Its fall triggered a global collapse of credit markets, threatening the world economy and perhaps even the fall of capitalism.
Lehman’s collapse though was not the underlying cause of the worse economic failure since the Great Depression. Detroit was being killed by $4-5/gallon gas. The transportation industries were reeling. Commodity prices, including food, were shooting through the roof, unleashing inflation upon America. The dollar was slipping. All levels of government were raising taxes and the housing market/bubble collapsed.
AIG, Fannie Mae and Freddy Mac all collapsed, joining Bear Stearns, IndyMac, Wachovia, Washington Mutual, New Century, and Countrywide. Citigroup was teetering on the abyss. Goldman Sachs and Morgan Stanley were threatened. This financial collapse was much greater than the S&L failures a decade earlier. Chrysler, GM, and their finance companies were headed into Chapter 11. 401K’s and other retirement funds evaporated.
And yet, Lehman Brothers had to die. The choice was Lehman or Merrill Lynch. Bank of America could not acquire both. J.P. Morgan Chase and Wells Fargo were digesting other financial giants. Merrill was simply too big to fail at that point. Had The Thundering Herd turned bearish, the consequences would have been much worse, perhaps the immediate unleashing of another great depression.
Three of the nation’s top five investment banking companies had gorged themselves on toxic sub-prime mortgages. Bear Stearns failed six months earlier.
Merrill Lynch, under new management, attempted to disengage from the housing market and build up its capital base.
Not Lehman Brothers though. It continued borrowing money, often on a short basis, while pouring tens of billions long into real estate, commercial and residential, at the top of the market. Merrill ran out of time, but at least it was trying to save itself.
Lehman’s top management (think CEO Richard Fuld) was arrogant, as out-of-touch as Bear Stearns’ senior management, addicted to slicing and dicing mortgages at high profits, intolerant of dissent, and obsessed with showing the world that Lehman could compete with the much larger Goldman Sachs and Morgan Stanley. Lehman had neither the capital not expertise to compete at their level. When Goldman Sachs pulled out of a deal, Lehman should have asked why, instead of jumping in.
The tone deaf Fuld at one point supposedly told Treasury Secretary Henry Paulson, former Chair of Goldman Sachs, that “I’ve been in my seat a lot longer than you ever were in yours at Goldman. Don’t tell me how to run my company. ”Paulson was warning Fuld and Lehman Brothers about its high leverage. The ultimate hubris of telling off your regulators is a recipe for economic suicide.
Instead of learning from the Bear Stearns collapse, and cutting back, Lehman continued to borrow. Its leverage at the time of collapse was about 33-1. In other words, it borrowed roughly $97 for every $3 it had of its own capital. It hid some deals off the books. The debt load was simply too great while the toxic assets too slim. Fuld was in denial as the firm failed.
On September 16, 2008 the Reserve Primary Fund announced it had broken the buck. The shares of the highly regarded money market fund were now worth less than $1/share because of its holdings of $875 million in Lehman paper. Small investors around the world discovered that they were invested in Lehman securities without their knowledge.
Business survives on unsecured short term commercial paper. The system is based on trust. The collapse of the Primary Fund sent financial shockwaves around the global economy in a nanosecond. Credit markets dried up. Even GE, the supposedly most solid of Blue Chips, had a liquidity problem. American Express was at risk.
Here’s the really scary part. If we parallel the Great Crash and Depression of 1929, we will suffer through at least another wave of distress selling on Wall Street.
We are told that one lesson should be greater regulation of Wall Street to prevent a repetition of the collapse. I thought Sarbanes Oxley of a few years earlier would solve our Wall Street problems.
The conduct of Fuld, Mozillo, Madoff, O’Neal, Pang, Raines, Stanford, and thousands of others violated numerous statutes and regulations. The problem wasn’t lack of regulation, but greed, pure, raw, unadulterated greed. Some genius will always devise a plan to get around laws and regulations. This time it was arms, cdo’s, clos, cmb’s, credit default swaps, rmb’s, siv’s.
A basic lesson of Econ 101 is that profit is a function of risk. The greater the risk, the greater the profit should be to compensate for the risk. These modern day titans of industry were blinded by the quick and easy profits, and dismissed the risks, relying upon computer models, which were not only based on false assumptions, but which cannot model human behavior and risk.
Garbage in, garbage out, and millions of Americans tragically out of work.
Goldman Sachs, J. P. Morgan Chase, and Greenlight Capital saw it coming. So did Warren Buffett. Fuld and Lehman stuck their heads into the sands of leverage.
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