Lessons of Lehman

Were there any?

This past week we have been treated throughout the press to a barrage of post-mortem articles about the significance, and otherwise, of the collapse of Lehman Brothers. That collapse produced the largest bankruptcy in American history and will provide a healthy living for attorneys worldwide for years to come.

The major thrust of the media attention follows two avenues: first, was the bankruptcy avoidable; and two, what have we all learned from it.

My take on the first point is that, yes, the collapse could have been avoided. At the moment of its disaster Lehman had a book of business very similar to those of its fellow investment banks – there was nothing uniquely stupid about Lehman. Moreover it had capital in the run up to crisis of around 11% – way above what the regulators consider sufficient even now. So on the surface there was nothing to single out Lehman for its role in the financial implosion last year.

So what did happen?

Lehman was unfortunate. It was unlucky enough to be the center of rumors about liquidity. It’s failure was precipitated by a liquidity crunch more than a fear of insolvency. It was a classic ‘run’ on the bank.

And such runs are the bread and butter of the regulators: so why did the ‘authorities’ not step in and provide support?

The answer appears to be twofold: they felt constrained by what they thought was the limited scope of their legal ability to act; and they, ultimately, wanted to avoid the impression that they could save all the banks. Remember, they had already driven Bear Stearns into a shotgun marriage with JP Morgan Chase earlier in the year, and they had muted pushing Lehman into Bank of America, only to be rebuffed in that effort. Other potential ‘deep pocket’ saviors like Barclays withdrew their interest as the crisis built towards its climax: no one had any idea of the consequences of taking on Lehman’s portfolio, and worried as they were about their own precarious balance sheets, no one wanted to add more risk just at a time when it seemed risk was impossible to measure.

So letting Lehman go became the only option.

My view has changed somewhat over the past year. I have hardened my opinion somewhat. On reflection I think it was correct to allow the bankruptcy. I have been stunned by the response of the banking industry: its sense of entitlement is extraordinary. This is a direct manifestation of the ‘moral hazard’ created through the years by the repeated bail out of failing banks. The impression in the banking industry is that no matter how stupidly they behave the public will always clean up the mess. After all banking is essential to the economy. By occupying this privileged and protected position banks feel safe to pursue practically any strategy they like, no matter how dumb it is. Management skills are not valued in the industry, trading and deal making skills are. Banking is a safe haven for those who want to play with other people’s money and make a personal fortune – or at least a very nice living – along the way.

My own experience in the industry was one of profound dillusionment: no one wanted to make strategic decisions and ‘thinking’ was devalued in favor of a macho ‘ability to do stuff’. that is to say to ignore risk so as to make short term profit. This I found especially odd because my employer had been at the epicenter of the real estate crisis at the end of the 1980’s – an event that cost many of my fellow managers their jobs and reputations. Yet we failed to learn anything at all. It has taken all this time for me to realize that this failure was not just in the bank that employed me, but was endemic to the entire industry.

It is a failed industry.

Yet the people who work there and conform to the ‘shoot first’ philosophy make a great deal of money. They are rewarded for amassing short term profits even if they end up destroying value in the long run.

You and I then are called in to pick up the pieces.

So: letting Lehman go down was supposed, in my mind, to force the bank’s attention on their innate vulnerability.

Did it?

Not at all.

For all the talk about the panic and the freezing up of the ‘credit markets’, nothing truly fundamental seems to have changed. Even most of the players are the same. Most of the Lehman people who drove the ship onto the rocks were quickly absorbed back into the industry where they are now, no doubt, replicating that driving skill they so amply demonstrated. But we should not pick on them too much: every single bank is trying to get back to the same activities. There doesn’t seem to be much of a change at all.

Yes there are surface changes: Goldman and Morgan Stanley are now registered as bank holding companies, which sounds arcane, but is a fairly important shift. Everyone focuses on this shift as as sign the ‘old days’ of rogue trading are over. They are not. I think the shift was driven more by a cynical need by the banks to get more securely under the bail-out wing of the Fed than it was an attempt to change their activities. Sure their leverage is down: but will it stay down? I have no confidence at all that it will. All it takes is for a new, and no doubt ‘innovative’, product to emerge and the pressure to pump up the balance sheet will be unavoidable.

Nothing has changed.

Given the devastation wrought by the ineptitude of the banks you would have thought that legislators and regulators would be clamoring to pile on the chains and lock the industry up as tightly as possible.

Not so.

The ‘reforms’ being touted in Congress are entirely superficial. The basic incentives for anti-social behavior are still in place. Which means we are headed, already, into another bubble of some sort.

So what have we all learned?

Not much apparently.

You and I were exposed, briefly, to a blizzard of jargon and obscure things like CDS’s and LIBOR spreads etc, so we can say that we learned a little about the games being played down on Wall Street. But the people who we need to have learned: those in the industry and those who regulate it, appear to want to return back to ‘normal’ as soon as they can.

I attribute this lack of learning to laziness and self interest. it is simply too much effort to impose restrictions on an industry that provides so much campaign money to politicians. The inherent corruption of the American political system is never more evident than in the legislative approach towards banking – conflicts of interest abound, and money talks, I doubt that the invective will produce a proper limitation on the industry. Let’s hope I am radically wrong.

Nor does there seem to be any recognition of the international scope of the problem. The banks are hoping against hope that there is only limited international cooperation: they especially hope that the US and UK act to water down attacks emanating from mainland Europe. Not that the European banks were innocent – they indulged in pure fantasy too by buying CDS’s to cover risk on their balance sheets rather than carrying the far more expensive basic capital. European banks were more thinly capitalized than many of their ‘gangster’ American cousins.

So here we are a year later. Plenty of words have been spilled about the Lehman debacle. And not much has been learned despite all the effort.

I think a major problem is that our leadership – worldwide – suffers from such a collective ‘group think’ on economic and financial matters that little originality is tolerated. And it is weak. No one wants to disrupt the hallowed market. So the market, embodied on the trading floors of the big banks, continues to corrode the fabric of the economy.

As you contemplate all this let me leave you with the advice I give myself when I try to think about banking: bankers are truly stupid people. They may be extremely bright. They may be clever as all heck. they might have degrees from top universities and they may know how to run wizard like models for risk management. But collectively they are stupid. They destroy shareholder wealth with a monotonous regularity. They rely on us to bail them out with equal regularity. They use our money and pay us nothing for it -our guarantees are offered up free of charge. And they aggrandize themselves through a wickedly perverse reward system that enriches most those who loose the most.

On second thoughts: it isn’t the bankers who are stupid.

We are.

Will that change?

Addendum:

Joe Stiglitz makes a good point: the big banks are now even bigger. They gobbled up failed rivals and now are emerging as ‘even too bigger to fail’ institutions. Yet no one in the administration has made a credible response to this greater concentration of finance. This issue: the size of the big players and their implied ability to tear the economy down, is key to getting the industry back under control. Until we have smaller banks that can be allowed to go into bankruptcy without destroying us all, we will be under their thumb. Don’t hold your breath for a solution however – the Obama administration’s watchword appears to be appeasement.