Not ‘too big to fail,’ too interconnected to fail

At about 12:30 a.m. on the morning of Monday, Sept. 15,2008, a press release went out from the 158- year-old investment bank Lehman Brothers announcing it was seeking bankruptcy protection. Lehman’s downfall would become the watershed event of the financial crises.

While this event may not be seared into American memories like the Sept. 11 terrorist attacks, the collapse of Lehman triggered the worst financial tsunami since the Great Depression and was a seismic shock to global financial markets.

It was the largest Chapter 11 bankruptcy in American history to that point, and triggered the longest and deepest recession in generations. Within 21 months, $17 trillion in household wealth evaporated; the unemployment rate doubled to 10.1 percent in October 2009; and the nation’s credit system froze up, costing millions of Americans their jobs, homes and savings.

The weakest recovery since World War II drags on. Despite unprecedented monetary policy in which trillions spent on quantitative easing and near-zero interest rates benefited those who wear Zegna and Ferragamo, it has not helped the average working American.

Main Street has taken a beating. Wages have been rising at the slowest pace since the 1980s, while the rising gap between workers’ productivity and their wages is diverted to stockholders and management.

The government underestimated the repercussions of letting Lehman fail by failing to anticipate the systemic risks posed by Lehman’s bankruptcy. Both Lehman’s size and its interconnectedness with companies worldwide effectively created a credit event that far surpassed the magnitude of any that had come before.

Financial firms were not “too big to fail,” they were too interconnected to fail. The companies were reliant on one another in a variety of ways that were essential to the smooth running of the financial system. The feds failed to grasp the impact of a mortgage written in California that had been sliced and diced and sold several times and ended up in the portfolio of a Norwegian pension fund.

Six months before the Lehman crisis, the feds kicked in almost $30 billion to facilitate the shotgun marriage of Bear Steams to JP Morgan. But this time they refused to backstop losses from Lehman’s toxic mortgage holdings. Why did the government step in to bail out Bear but fail to rescue Lehman, a firm twice Bear’s size?

In part, Lehman Brothers was allowed to fail because of Bear Steams. The political fallout from Bear’s bailout worked against Lehman. Public backlash against taxpayers potentially assuming Bear’s losses made rescuing Lehman Brothers politically untenable. The feds believed they could not enact a second bailout just weeks before a presidential election.

They also thought a bailout might lead other firms to expect a similar treatment. The feds were reduced to jawboning Bank of America, HSBC, Nomura Securities, and Barclay’s Bank to “rescue Lehman on their own”. This proved fruitless without government assistance.

So the second domino would fall; it would not be the last. Only days later, all hell broke loose and the feds had another change of heart; they opened their checkbook and bailed out insurance giant AIG, which was on the verge of collapse. Since there were no “white knights” with sufficiently deep pockets to buy AIG, they had only one option: To effectively “nationalize” the company. They provided an $80 billion credit line from the Federal Reserve, plus additional loans and other direct investments that eventually totaled more than $170 billion, in exchange for an 80 percent equity stake in its ownership.

So the die was cast. Henceforth, the feds would be the business community’s sugar daddy; passing out allowance money by the billions to unruly children such as General Motors and Chrysler, while trying to keep them from squandering too much of it on “tooth-rotting candy” in the form of huge bonuses and lavish perks for top management.

To paraphrase Ralph Waldo Emerson: “A foolish inconsistency is the hobgoblin of little minds”.

Originally Published: September 5, 2015

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