The Lehman Brothers story

Next month is the 11th anniversary of the fall of the famed investment banking firm Lehman Brothers (“Lehman”), which froze up the nation’s credit system when it collapsed on Sept. 15.

The firm was founded as a dry goods business in 1850 in Alabama by brothers Henry, Emmanuel, and Mayer. Lehman began focusing on cotton trading and moved to New York during the late 1850s. That office eventually became its headquarters.

By 1900, Lehman had begun moving into underwriting new issues of common stocks for corporate clients, as well bond trading and financial advisory services. During the ensuing decades, it underwrote issues for corporations like Sears Roebuck, RCA, and Macy’s. In 1984, Lehman was acquired by American Express and merged with Shearson, the company’s brokerage subsidiary. This lasted until 1994, when American Express decided to get out of the brokerage business and spun off Lehman.

The company saw considerable success in the years that followed, as it increased its net revenues more than six-fold, to $19.2 billion. By the end of 2007, it was the fourth largest investment bank in the United States and seemed poised to continue its stellar growth.

But Lehman had become increasingly reliant on the subprime and commercial real estate markets. This went hand-in-hand with a 46 percent increase in its leverage ratio, from 24 to 1 in 2003 to 35 to 1 in 2007. Much of this leverage took the form of short-term debt with maturities as short as a single day. So Lehman had to continuously sweet talk its lenders about the “solid value” of the assets it had pledged as collateral for these “here-today-gone-tomorrow” loans.

The sweet talk was undercut by continued erosion of the housing and mortgage markets during the summer of 2007. Lehman’s common stock price fell 37 percent from June to August, as the firm closed its sub-prime mortgage arm, wrote off $3.5 billion in mortgage related assets, and laid off more than 6,000 employees by year’s end.

Things got even worse in 2008. In January, Lehman closed its wholesale mortgage lending unit and laid off another 1,300 employees in a vain attempt to stem further hemorrhaging from its sub-prime mortgage operations. Then Standard & Poor’s credit rating agency downgraded its outlook on Lehman from “Stable” to “Negative” on the expectation that its revenue would decline by at least another 20 percent, which caused Lehman’s stock price to plunge an additional 48 percent.

Lehman attempted to counter by selling $4 billion in convertible preferred stock, but the fresh cash was quickly soaked up by more write-offs. Rumors flew that other firms were refusing to trade with Lehman.

The company contemplated “taking itself private,” but financing wasn’t available. Lehman’s next move was to try and locate buyers for $30 billion of its commercial mortgages, whose actual market value couldn’t be determined because their trading activity was virtually non-existent. Talks with the Korea Development Bank, China’s CITIC Securities, and the Royal Bank of Canada went nowhere.

The time had come for the federal government to step in if Lehman was to be saved. But public backlash against the earlier Bear Stearns bailout made such a rescue politically untenable. With voices from all sides of the political spectrum screaming at the feds for using taxpayer funds to bail out big Wall Street firms that had caused this mess, while refusing to lift a finger to help American families in danger of losing their homes.

On Sept. 15, 2008, Lehman had to file for Chapter 11 bankruptcy, leaving its viable businesses to be snapped up at fire-sale prices by sharp-eyed bottom fishers.

At the time it was the largest Chapter 11 bankruptcy in American history. In retrospect, it’s generally regarded as the most disastrous decision by the feds since the early 1930s, when the Federal Reserve chose to shrink the nation’s money supply by one-third, which shattered the American economy for the rest of the decade.

Let them eat credit

The Federal Reserve Bank cut interest rates by a quarter of a point on July 31, the first reduction in more than a decade. The 25-basis points reduction was seen as an effort to stimulate the economy and counteract the escalating tit-for-tat trade war with China that is seen as impeding global growth.

The Federal Reserve, the world’s most powerful central bank, is again bearing the burden of keeping the economy growing and minimizing financial instability. What’s more, they are pursuing pro-growth policies without any fiscal policy support from elected officials.

Just last month, President Trump reached a bipartisan two-year budget agreement with Democratic leadership in the House of Representatives and Republican leaders in the U.S. Senate that raises discretionary spending caps by $320 billion and suspends the debt ceiling until July 31, 2021. The legislation will add $1.7 trillion to projected debt. It is a really bad idea to assume the future will look after itself. The good news is that they got on well together to pass the legislation. If you believe that you can’t be helped.

This budget deal avoids the risk of another partial federal government shutdown and a potentially catastrophic default on the nation’s debt. The Republicans voting for it touted the increase in military spending while the Democrats talked up the additional domestic spending it includes. The federal debt has grown from about $19 trillion in January 2017 to more than $22 trillion now. Fear of debt and its potentially dangerous implications are nowhere to be found in 2019.

But it’s not just the ruling class in Washington that has become addicted to debt; the whole country is waist deep in it. Taken together, all segments of U.S. debt – federal, state, local, corporate, and household – are at 350 percent of the gross domestic product. American household debt continues to climb to record levels, reaching $13.54 trillion in the fourth quarter of 2018, $869 billion above 2008′s $12.68 trillion peak, according to the Federal Reserve Bank of New York.

The Federal Reserve also claims to be tweaking the benchmark federal funds rate because it is worried that inflation is running below its target of 2 percent. According to the Fed, prices rose just 1.6 percent in the year through June, not counting volatile food and fuel prices.

Inflation as defined and measured by the Fed may be running pretty low right now, but bear in mind that the typical family’s living costs may be nothing like the official stats. It is also fair to say that Americans want a bigger paycheck, not higher prices resulting from a 2 percent inflation target. On a daily basis they experience the Dickensian nightmare of the accumulated high cost of several decades of low wages.

Don’t forget that even modest inflation for a prolonged period can seriously erode purchasing power. For instance, inflation averaged 2.46 percent annually between 1990 and 2018. Sounds low, but you would need just about $2,000 today to buy what $1,000 would have bought in 1990. You don’t have to be a socialist or an economist to understand that despite the strong labor market, today’s wages provide about the same purchasing power as years ago – if you are lucky.

To compensate, households turn to debt. The average American now has about $38,000 in personal debt, excluding home mortgages. The average household carries about $137,000 in debt and the median household income is about $59,000. So when the cost of living rises faster than household income, more Americans use credit to cover basic needs like food, clothing, and medical expenses. When wage growth does not keep up with the cost of living, government promotes cheap credit to grease the economic wheel, especially in an on-demand society that values the immediate over the remote.

Put differently, U.S. economic policy has for decades been, to paraphrase the misquoted Marie Antoinette, “Let them eat credit.”