Too big to jail

Sept. 15 is the 10th anniversary of Lehman Brothers declaring bankruptcy. It was a day after the global money markets seized up, turning a worldwide daisy chain of financial institutions into a ticking bomb. In the wake of the bankruptcy, it seemed likely that the United States financial system as a whole would cease to operate, a financial blackout that would render paychecks, credit cards, and ATMs useless.

Lenders, including large companies, financial institutions, and money market funds, suddenly hoarded cash in the face of growing losses and threats to their own sources of credit. They no longer knew which borrower was a good risk, so they treated all of them as bad risks.

The world experienced the worst financial crisis since the Great Depression of the 1930s and the economy plunged into deep recession. The Federal Reserve and Treasury Department misjudged the scale of the fallout from Lehman’s bankruptcy.

The failure of Lehman Brothers started a chain reaction in financial markets, as it was the first true test of the “too big to fail” hypothesis. Whereas Bear Stearns was sold to JP Morgan in March 2008, Lehman failed to find a buyer in time. The federal government refused to provide financial assistance and the company was forced into bankruptcy. Lehman was the fourth largest investment bank, and its failure sent huge waves across global financial markets. Market volatility peaked, and for some time it seemed that no bank was safe.

Merrill Lynch, the third-largest investment bank, rushed to sell itself to Bank of America that same weekend. Even Goldman Sachs and Morgan Stanley felt the shock and quickly tried to raise capital. The Federal Reserve allowed those two banks to change their charters and become bank holding companies which facilitated their funding via the discount window at the Federal Reserve.

On September 16, the federal government rushed forward with an initial $85 billion in taxpayer cash to bail out AIG, the nation’s largest insurance company. The very next day the nation’s largest money market fund was forced to “break the buck”, that is, report a share value of less than a dollar. The firm’s stake in debt securities issued by Lehman Brothers, with a face value of $785, million was essentially worthless. As a result, the share value fell to 97 cents. (Gasp.)

In the biggest bank failure in United States history, federal regulators seized the assets of Washington Mutual, the sixth largest U.S. bank, on September 27. JP Morgan acquired Washington Mutual’s bank deposits, assets, and their troubled mortgage portfolio from the Federal Deposit Insurance Corporation for $1.9 billion, making it the largest U.S. depository institution.

The crash brought together many forces: stagnant wages, widening inequality, anger about immigration and, above all, a deep distrust of elites and government. The road to recovery has been long for ordinary workers since those white-knuckle days of September 2008, resulting in a wave of nationalism, protectionism, and populism.

The ordinary American scraped by in the aftermath of the crisis, while Wall Street bankers soon returned to wealth and profitability, continuing their well-upholstered lives. The bankers were able to avoid accountability for the financial institutions they ran crashing the economy by trading trillions in fraudulent securities tied to risky or even certain-to-fail mortgages. No senior executive ever had to plea to criminal charges.

Policymakers and prosecutors took the view that prosecuting senior bank executives would cause too much collateral damage to employees, customers, other banks, and the economy. In 2013, then-Attorney General Eric Holder told the Senate Judiciary Committee that he was “concerned that the size of some of these (financial institutions) becomes so large that it… become[s] difficult… to prosecute them when we are hit with indications that… if you do bring a criminal charge, it will have a negative impact on the national economy, perhaps even the world economy.”

In short, they were too big to jail.

Originally Published: September 8, 2018

Hold Wall Street managers to account

At 1:45 a.m. on Monday, Sept. 15, 2008, Lehman Brothers Holdings Inc., the fourth largest investment bank, sought Chapter 11 protection in the biggest bankruptcy proceeding ever filed. There are many reasons why Lehman failed and responsibility is shared by auditors, government officials, regulators, and credit rating agencies.

Looking back, much of the blame for Lehman’s failure and the ensuing financial meltdown that led to the Great Recession resided with senior executives, aka professional managers, in the financial markets who did a poor job of allocating capital and managing risk. They acted less like stewards of their firms and more like the keepers of a guild, accountable only to themselves and focused on short-term results at the expense of long-term performance.

The failure to understand that there are huge risks associated with the pursuit of high returns was a major contributor to the financial meltdown. One way to avoid repeating this disaster would be to require top managers in industries that are important to the public welfare to earn government licenses that testify to their qualifications, just like physicians and lawyers, who must pass tough state exams, and accountants, who must also demonstrate a certain number of years of successful professional work in their field to gain a certified public accountant license.

Why not have the same rigorous licensing requirements for professional managers before they are permitted to hold top management jobs in critical industries and public-sector positions? It has become clear that the challenges of managing large organizations have grown to such a level of complexity that only individuals with the right mix of skills can effectively meet them.

One way to begin professionalizing management is to require anyone graduating with a management degree to pass a comprehensive federal or state exam that tests their mastery of the fundamental body of knowledge they allegedly learned, including accounting, finance, statistics, data analysis and organizational behavior.

During the financial meltdown, Lehman’s top executives could have by no means been described as competent. Ditto for Merrill Lynch, AIG, and so many other firms. Finding incompetent executives among this crowd was like finding sand on the beach; they were clueless to the real dangers of excessive risk taking in the form of the lack of protective equity capital and massive use of leverage built around short-term borrowings.

Despite earning more than managers in any of the world’s other major industries, they were like irresponsible children who had somehow gained access to Cold War missile control rooms, playing with the shiny buttons that could launch nuclear warheads against an unsuspecting world.

Which they ultimately did, wiping out more than $11 trillion of wealth in the process and leaving the American taxpayer to clean up the mess.

In addition to core technical skills, a management licensure test should measure the ability to think critically and consider the moral consequences of decisions. Is it too much to expect a management graduate to be educated about how to leverage the power of markets to create a better world rather than serving only their own selfish interests? Or to possess the ability to think critically, which allows them to solve problems beyond those addressed by their functional training?

For sure, such an examination would increase employers’ faith in a graduates’ competence. It might be wise to make passing the test a periodic requirement to ensure that managers stay current in their knowledge and the ethical challenges posed by an ever-changing business world.

To paraphrase the philosopher George Santayana: those who fail to learn from history are destined to repeat it. The incompetence of senior managers was a driving force behind the 2008 financial meltdown from which many Americans still have not recovered nearly a decade later. The time has come to hold managers to the same standards as other professionals whose competence impacts the well-being of society.

Originally published: September 16, 2017

AIG’s $180 billion bailout still stings


Eight years ago this month the global financial system seemed on the verge of collapse, and its rescue led to the greatest depredation on the public purse in American history. There were many crucial events during the month of the long knives, but no corporation was more central to the mess than AIG.

On Sept. 7, 2008, the federal government took control of Freddie Mac and Fannie Mae and injected $100 billion to ensure the troubled mortgage lenders could pay their debts. On September 15, Lehman Brothers announced it would file for Chapter 11 bankruptcy and Bank of America acquired Merrill Lynch for $50 billion.

Then, in the biggest bank failure in U.S. history, the Federal Deposit Insurance Corporation (FDIC) seized the assets of Washington Mutual, the sixth largest U.S. bank, and JPMorgan acquired the bank’s deposits, assets, and troubled mortgage portfolio from the FDIC. On Sept. 21, the Federal Reserve approved Morgan Stanley and Goldman Sachs transition to commercial banks.

While many blamed the investment banks for high leverage, bad risk management and overreliance on faulty internal models, not to be overlooked is the role AIG, the nation’s largest insurance company, played in the crisis. AIG was once one of the largest and most profitable companies in corporate America, with a gold-plated “AAA” credit rating.

But on September 16, the federal government provided an initial $85 billion in taxpayer cash to bail out the firm. In return, AIG became a ward of Uncle Sam, which acquired 79.9 percent ownership of the company. This was only the first of four bailouts for AIG, totaling an estimated $180 billion.

AIG was in worse shape than Lehman Brothers had been. Yet unlike Lehman, the feds chose to save it. The explanation: AIG was regarded as too big, too global, and too interconnected to fail.

After the 1999 repeal of Glass-Steagall, the law that had regulated financial markets for over six decades, President Clinton signed the Commodity Futures Modernization Act (CFMA) in 2000, which effectively removed derivatives such as Credit Default Swaps (CDS) from federal and state regulation, proving once again that regulators exist to protect the interests of the regulated.

CDS are essentially a bet on whether a company will default on its bonds and loans. AIG was a huge player in the CDS business, which allowed the firm to insure asset-based securities containing sub-prime mortgages against default.

Although swaps behave similarly to insurance policies, they were not covered by the same regulations as insurance after passage of the CFMA. When an insurance company sells a policy, it is required to set aside a reserve in case of a loss on the insured object. But since credit default swaps were not classified as insurance contracts, there was no such requirement.

AIG’s CDS business caused it serious financial difficulties in 2007, when the housing bubble burst, home values dropped and holders of sub-prime mortgages defaulted on their loans. By selling these contracts without reserves, the firm left itself unprotected if the assets insured by the swaps defaulted. AIG had insured bonds whose repayments were dependent on sub-prime mortgage payments. Yet it never bothered to put money aside to pay claims, leaving the company without sufficient resources to make good on the insurance.

Taxpayers stepped in to pay in full the dozens of banks whose financial products were insured with AIG swaps. Unlike in corporate bankruptcies, none of these counterparties were forced to take a haircut, requiring the government to pump more public money into the banks.

To add insult to injury, two weeks after the government provided its fourth bailout to AIG in 2009, it was revealed that the firm was paying $165 million in bonuses to retain key employees to unwind the toxic financial waste. Most people understand that if you go to government for a handout, executives should forgo bonuses. Then again, so much of what happened eight years ago this month defied common sense.

Originally Published: Sep 16, 2016.

Remembering a day that was too big to forget

This month marks the anniversary of the collapse of Bear Stearns, once Wall Street’s fifth-largest investment bank. The demise of the 85-year old institution signaled the real start of the 2008-2009 financial crisis. Eight years later, we can only hope our leaders learned something from the experience.

The collapse and Bear’s subsequent bailout by the Federal Reserve, with the support of the Treasury Department and JPMorgan Chase sent shockwaves throughout the financial system. Bear’s incredibly rapid demise raised serious questions about the banking industry’s use of leverage, inadequate oversight of commercial and investment banks, and the role of the Fed and other regulators in preventing the failure of major financial institutions.

Late on Sunday afternoon, March 16, 2008, Bear’s board of directors accepted JPMorgan Chase’s offer to purchase the company. Less than 18 months after its stock was trading at an all-time high of $172.61 a share, Bear Stearns had little choice but to accept the humiliating offer of $2 a share.

JPMorgan Chase later raised the bid to $10 per share and the Fed provided $30 billion in collateral guarantees to facilitate the deal. The Fed considered Bear too large and too interconnected to fail and saw no choice but to arrange a bailout to prevent a global market crisis. It was hoped that the Bear rescue would nip the problem in the bud and avoid the damage to the larger financial world that many policymakers thought would result from the failure of a major investment bank.

The precise nature of the transaction seemed unclear, but the Fed appeared to be accepting responsibility for the toxic, illiquid assets on Bear’s balance sheet if their eventual liquidation resulted in a loss. In this sense, it appeared that the Fed became the residual owner of these securities and put the federal taxpayer on the hook for Bear’s reckless risk taking activities. Some believe that this action exceeded the Fed’s power.

The first sign of trouble at Bear was the July 2007 collapse of two of its hedge funds. The funds had invested heavily in collateralized debt obligations backed by subprime mortgages, and their failure alerted the rest of the financial system to this contagion.

The hedge funds’ collapse also raised concerns about the firm’s own exposure to mortgage-related securities. It damaged the firm’s reputation, weakened its finances and served as the precursor to Bear’s ultimate collapse. Within a year “the plumbing had stopped working” and credit ceased to flow through the financial system.

Hopes that a global financial crisis could be averted proved misplaced just six months later when Lehman Brothers, another bank that was heavily involved in the mortgage business and was even larger than Bear filed for Chapter 11 bankruptcy on September 15, 2008. The public backlash against the Bear bailout made rescuing the 158 year-old Lehman Brothers politically untenable, especially just weeks before a hotly contested presidential election.

The 2008-2009 financial crisis proved to be the most expensive in history. On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd­ Frank), one of the most sweeping financial reforms in U.S. history.

The law’s stated aim is to “promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.” Essentially, Congress’s intent was to reduce system-wide risk and to prevent another financial collapse.

Let’s hope policy makers actually learned enough about how the economy and the financial system fit together from the 2008-2009 financial crisis to avoid future learning experiences. They would be well advised to recall the words of that prolific author, anonymous, who said, “The past is prologue: but which past?”

originally published: March 5, 2016

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

The day Wall St. failed Main St.

Six years ago this weekend, Wall Street was rocked by the collapse of Lehman Brothers. What began as a banking crisis morphed into something that shook the U.S. economy to its core. Only federal intervention prevented an even more catastrophic result.

How the world’s biggest economy came to the brink of depression is a question that will be debated for a long time, but one could argue that the predicament stemmed from a financial system that was “too interconnected to fail.”

On Sunday, Sept. 14, 2008, Lehman CEO Dick Fuld had run out of options to save one of Wall Street’s grandest institutions. In the early hours of Sept. 15, the company issued a press release announcing that it was seeking bankruptcy protection.

On the day of Lehman’s filing, the Dow Jones Industrial Average plummeted 500 points, its largest decline since Sept. 11, 2001. Adding to the anxiety was the Sept. 14 announcement that America’s best known securities firm, Merrill Lynch, had decided to sell itself to Bank of America for $50 billion amid fears for its own survival.

All hell broke loose within hours of the Lehman bankruptcy. Credit markets froze and banks stopped lending to one another. Lenders no longer knew which borrower was a good risk, so they treated all of them as bad risks.

The Feds made an emergency $85 billion loan to the American International Group because of AIG’s enormous exposure to sub-prime mortgages through the underwriting of credit default insurance. Unlike for Lehman, here the feds opened the checkbook because they determined that the company had to be rescued to protect the financial system and the broader economy. They then allowed Morgan Stanley and Goldman Sachs to become bank holding companies and authorized the Federal Reserve Bank of New York to extend credit to both firms.

Lehman’s downfall created widespread panic in financial markets, as investors scrambled to withdraw their money. On Sept. 16, the nation’s largest money market fund was forced to cut its per-share value below the sacred $1 level because a major portion of its portfolio, invested in short-term debt issued by Lehman, was frozen in bankruptcy court.

The announcement brought Wall Street’s problems home to Main Street by undermining the confidence of millions of small investors in money market funds as a safe place to park their savings. That prompted the Treasury to announce a temporary program to guarantee investments in participating funds.

Much has been written about the causes of the crisis and different witnesses provided conflicting accounts. But it may be that being too interconnected to fail counted even more than size.

That’s why the feds decided so many financial institutions had to be bailed out; sold off to others with government guarantees to sweeten the deal, loaned enormous sums of taxpayer money or recapitalized with government equity.

The elaborately interconnected nature of the financial industry greatly increased the speed and efficiency with which money could move through society. But all the sophisticated technology in the world ultimately depends on one sacred principle: A person keeps his or her word. Suddenly people in the financial industry stopped trusting what their counterparts said about the .value of the portfolio being offered as collateral on a loan and a whole host of other avowals.

How can you do business with a person you can’t trust? As a result, the entire financial world melted down. And the feds had to rush in with open checkbooks to stave off the apocalypse.

originally published: September 2014

Looking back – and forward- on collapse of Lehman Brothers

Six years ago this month, Lehman Brothers, a 158-year-old institution and one of the nation’s five largest investment banks, went bankrupt. Its demise produced the equivalent of a global financial blackout and marked the beginning of the biggest economic crisis since the Great Depression.

It was also completely avoidable.

Six years after Lehman’s collapse, the economy is still reeling. In July, more than 10 million Americans were unemployed and another 9.8 million were underemployed. The labor participation rate of 62.9 percent is the lowest since 1978.

Lehman Brothers had become increasingly reliant on fixed-income trading and mortgage securities underwriting. This went hand-in-hand with an increase in its leverage ratio, from 24 to 1 in 2003 to 44 to 1 in 2007. Since much of this leverage took the form of very short-term debt, 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.

But this sweet talk was undermined by continued erosion of the housing and mortgage markets during the summer of 2007. After Lehman’s stock price fell 37 percent from June to August, 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 the end of the year.

Things only got worse in 2008. In January, Lehman closed its mortgage lending unit and laid off another 1,300 employees in a vain attempt to stem further cash hemorrhages from its sub-prime mortgage operations.

After Bear Stearns collapsed in March, Standard & Poor’s rating arm downgraded its outlook on Lehman from “Stable” to “Negative” on the expectation that its revenues would decline by at least another 20 percent. That caused Lehman’s stock price to plunge by an additional 48 percent.

Lehman attempted to counter this by selling $4 billion in convertible preferred stock. But this fresh cash was quickly soaked up by more write-offs, including Lehman’s $1.8 billion bailout of five of its short­ term debt funds. Ravenous short-sellers (the “Vultures of Capitalism”) began circling and rumors flew that other firms were refusing to trade with Lehman.

With its common stock in virtual free fall, Lehman contemplated taking itself private, but the idea was abandoned when it became clear that the necessary financing wasn’t available. An effort to locate buyers for $30 billion of its commercial mortgages (such as office buildings and shopping malls) met with a similar fate.

The federal government had to step in if Lehman was to be saved. But any such move was complicated by the enormous public outcry that had arisen over the $29 billion “federal bailout” of Bear Steams that March. Voices from all sides of the political spectrum screamed about the feds using taxpayer funds to bail out big Wall Street firms that had caused the mess, while refusing to lift a finger to help American families who were losing their homes.

Since a presidential election loomed in a matter of weeks, Treasury and the Federal Reserve felt that nothing short of a congressional directive to “save Lehman” would allow them to move. But the Bush administration did not approach Congress and the federal government was reduced to trying unsuccessfully to convince other financial giants to bailout Lehman.

On Sept. 15, 2008, Lehman filed the largest Chapter 11 bankruptcy in American history to that point, listing assets of $639 billion and liabilities of $768 billion and leaving its viable businesses to be snapped up at fire-sale prices by sharp-eyed bottom feeders. The federal government’s inaction is generally regarded as its most disastrous financial decision since the early 1930s.

In retrospect, it was political fallout from the Bear Stearns collapse that proved to be Lehman’s death knell. The feds underestimated the impact Lehman’s demise would have on capital and credit markets. Only after the true scope of the problem became clear in the subsequent days and weeks did the feds go to Congress to request the controversial $700 billion Troubled Asset Relief Program to protect other troubled banks from insolvency.

originally posted: September 6, 2014