Lehman: The Real Story

Tuesday 15th September is one year since Lehman Brothers filed for bankruptcy.

What we’ve learned:

• Politicians and Bankers have an approximate grasp of how the economy operates.
• Very few politicians have a clue about the financial markets.
• Banks don’t understand derivatives so how can the regulators?
• Leaving investment products and trading systems to the IT guy and the math wiz is extremely hazardous.
• Pay for short term results makes that even more hazardous.
• Politicians and the media are wrongly convinced that banks are the most important part of the economy.

1) Remind us. Why did Lehman collapse?
The banks was hugely dependent on short term money but they expanded away from their advisory business to trading on their own account, in derivatives giving them exposure to long dated (and more volatile) securities.

Regulators demanded that banks buy insurance against their derivatives defaulting, but that insurance was with AIG. As author Andy Kessler writes, “The "default insurance" was in the form of credit default swaps (CDSs), often from AIG's now infamous Financial Products unit. Never mind that AIG never bothered reserving for potential payouts or ever had to put up collateral because of its own AAA rating. The whole exercise was stupid, akin to buying insurance from the captain of the Titanic, who put the premiums in the ship's safe and collected a tidy bonus for his efforts.”

Lehman was heavily dependent on the short-term money market. This is how it works: Imagine you are a big financier. You borrow lots of money on a day-to-day basis. Your house is the security. You get a super low interest rate. You use that money to borrow even more. You build office blocks, shopping centers. You’re a tycoon.
Then your properties drop in value. Your creditors panic and demands all the money back at once.

You go from big businessman to insolvent in 24 hours. The trouble is, so do the people who lent to you. That’s the Lehman story. It was a huge borrower of short term money.

The trouble is, the Fed didn’t understand that. The timeline shows that the Fed and the US Treasury did not realize the impact that Lehman’s collapse would have on the US financial system.

2) Why did Lehman matter?

Lehman traded lived on short term money, called commercial paper. This is money that companies, municipalities, churches, insurers don’t need right now. It could be a company’s payroll. They don’t need the money for two days so they lend it to a money fund that lends it to investment banks.
Now, Paulson didn’t appear to understand the consequences. When he was discussing the possibility of Lehman’s bankrupty the weekend before it happened, he was talking purely to investment banks. The likes of General Electric, which has a huge money market arm, were not in the picture. Yet on the day of Lehman’s collapse, Paulson and Tim Geithner, then head of the New York Federal Reserve, hurriedly met with Jeffrey Immelt, head of GE.

The government issued state guarantees for GE Capital’s borrowings, totaling $126 Billion.
As the commercial money market ground to a halt, investors panicked. Several money funds came close to collapse.
Lehman was also a broker to the hedge funds. They lost confidence in other prime brokers like Goldman Sachs and Morgan Stanley, pulling their money out.
They money exited emerging markets, hammering economies in Russia and eastern Europe.

3) Why did the US government let it fail?

Days before the Federal Reserve and US Treasury had saved Fannie Mae and Freddie Mac. Half a year earlier it had bailed out Bear Stearns.
Former US Treasury Secretary Henry Paulson says he had NO POWER to save Lehman. Remember that.
When the US government refused to extend a loan to Lehman, its chief executive Dick Fuld told his lawyer “I don’t understand.” He repeated the phrase again and again, “It doesn’t make sense.”

Two days later, the Fed bailed out American Insurance Group for $85 Billion. The Fed had no regulatory authority AT ALL for AIG. It was an insurance company. Not a bank. That didn’t stop the Fed and US Treasury taking unprecedented steps.
Yet former Treasury Secretary Paulson says he had NO POWER to save Lehman.
Weeks earlier, records show he thought bailing out Lehman was not “acceptable”. That’s very different. Paulson now insists he was fully aware of the consequences of letting Lehman collapse.

Well, look at those consequences:

A) The dollar jumped when investors panicked. Money that had been flowing into emerging markets, pushing up the oil price, property prices, shares – suddenly that cash was pulled out, stuffed into the cattle trucks and hauled back to the United States.
Result: the dollar shoots up. As companies rush to repay their dollar loans, the USA experiences an INFLOW of cash. Very useful when the banks won’t lend.
Other currencies from the British pound to the Russian Rouble are pushed down, their economies destabilized. Soon they will be deep in recession.

B) The world’s biggest insurer AIG owed $15 billion of that to Goldman Sachs, so when AIG was bailed out two days after Lehman’s collapse, that was effectively a bailout for Goldman Sachs. Former US Treasury Secretary Paulson was the ex-boss of Goldman Sachs.

C) Competition. Lehman was a formidable competitor in its day. With Lehman gone, banks like Goldman Sachs and JP Morgan would get a greater share of both business and fees. Goldman executives conceed this is precisely why the bank was able to report record revenues in the second quarter.

D) After Lehman, banks were considered “too big to fail”. Bankruptcy was ruled out, even if they were crooked. No banks would fail. The taxpayer would pay, and keep paying.
It also was used to justify the $700 Billion bank bailout – the Emergency Economic Stabilisation Act, passed two weeks later.

4) So what was the real story with Lehman?

The surviving big banks are very profitable. Especially the one that both previous and current Treasury Secretaries worked for: Goldman Sachs.

They’re profitable and they haven’t changed. They’ve avoided any massive new regulatory oversight and they’re trading with the same short term borrowings, in the same instruments as before the crisis.
Lawrence MacDonald, whose book A Colossal Failure of Common Sense came out in July 2009, says the bank was not in substantially worse shape than other major Wall Street banks.

But rivals succeeded in pushing Lehman out of the market. Short selling shows this.
When you borrow shares and sell them, you must have shares lined up to replace them. Otherwise it’s called naked short selling – manipulating the share price by driving them down too low. This happened with 32 million Lehman shares – a very suspicious number that the Securities and Exchange Commission has not investigated.

The Wall St Journal did investigate the short selling and found the major short sellers were the other banks. With friends like investment bankers, who needs enemies?

Since the collapse of Lehman, banks like Goldman Sachs have seen profits jump, mainly because there is less competition.

But, throughout this crisis, central bankers and politicians have overestimated the importance of the investment banks. Even when former Treasury Secretary Henry Paulson allowed Lehman to go bankrupt, the record of whom he met with and talked to shows he thought it was an investment banking issue.

He missed the importance of the money market beyond the investment banks, the network of school districts, hospital trusts and companies whose cash flows support the economy.

Those corporate cash flows account for 70 per cent of US corporate credits, compared with just 30 per cent from banks.

Ironically, when politicians steeled themselves to let a big bank collapse, they chose the wrong bank.

5) Could Ben Bernanke be telling the truth?

If the Fed has not lost much money, it is because it has not lent to basket case banks.
Federal Reserve Chairman Ben Bernanke has argued that the Fed didn’t have to tools to save Lehman Brothers. The bank had no collateral, no assets against which to lend. The Federal Reserve’s total lending reached $1.5 Tln at the height of the crisis. Former Fed governor Alan Blinder thinks it could lose up to $30 Bln of that. Much less than the $700 Bln of money that politicians secured for the Troubled Assets Relief Programme, much of which has not been accounted for.

6) So what has changed since Lehman?

There was supposed to be a new banking model – more dependent on taking deposits and doing bank things like lending to business.

However the government bailout money – and state guarantees that are even more important – have allowed US investment banks to go back to their reckless ways. The appetite for easy riches hasn’t changed on Wall Street. It’s why people work there.

Wall Street has lost 10% of its workforce or 30k jobs in the past year. Moody’s expects another 20k over the next 2 years. So its been streamlined but the bonuses have not declined.

If there is less business, there is significantly less competition.

The bundled loans and so-called insurance – the junk that Wall Street traders knew was junk (they coined the phrase toxic waste) – is harder to market because the consumers that Wall Street sold it to, the pension and investment funds, have been badly harmed by the previous toxic explosives offered by Wall Street. Their fingers weren’t burned. They were blown off.

The structured credit market has shrunk. Despite battered prices, investors are still scared. Banks won’t lend to each other.

Mortgage loans packaged by WS fell to $169 Bln this year less than a quarter of the $775 Bln this time two years ago.


In Europe the credit crunch actually worsened over summer. Bank lending shrank for the 5th month running. This will hit small firms who cannot issue bonds. Banks insist it’s because of falling demand. No one believes them. Money that the governments are pumping into the economy is being deposited at the central bank. Banks think that earning 0.5% at the central bank is less risky than lending into the fragile economy.

It was unfair that Wall St got bailed out, just as bad that the incompetent US car giants got bailed out. But now loads of people expect someone else to subsidise their purchase of a new car, and university leavers are complaining they have to compete with people who have more skills and they want the government to create jobs of suitable status. It’s what one US writer calls a Confederacy of Wusses.
That’s the entitled. Spare a thought for those who don’t get to claim something for nothing.

More than 16 per cent of working age Americans find themselves on the US Bureau of Labour Statistics broadest measure of unemployment. In states like Oregon, that rises to 22%. Even in Silicon Valley, home of the IT industry, the number of jobs was already down 16% so far this decade BEFORE the crisis struck.

There is a huge story about the real economy, wholly ignored in the media coverage of Lehman’s anniversary.

1 comment:

Writerjudd said...

This video offers additional insights into how Lehman was taken down.