Tuesday, September 8, 2009

Remembering Lehman on the Eve of the First Anniversary of Its Collapse: Part I

As we approach the first anniversary of Lehman Brothers’ collapse, a failure that many believe triggered the current global economic crisis, we should perhaps pause and reflect on the topsy-turvy financial year that Americans have survived. This is not an anniversary that Richard S. Fuld, Lehman’s former chairman and chief executive officer is looking forward to celebrating. Fuld has been vilified and humiliated before a congressional panel last October and named in nearly 40 different legal actions. “I’ve been pummeled, I’ve been dumped on, and it’s all going to happen again. I can handle it. You know what, let them line up,” Fuld stated recently. To be fair to Fuld, he took control of Lehman in 1994 at one of Lehman’s darkest hours and rebuilt it into the fourth-largest U.S. investment bank, a Wall Street powerhouse whose massively profitable mortgage banking machine inspired rivals’ envy. The question remains, however, how did it all go wrong? Is Fuld really to blame for Lehman’s demise or was Lehman the first victim of a massive systemic failure in the American financial services industry? Perhaps, more importantly, why didn’t the federal government save Lehman like it saved, Long-Term Capital Management, a hedge fund in the late 1990s, Bear Stearns a mere six months before Lehman’s collapse, Merrill Lynch at the same time that it allowed Lehman to collapse, Bank of America, Goldman Sachs, AIG and countless other financial institutions after it allowed Lehman to collapse, that were deemed too big to fail?

On Friday, September 12, 2008, U.S. Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke assembled thirty of the most powerful figures in the American banking industry to the headquarters of the U.S. Federal Reserve in New York. The group of thirty was told Merrill Lynch and Lehman Brothers were on the brink of collapse. The U.S. government would not bail them out because it was only a week since the U.S. government had agreed to rescue Fannie Mae and Freddie Mac. It was up to the thirty banking executives in the room to save Merrill and Lehman. The future of the entire global banking system was now under threat because the collapse of these two Wall Street giants would deal a huge blow to the world’s confidence in the U.S. financial industry. In particular it would raise questions as to whether American financial service companies could make good on their debts, if Lehman and Merrill were to collapse.

Ken Lewis, chief executive officer of Bank of America, was interested in buying Merrill, but Lehman was out of the question, primarily because no one was really sure of the Lehman’s true financial condition, that is--the true state of the Lehman’s finances, the true worth of thousands of “esoteric contracts” to which Lehman was a counterparty. There could be billions of dollars in liability for the company that eventually purchased Lehman. Lehman’s potential liability for its outstanding loans was not clear and no one wanted to take on such a tremendous risk. Except perhaps Barclays, a 300 year-old British bank, who wanted flagship operations in the United States. The Financial Services Authority and Bank of England were adamant in their belief that the U.S. Federal Reserve would not allow Lehman to fail. They had grave reservations about the idea of a Barclays-Lehman deal. They wanted reassurances from the U.S. government, in particular they wanted guarantees as a condition precedent to the deal. If Barclays were to purchase Lehman blind, unsure of the liabilities Barclays would inherit from the “esoteric contracts,” the U.S. government would have to provide some insurance for Lehman’s and eventually Barclays’ potential losses. The U.S. government refused not because it did not want to save Lehman but because the U.S. government itself did not know what the ceiling of the potential Lehman losses would be. Lehman was too big for the U.S. government to rescue. The Barclays deal was dead and so was Lehman.

On Monday, September 15, 2008, 158 years after it was founded, Lehman filed for bankruptcy. It was a catastrophic event. Shockwaves were felt throughout the global banking industry. Within days, Halifax Bank of Scotland had been rescued by Lloyds of London. Within two weeks, Bradford & Bingley was nationalized. Within a month, the British government had given financial bailouts to Lloyds of London and Royal Bank of Scotland with an unprecedented £37bn. Banks were in crisis everywhere. Not to be outdone, the United States developed a $700bn Troubled Asset Relief Program (TARP) to bailout American banks. On September 21, 2008, Goldman Sachs and Morgan Stanley were given permission from the U.S. government to convert their status from investment banks to regulated commercial banks, marking the end of the last two major independent Wall Street investment banks. It was the end of an era.

A year later, as we remember Lehman, the American banking system is still fragile, recovery is slow, and many questions and lessons exist regarding the near-death experience of the American banking system. "You had an old 19th century-style panic," said Cary Leahey, senior economist at Decision Economics. "There was no single catalyst" for the upheaval. Economists believe that big investment banks and other influential financial market players had taken on massive risks, borrowing heavily to bet on securities tied to subprime real estate loans which were outside the scope of regulators’ authority. As a result, when the U.S. housing market collapsed, this sent the walls crashing down, freezing credit markets and economic activity in the worst crisis since the Great Depression. Hugh Johnson, chairman and chief investment officer at Johnson Illington Advisors stated that "there was a belief that the financial crisis could not be solved and would lead to a second Great Depression.” The U.S. government took aggressive action. The new regulatory focus may curb the excesses that led to the boom and bust of Lehman. However, the current focus on regulation and risk mitigation "have enormous implications for the availability of risk capital in the U.S. and the primacy of the U.S. financial system," said Joel Naroff of Naroff Economic Advisors.

What shall be remembered about the Lehman collapse?

First, although some historic names have vanished forever and others are mere shadows of their former selves, Wall Street hasn't changed all that much. It still operates on the principle of an insider club where disclosure is minimal even to regulators. The best interest of the public is not the primary concern. Business is good and likely to get better. Simply look at the second quarter earnings report for the major financial service firms. Previously on July 22, 2009, I commented on the amazing second quarter earnings of the large banks that had received TARP funds and queried whether they really needed the TARP funds, in the first place? Currently, the burgeoning need for Wall Street’s capital raising services will be a welcomed relief in a world that's suffered trillions of dollars in losses over the past two years.

Second, regulators and central bankers could not save Lehman because Lehman was too big to save. The huge uncertainty of Lehman’s potential losses illustrated that the world's capital markets have become too powerful relative to the central banks. "The U.S. government didn't let Lehman fail; it didn't have the authority to save it," Treasury Secretary Tim Geithner said in an interview with Fortune.
"The fundamental constraint was that the Treasury at that point had no authority" to put capital into Lehman, and "the central bank did not have the ability to fill a capital hole." There was no buyer willing to assume most of Lehman's obligations, as Morgan Stanley did for Bear Stearns. The U.S. government would have been risking unlimited losses because Lehman didn't have enough collateral to back hundreds of billions or trillions of dollars of outstanding loans.

Third, the American financial markets can overwhelm the U.S. government’s resources. Lehman shall remain an unfortunate footnote in U.S. financial history. However, Lehman's collapse underscores for all of us that financial regulation is not only fashionable, it is instrumental for the survival of the American financial system and global economic stability. Despite everything that has transpired, hope is not lost. In the words of Mr. Fuld, “I’m not a defeatist. I do believe at the end of the day that good guys do win.”

Lydie Nadia Cabrera Pierre-Louis
Assistant Professor of Law
St. Thomas University


  1. Lehman's collapse is a sad story but I had no idea how sad. Professor Pierre-Louis raises a very interesting perspective about the size of the financial markets outpacing the size of the government. It's difficult to regulate an entity that is financially superior to the govenment.

  2. Great analysis. I can't wait for part 2.

  3. lydie:

    thank you for this historical reminder. i wonder though, were lehman brothers contracts and potential liabilities greater than AIG's? was AIG considered too important an entity to fail, based on its massive insurance coverages worldwide?

    and i assume that lehman brothers was heavily invested in credit default swaps and collateralized debt obligations. more so than bear stearns? and merrill lynch?

    great post.

  4. It's really a shame that these big companies such as Lehman are looking out for their own best interest when the rest of the country has to suffer when these companies fail. This country will come back stronger than before, it's just unfortunate that we have to endure this economy now.