Tuesday, September 15, 2009

Remembering Lehman on the First Anniversary of Its Collapse: Part II

Lehman Brothers’ collapse exactly one year ago, on Sept. 15, 2008, ignited a massive contraction in the $3.6 trillion money market industry, which provides short-term loans often referred to as commercial paper, used by businesses worldwide to cover everyday expenses, including payroll and utilities. The panic left companies such as Goodyear Tire & Rubber Co., whose operations are a long way from Wall Street stranded with insufficient cash and ravaged the investment accounts of millions of unsuspecting average Americans.

Everyone knew that Lehman was too big to fail without dire consequences. Tim Geithner, Treasury Secretary, recently said in an interview with Fortune that regulators expected bad things from Lehman’s collapse, but things proved even worse than they expected. When Lehman filed for bankruptcy its commercial paper was transferred to the Reserve Primary Fund. As result, Reserve Primary Fund became the first big money-market mutual fund to have its net asset value fall below $1 per share. It was the first time in history that a money market mutual fund opened with less than $1 per share net asset value. The event scared millions of average investors and prompted the U.S. government to guarantee money fund accounts to avoid a deposit run that could have destroyed short-term financial markets. The U.S. government has been keeping the American financial system functioning every since because companies that were too big to fail, did fail.

Wall Street was aware that the unregulated subprime mortgage lending business and the securitization of such inferior loans into investment vehicles such as collateralized debt obligations (CDOs) had pushed the financial system to the breaking point. What the Wall Street bankers failed to calculate was that short term borrowing would be literally frozen and would throw the global economy into a tailspin. The failure of Wall Street bankers and regulators to understand the importance of commercial paper and how that market would be negatively affected by Lehman’s collapse was critical because its aftershocks came closest to destroying the world economy. The run on money market funds, considered the safest investments after bank deposits, and also the principal buyers of commercial paper, sent shockwaves through the global economy. World stock markets lost $2.85 trillion, or more than 6 percent of their value, within three days of Lehman’s bankruptcy filing. Worldwide the cost of banks borrowing overnight funds from other banks, as measured by the London Interbank Offered Rate, or LIBOR, jumped 4.29 percentage points between Friday, Sept. 12, 2008 and Tuesday, Sept. 16, 2008. “We did not expect how the Lehman Brothers' bankruptcy would transmit through the commercial paper market and cause all the stress in the money funds,” said David Nason, a former assistant Treasury secretary for financial institutions under Treasury Secretary Paulson.

The financial chieftains inclusive of Goldman Sachs and JP Morgan Chase tried desperately to unwind their derivatives trades and keep bank-to-bank loans flowing, but they ignored the commercial paper market, the lifeblood of the economy. It was an oversight that would flat-line the American economy. Within a week of Lehman’s bankruptcy filing, the U.S. government stepped in to halt withdrawals from money market funds and provided a $1.6 trillion backstop for the commercial paper market. With these first defensive measures, the U.S. government became committed to strengthening the American financial industry regardless of the cost. “They put the entire financial system at risk, and they didn’t have to,” said Harvey R. Miller, a partner at Weil Gotshal & Manges LLP in New York who represented Lehman in the bankruptcy. Miller stated that “[government officials] were warned. I told them, ‘Armageddon is coming. You don’t know what the consequences will be.’ Their response was, ‘We have it covered.’” Lehman’s problems stemmed from borrowing too much to finance too many hard-to-sell investments, such as mortgage-backed securities, that were rapidly declining in value as a result of the deteriorating real estate market. Lehman was different because the U.S. government let it declare bankruptcy rather than bail Lehman out, as it had bailed out Bear Stearns, Merrill Lynch and Long-Term Capital Management because no one, not even the U.S. government, wanted to be responsible for Lehman’s undeterminable losses, which could tally into the millions or even billions. As a result, Lehman’s creditors were wiped out as well as its stockholders and the aftershocks are still reverberating in the world economy.

On the one year anniversary of Lehman’s collapse, "policymakers haven’t learned the key lesson of Lehman’s collapse," said Richard Bernstein, CEO of Richard Bernstein Capital Management LLC in New York and former chief investment strategist for Merrill Lynch. Bernstein added “[by] designating certain institutions as too big to fail, and not having a thorough regulatory process to match, practically invites another catastrophe.” Perhaps the U.S. government should consider breaking up financial behemoths such as Bank of America Corp. and Citigroup Inc., or limit their expansion, instead the U.S. government has given them billions of dollars in tax incentives and loan guarantees that enabled them to grow even bigger and have created a factual predicate were it could all fall apart, again.

Lydie Nadia Cabrera Pierre-Louis
St. Thomas University


  1. Commercial paper is an often misunderstood and under appreciated aspect of our financia structure. When we think of borrowing, we think long term or short term notes. We do often consider the overnight interbank or intercompany borrowing world. Professor Pierre-Louis, thank you for bringing this analysis to the forefront.

  2. Professor Pierre-Louis thank you for highlighting the importance of commercial paper in the current financail debacle. Very little is written about.

  3. A problem definitely still exists. Some companies are just too big. I'm not sure whether its negligence on the part of the American government to regulate the companies or if its willful because the country profits so much off these companies.