In Remembrance of Lehman Brothers
Paul H. Tice
Lehman Brothers, the fourth largest U.S. investment bank, filed for bankruptcy protection on September 15, 2008 to send a message to the markets. Eight years later, we are still struggling to decode the message and draw the proper lessons from that catastrophic event.
Much has been written and said about the bankruptcy of Lehman Brothers over the intervening years, including government inquiries, forensic reports and countless case studies. Yet for all this accumulated body of work, we still seem to be missing some of the basic take-away points.
The first Lehman lesson should be an obvious one: in the modern age of integrated global finance, the bankruptcy of a major investment bank can never be orderly, much less therapeutic for the markets. Lehman Brothers still ranks as the largest U.S. corporate bankruptcy to date, with $613 billion of total liabilities reported when it filed Chapter 11. When the firm collapsed, it touched off a global financial crisis, seized up credit markets worldwide and deepened an already-gathering U.S. recession.
The Lehman bankruptcy estate is now readying its eleventh distribution of cash to creditors, with no end in sight for the process. Along the way, there has been an incredible destruction of economic value across the financial sector, both in terms of spent time and legal costs.
And yet, under the Dodd-Frank Act, it will be the same game plan going forward, with any future failing financial firm to be resolved through an “orderly liquidation” process.
While all systematically-important financial institutions must now have “living wills” in place, these confidential company directives are more placebo than panacea, and do not abrogate the need for regulatory support and consistency to maintain liquid and functioning financial markets during periods of stress.
Even with the proper paperwork on file, there is little reason to expect different results the next go-round, especially in a repeat scenario of 2008 when a series of major bank bankruptcies would need to be orchestrated in the midst of a systemic crisis caused by a market-specific trigger.
Second, while some have argued for the re-instatement of the Glass-Steagall Act, the housing of securities underwriting and trading activities in larger commercial banks actually represents a source of stability for the financial system, not the reverse.
Most of the industry players that disappeared along with Lehman in 2008 were stand-alone investment banks with smaller balance sheets that were more exposed to mark-to-market accounting, due to their large trading books and collateralized agreements. When these investment banks ran into trouble, the solution was to simply merge them with their stronger commercial bank brethren, accelerating an industry consolidation that started back in the 1990s. With or without public financial support, such government-facilitated combinations were preferable to the Lehman Chapter 11 alternative.
Third, it was not a lack of regulations on the books, but rather regulatory uncertainty and a lack of supervisory oversight, that contributed to the 2008 financial crisis, both before and after Lehman’s bankruptcy filing.
Nonetheless, the Dodd-Frank Act, with its companion Volcker Rule, has mandated a total of 390 new rulemakings for the financial sector. Of this target, 274 major rules or 70% had been finalized by July 2016, according to the latest progress report prepared by Davis Polk. Six years into it, Dodd-Frank has added roughly $36 billion of regulatory costs and 74 million man-hours in paperwork filing for the industry, based on numbers compiled by the American Action Forum.
While some regulatory changes have been positive—notably, central clearing requirements for credit derivatives—Wall Street banks are now consumed with legal compliance, as opposed to financial innovation, market-making and providing liquidity for investors. In many ways, what has happened to the financial sector post-crisis is similar to the regulatory takeover of the U.S. electricity sector during the 1930s, with banks now functioning as the equivalent of public utilities. The key difference, though, is that finance is much more complicated than just keeping the lights on.
Lastly, the antidote for the weak corporate governance and poor risk management demonstrated by Lehman Brothers and many of its peers in the run-up to 2008 would include a series of simple prescriptions—such as less-compliant boards, more-proactive auditors and improved balance sheet transparency—rather than the wholesale elimination of all risk-taking.
Since 2008, Federal Reserve policy has distorted the pricing of all risk assets, as interest rates have been kept too low for too long, undermining fundamental trade conviction and positioning appetite and amplifying price movements. These days, even a 25 basis point increase in interest rates from a zero starting point is enough to paralyze the markets. Now, every extreme volatility event in the markets is casually referred to as a “Lehman moment,” which shows how much memories have faded over the past eight years.
As the industry currently stands, the likelihood of a recurrence of the 2008 financial crisis is arguably very low, but at what cost? The U.S. economy continues to generate sub-par growth, and few question whether a key contributing factor is a moribund financial sector cowed by compliance, averse to risk and struggling to retain talent due to artificially-suppressed compensation levels. Given the stigma attached to a career in finance these days, it is not surprising that the number of finance majors coming out of business school has fallen off dramatically in recent years.
When Lehman Brothers collapsed, it also altered the course of an American presidential election, and changed the direction of this country. Since then, Wall Street has been pitted against Main Street, and bi-partisan criticism of Wall Street banks has devolved into antipathy towards big business and wealthy Americans. More recently, it has led to atavistic attacks on free trade and global markets and charges that the entire U.S. capitalist system is “rigged.”
All of which, at some level, can be traced back to the failure to deal with the bankruptcy of Lehman Brothers in a frank and open manner. By not learning the proper lessons from Lehman and 2008, we remain stuck re-litigating the past, unable to move on.
Something to think about as everyone pauses today to remember where they were eight years ago when the world’s financial markets stood still.
15 September 20167. Paul Tice is an Executive-in-Residence at New York University’s Stern School of Business and spent 14 years of his Wall Street career at Lehman Brothers.