The counterfactual argument goes something like this: If only the government had rescued Lehman, things would never have gotten so bad.
Rather than dwell in this fantasyland of what if, let’s study the history.
The decades leading to the crisis were a unique period in American history. Under Alan Greenspan, the Federal Reserve lowered interest rates to below 2 percent for three years and to 1 percent for more than a year. This monetary policy was unprecedented, and it had huge ramifications worldwide. The U.S. dollar took a hit; from the start of those low rates in 2001 until 2007, the world’s reserve currency lost 41 percent of its value.
This affected anything priced in dollars or credit. Prices of oil, gold and foodstuff skyrocketed. Home construction and housing sales and prices boomed. There was a land rush, as many banks abandoned traditional lending standards to stake their claim.
The low rates had sent bond managers scrambling for higher-yielding fixed-
income paper. They found that yield in securitized subprime mortgages, a novel financial product. Three elements made this possible: The first was ultra-low yields.
The second was a new class of lenders — Greenspan called them “financial innovators” — that were not traditional depository banks but were mortgage originators only. Their business was strictly making loans for the sole purpose of selling them to Wall Street securitizers. They did not hold the mortgages longer than a few weeks, and they sold these 30-year loans with warranties of only 90 or 180 days.
The third element was the corruption of the ratings agencies. They blessed this junk subprime paper with a pristine AAA rating. “Just as safe as a U.S. Treasury,” they claimed, while failing to disclose that they were paid large fees by the underwriting banks for those ratings.
How could this occur? In the years before, the banking sector helped push through an orgy of radical deregulation. The usual watchdogs had been defanged and defunded. At the same time, the Fed had all but abandoned its role as chief regulator of banks.
Hence, the banking sector had become a kind of self-regulating organization, writing its own legislation, weighing in on key appointments to oversight bodies.
Similarly, nearly all of the major investment partnerships had become publicly traded companies. This radically shifted the liability for failure. It put an end to “joint and several liability” — meaning that each partner was responsible for what any of his partners did, which focused the firm intensely on avoiding extreme risk-taking. Once they became public companies, the liability dropped from around the necks of the partners to the shareholders.
Guess what happened to serious risk-taking? It was embraced by management, which no longer worried quite so much about reckless colleagues. This dramatically changed the incentives and risks for bank management. Indeed, bankers embraced risk with a reckless abandon. The five largest U.S. investment banks lobbied the Securities and Exchange Commission — and won — a waiver of their “net capital” rules, which had kept their total leverage to a 12-to-1 ratio of assets versus liabilities. This was called the “Bear Stearns exemption.” Soon after their leverage ramped up to 20-, 30-, even 40-to-1.
This was the backdrop for a terrific storm. Bear Stearns was the first to go down. Fannie Mae and Freddie Mac were next, seized by the government in a dramatic intervention. Lehman was merely the next bank in the financial trailer park to be ravaged by the tornado.
That’s the broad context. Now let’s see if I can dazzle you with some details about Lehman that you probably don’t know:
1 At the Ira W. Sohn Investment Research Conference in May 2008, hedge fund manager David Einhorn explained — in a talk titled “Accounting Ingenuity” — why he believed Lehman Brothers was insolvent. At the time, Lehman shares were still trading in the mid-$40s.
2 Lehman’s accounting was especially opaque, even relative to other investment banks (and that’s really saying something). Its Level 3 assets were described as “mark-to-make-believe.” The firm was especially evasive when asked for hard numbers for its liabilities. Even a cursory review of Lehman’s books revealed lots of red flags: It was smaller, more heavily leveraged and had greater exposure to the mortgage market.
3 The Wall Street Journal pointed out the complicity of Lehman’s accountants in the collapse. Management chose to “disregard or overrule the firm’s risk controls on a regular basis,” even as the credit and real-estate markets were showing signs of strain. In May 2008, a Lehman executive alerted management about accounting irregularities, a warning ignored by Lehman auditors Ernst & Young.
4 The infamous “repo 105” — it’s a fraudulent accounting gimmick that temporarily removed more than $50 billion in securities inventory from its balance sheet and hid liabilities from shareholders. By creating a materially misleading picture of the firm’s financial condition in late 2007 and 2008, Lehman’s management and its accountants engaged in fraud. This also suggests that Lehman was much more leveraged and at far greater risk for insolvency than was realized. (So, no, short-sellers did not kill Lehman.)
5 Warren Buffett made an offer to Lehman, one that turned out to be more generous than the offer later accepted by Goldman Sachs. (One may surmise that chief executive Richard Fuld’s rejection of Buffett’s bid was the last straw as far as the Fed and Treasury were concerned. If Lehman was unwilling to help itself, why should the taxpayer write another $30 billion check?)
6 Many potential suitors kicked the tires, but none could get past Lehman’s massive liabilities or opaque accounting.
7 Once Lehman filed for bankruptcy, Barclays scooped up most of the U.S. and British operations — without any of that toxic junk paper to worry about. Nomura Securities took over Lehman’s Asian operations.
8 A Harvard study calculated that Fuld earned $522.7 million from 2000 to 2007. He garnered $461.2 million of that by selling 12.4 million shares of Lehman.
9 None of the five "Bear Stearns exemption" firms -- Merrill Lynch, Morgan Stanley, Goldman Sachs, Lehman Brothers and Bear Stearns — exist in their pre-crisis forms. Lehman went bankrupt; Bear Stearns was bought by JPMorgan (with a $29 billion guarantee from the Fed); Bank of America bought Merrill; both Morgan Stanley and Goldman Sachs became bank holding companies so they could tap the Fed's credit lines.
10 Lehman Brothers was dissolved 158 years after its founding.
Some of us who were watching this closely at the time realized that Bear Stearns and Lehman were not merely “one-offs.” They suffered the same disease as others: Too much junk paper, too much leverage, too little capital and zero risk controls.
The storm that tore through the financial sector was far greater than any one company or person or event. And it made the teetering of firms such as AIG, Washington Mutual, Wachovia, Bank of America and Citigroup all but inevitable.
Ritholtz is chief investment officer of Ritholtz Wealth Management. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. Follow him on Twitter at @Ritholtz.