Okay, folks. It’s been five years since Lehman Brothers failed, setting off a chain of unanticipated consequences that came within inches of melting down the world’s financial system. Had the Federal Reserve, other central banks, and the U.S. government not intervened and thrown trillions of dollars at the crisis to keep financial markets afloat, we would be talking about Great Depression II.
But rather than offering the conventional wisdom about what’s happened since Lehman filed for bankruptcy on Sept. 15, 2008, which is readily accessible in a zillion places, I’d like to offer some unconventional wisdom — at least, I hope it’s wisdom — based on my 40-plus years of writing about business. My specialty is fiascoes and failures, which is why there’s a toy vulture hanging from my office ceiling, a mid-1980s Father’s Day present from my children.
The true lesson I take from Lehman is that a simple move that was praised by free-market types at the time — letting Lehman fail — set off unanticipated consequences that brought the financial world to its knees within days. It was an object lesson about how things that seem simple on the surface can come back to bite you in unanticipated places in unanticipated ways.
Lehman failed six months after the Fed and the Treasury bailed out Bear Stearns — actually, they bailed out Bear Stearns’s creditors and counterparties; its shareholders were largely wiped out. There was grumbling at the time that the government should have let the market take down Bear and instill discipline by inflicting heavy pain on Bear’s creditors.
But when Lehman went under, two horrible, unanticipated things happened. One was that a big money-market fund, the Reserve Fund, had to take losses because it owned Lehman paper. Reserve’s “breaking the buck” ignited a run on all money-market funds, forcing the government to guarantee all accounts in order to quell the panic.
Second, some hedge funds that used Lehman’s London office as their “prime broker” found their assets frozen as a result of its bankruptcy. That triggered a mad scramble in the United States as hedgies pulled their accounts out of Goldman Sachs and Morgan Stanley, neither of which had full access to the array of Fed lending programs that commercial banks did. Both firms would have gone under — inflicting catastrophic pain on the financial system by setting off a worldwide cascade of failures — had the Fed not made Goldman and Morgan Stanley bank holding companies and given them access to unlimited cash to meet customer withdrawals. The run promptly stopped.
These two Lehman side effects, which too many people have forgotten, typify the problems of dealing with financial crises. You don’t know where the problem will come from, so you need to have all sorts of resources available.
We’ve forced giant, too-big-to-be-allowed-to-fail financial institutions to beef up their capital relative to their assets, which is a good thing. However, we’ve gravely weakened the ability of the Federal Reserve by taking away key powers that it had used to stabilize things. That’s bad. Really bad. This problem, combined with the unhappy fact that much of the rest of the federal government is dysfunctional, will cost us dearly when the next financial crisis hits. And there always is a next one.
We should have broken up and simplified giant financial institutions that hold federally insured deposits and limited their ability to get themselves (and U.S. taxpayers) into trouble. Instead, we got the hideously complex Dodd-Frank legislation, passed three years ago, which requires all sorts of ultra-complex rule-making. The process is going so slowly — surprise! — that President Obama claims to be frustrated and disappointed.
The absolute classic is the Volcker Rule, which says that banks can’t trade for their own accounts, but can trade to make markets for their customers who want to trade. Hello? Differentiating between those two activities is so complicated — I would argue, impossible — that the proposed Volcker Rule regulations are hundreds of pages long. To me, this means that in practical terms they’re useless.
We could have adopted what I call the Hoenig rule, proposed by former Kansas City Fed chief (and current Federal Deposit Insurance Corp. vice chair) Tom Hoenig, and barred federally insured financial institutions from trading at all. That poses problems, yet at least is workable. But Hoenig’s name carries almost no cachet in Washington.
Similarly, we have “living wills” for several dozen giant institutions such as Goldman Sachs, AIG and JPMorgan Chase, known collectively as SIFIs. The acronym, which stands for systemically important financial institutions, is pronounced SIF-eeze, which evokes images of a communicable financial disease. But SIFIs’ wills are hundreds — and in some cases thousands — of pages long. Good luck on regulators’ reviewing those. Good luck, too, if several SIFIs run into trouble at the same time. If that happens, it’s likely that the whole financial system will be in trouble. That means it will be difficult, if not impossible, for acquirers to raise the money needed to purchase assets from stricken SIFIs.
One proposed magic bullet gaining currency these days is to solve the system’s problems by bringing back the Depression-era Glass-Steagall Act, which separated boring, bread-and-butter commercial banking from the more go-go investment banking. I sympathize with this proposal more than you can imagine. In fact, in March 1995, at my previous job as Wall Street editor of Newsweek, my first column opposed Glass-Steagall repeal. And I wrote it on my own time, before I was even on Newsweek’s payroll.
My problem with repeal wasn’t (and isn’t) that it would violate a supposedly sacred separation between commercial banking and investment banking. That distinction was already blurred. I just thought it was a terrible idea to allow already complex giant financial companies to get bigger and more complex — and less and less manageable.
That proved to be the case. The 1998 repeal allowed Citigroup to merge with Travelers, a giant insurance company. It proved such a mess that the companies have since separated. So the repeal was for nothing.
Institutions, you see, can be too big and too complicated for even superior managers to run effectively. That’s the lesson we should take from Chase’s London Whale fiasco, in which a strategy supposedly designed to protect the bank from various risks ended up inflicting a 10-digit loss. The good news is that stockholders bore the whole $6 billion or so loss, because the company was soundly capitalized. The bad news was that even a chief executive as good and as obsessive as Chase’s Jamie Dimon didn’t know what was happening until it was too late.
In addition to not helping solve the fundamental problem of “too big to fail,” reimposing Glass-Steagall would inflict regulatory whiplash. In 2008, as the world melted down, regulators begged Chase to buy Bear Stearns, leaned on Bank of America to complete its then-pending purchase of Merrill Lynch and begged Wells Fargo to buy Wachovia, which had major brokerage operations. All those deals, done at the behest of regulators, would be reversed. If that happens, can you imagine any big institution helping the government by buying some failing institution the next time around?
Meanwhile, hyper-partisanship is weakening the Fed and the government as a whole, reducing our ability to respond to any new crisis. I’m appalled at the Obama administration’s undermining the Fed by not promptly announcing a proposed successor to Ben Bernanke; the controversy hurt the Fed on multiple levels. Then again, I can’t believe that the Republicans are heading us back into another debt-ceiling drama, but it sure looks that way.
You hear talk these days that big institutions’ higher capital levels, their living wills, and closer scrutiny by better-equipped regulators mean that the days of 2008-type post-Lehman financial panics have come to an end. Don’t you believe it. “This time it’s different” are the four most dangerous words in finance. I’ve heard them after every big financial mess since the late 1960s — and a few years later, there’s another mess. These words haven’t proved right yet. And they won’t be right this time, either.
Sloan is Fortune magazine’s senior editor at large.