The collapse of the investment bank Lehman Brothers over the weekend of 13-14 September last year was an event of world-historical magnitude. What was so important about it wasn’t the local havoc it caused, the loss of jobs and livelihoods and savings; it wasn’t even the fact that the US Treasury’s decision to allow the bank to go bankrupt triggered a full-blown stock market collapse, the nauseatingly expensive bail-out of AIG just a few days later, the seizing up of credit markets, the near implosion of the global economy, and then a worldwide recession/ depression. Those things are all a very big deal; but the most important lesson of Lehman was that it established, irrefutably, the fact that the big Western banks are now Too Big to Fail. Their size, and their interconnectedness, is such that these institutions can’t be allowed to die a natural death, whatever happens. These banks have an implicit guarantee that if they ever get sufficiently deeply into trouble, the taxpayers will be there to bail them out.
After a meeting with Nicolas Sarkozy in the autumn, Angela Merkel stated her conviction that ‘no bank should be allowed to become so big that it can blackmail governments.’ She’s right – but unfortunately, that’s the system we have, and will continue to have for the foreseeable future. It is a monstrous hybrid in which bank profits are privately owned, but are made possible thanks to an unlimited guarantee against losses, provided by the taxpayer. Goldman Sachs, the biggest of the investment banks, was rescued from insolvency by a taxpayer injection of $10 billion last October; then it collected another $12.9 billion in credit default swap insurance, also provided by the taxpayer, thanks to the bail-out of AIG; then it announced that it was paying itself $16.7 billion in pay and bonuses for the first three quarters of this year. The lack of competition (from imploded rivals) and that taxpayer guarantee against failure made this possible. This is the world that the collapse of Lehman made.
The star, or anti-hero, of Lehman’s story is the bank’s last CEO, Richard Fuld. He had worked at Lehman Brothers for 40 years, had been its head for 15, and held unchallenged sway as the person who dominated the bank’s culture and decision-making. The general public’s first sustained look at Fuld came when he testified to Congress in the aftermath of his bank’s destruction. His strange and strong affect was immediately apparent: a man who gave the impression of having to fight very hard, at all times, to rein in a powerful feeling of anger. He looked angry on the way in, he looked angry on the way out, he looked angry when he was offering a non-apology for what had happened, and he looked angry when Congressman Henry Waxman was asking him if it was true he had taken $480 million in compensation out of the collapsed company in the years since 2000. To many viewers, Fuld also looked like what Wall Street would look like if it allowed its mask to slip: arrogant, furious at criticism and perceived slights, and so far gone in its own sense of embattled entitlement that it seemed to have lost touch with reality.
The glimpses of Fuld in the riveting BBC documentary about the fall of Lehman, The Love of Money, show he was often like that. There is a startling moment from an internal company video when the taut-faced Fuld discusses his feelings about short-sellers – that’s stock market players betting that Lehman stock would go down. He denies being angry about them, in a way that makes it clear he’s setting up a punchline, and then says: ‘I want to reach in, rip out their heart and eat it before they die.’ He says it as if he means it, and the noise made by his audience is closer to a gasp than a laugh.
It was Fuld who presided over the historic mistakes that destroyed Lehman. These were a two-step: first, the bank geared up its levels of leverage to a dangerously high 44 to one. That means every $1 million the bank owned had been stretched to acquire $44 million of assets. The reason for being so heavily leveraged was simple: it increased the amount of money the bank could make. It was equivalent to plonking bigger sums, of borrowed money, down on the casino table. The reason it was a very dangerous thing to do was equally simple: it meant that only a small downward movement in the value of the assets would be enough to wipe out the bank. The second part of the two-step was what Lehman did with that leverage: it made gigantic investments in the property market, not just in the now notorious sub-prime mortgages but also in the next (theoretically safer) category up, Alt-A loans, and also, to a huge extent, in commercial property. In effect, Fuld allowed his colleagues to bet the bank on the US property market. We all know what happened next.
As insider accounts of Lehman’s collapse begin to come out, one of the interesting issues is what one might call the Good German question: just how much did Lehman Brothers’ 26,000 employees know about what was going on at the bank, and the risks it was taking? These two accounts give diametrically opposed answers to that question. Lehman, like many other banks, had a sharp division between bankers, who oversaw the traditional investment banking side of the business (such as mergers and acquisitions and other services to customers), and traders, who bought and sold on the bank’s own account. The Murder of Lehman Brothers is a pseudonymous version of events by ‘Joseph Tibman’, an investment banker, who sees the bank as a ‘negligent homicide’, in which thousands of honest employees were betrayed by the actions and mistakes of a few people at the top. Tibman still works in finance – hence the pseudonym, he says, though I’m not absolutely sure that follows. His book is calm and sad and it has a strong sense of Lehman’s history, including what Tibman sees as Fuld’s finest hour, the aftermath of 9/11, which the bank’s employees lived through in its headquarters at 3 World Financial Center, slap beside the World Trade Center. This doesn’t mean he lets Fuld off for his many mistakes, and Tibman is good on the way Fuld’s embattled, paranoid worldview had seeped into the mentality of the bank, and helped prevent people realising just how deep a hole they were in.
A Colossal Failure of Common Sense is by Larry McDonald, a trader at the bank, and his view of its culture is much darker than Tibman’s. McDonald’s background was in convertible bonds. These are a form of debt which under certain circumstances can switch to equity: in other words, you lend money to a company, and then if its shares go up, you can decide that you now own a piece of the company. This is a good deal for investors, when it works; as a result, in one of capitalism’s many happy paradoxes, this kind of bond is popular with companies in trouble, desperately trying to suck in cash from investors. It follows that an expert in convertible bonds is also an expert in troubled companies, and in balance sheets and trading figures that don’t tell the entire truth. That background gave McDonald, who arrived at Lehman in 2004, a very different perspective on the company. It helped that he had arrived at Wall Street the hard way, not via the Ivy League but through an education in the ways of capitalism at the raw end. He had seen, first hand, how financial products were sold:
This was a classic sweatshop, a small outfit being paid by an obviously failing corporation to unload cheap stocks. These fat chain-smoking salesmen would say anything to their victims … In their own way these bucket shops are specialists. They have no clients from whom to protect their reputation. They also have no reputation to defend. They just get out there and sell stocks and bonds they often know full well are worthless, and to hell with the consequences … All [the boss] wanted me to do was locate guys with cash and then sell ’em, jam them into worthless penny stocks with promises or anything else that worked. From my view across that hellhole of an office, just picking up the merest snatches of conversation, I could work out that this was an underworld operation, selling stock in fake shells of corporations to raise cash, which was tantamount to ripping investors off, stealing them blind.
McDonald didn’t go to work at the sweatshop, but he nonetheless learned something important from it: that the official rules of the market are different from what actually happens. At Lehman, with his experience and his background in convertible bonds, he fell in with a group of colleagues who had begun to have doubts about the bank’s increasingly large bets on the property market. ‘This housing market, it’s all ’roided up,’ one of them said – meaning, artificially pumped up on steroids. The group knew that any direct challenge to the bank’s direction was unthinkable in the culture of Lehman under Fuld, so they began to make inquiries and investigations of their own. McDonald and a colleague flew out to California and sniffed around one of the mortgage lenders with whom Lehman was involved. He went, incognito, to a restaurant popular with the salesmen behind the mortgage boom. His conclusion: ‘In that restaurant, crammed with self-satisfied know-nothings, we had gazed upon the amoral soul of the housing boom, the crux, the fulcrum, the place where so many dreams would begin, and where surely heartbreak and financial collapse must follow.’ The salesmen were stuffing mortgages down the throats of people who had no chance of paying them back, and these mortgages were being turned into financial instruments which were spread everywhere through the economic system. It was a recipe for disaster.
A small group at Lehman were by now convinced that the bank was taking indefensible risks in the housing market. They did what they could to avert catastrophe, both by raising concerns internally and also by hedging the risk, i.e. making bets the other way, to reduce the bank’s overall exposure to a downturn. (This, incidentally, was what saved Goldman Sachs’s bacon during the property bust: although the bank had extensive exposure to the property-based toxic assets, it had also made gigantic hedging bets the other way, which cashed in to big effect once the market turned.) In fairly short order, the concerned parties were all forced to leave the bank. Fuld and his henchmen simply didn’t want to hear any of their bad news. The bank carried on sleepwalking towards disaster.
As for the specifics of the disaster, the insider accounts don’t add much that we didn’t already know. The increasing pressure on property-based assets put Lehman in difficulty; short-sellers added to the pressure by betting against Lehman’s stock price; a feeling grew that the bank’s accounts didn’t tell the whole truth; the bank announced a record loss of $2.8 billion for the second quarter of 2008, and then another record of $3.9 billion for the third; its own bankers, J.P. Morgan, asked for an increase in its Lehman collateral – in effect, its safety margin of deposits – of $5 billion; Lehman couldn’t find the cash, and went to the Treasury for help. The response of Hank Paulson, Treasury secretary, backed by the head of the Federal Reserve, Ben Bernanke, and the head of the New York branch of the Fed, Tim Geithner, was to summon a group of bank heads and tell them to put a deal together that would rescue Lehman.
This was something that has been done a good few times over the years: a meeting of senior bankers to decide who’s going to pick up the tab for an imploded peer. The last such gathering had been as recent as March 2008, when Bear Stearns blew up and its remains were bought by J.P Morgan, with the US government providing a guarantee to cover any losses from toxic assets. This time, the formula didn’t work. The idea was to spin off Lehman’s toxic assets into a ‘bad bank’, and sell off the rest as a going concern. But Lehman Brothers’ accounts were opaque, and the bank seemed to have grossly overstated the value of many of its assets. Bankers who were expecting bad news instead found news that was terrible, and worryingly vague. One of the bankers who had been brought in to rescue Lehman, John Thain of Merrill Lynch, took fright, stepped out of the building, put in a call to the head of the Bank of America, and arranged the sale of his own bank – a bit like popping out to the loo on a blind date and proposing to somebody else. Other American banks weren’t interested. The only player that was turned out to be Barclays. The British bank came very close to buying Lehman, but hit an obstacle which is varyingly described depending on who is speaking. The US Treasury has said that the Financial Services Authority, the British regulator, blocked the deal. The FSA has said that no deal was formally proposed. Barclays have said the same thing. Tibman offers a version which feels true:
The consistent explanation is a technical hitch. Until the ‘bad bank’ or spinco [spin-off company] could be created, Barclays would have to guarantee the impaired assets, just as the US government backed the Bear Stearns assets that went to J.P. Morgan Chase. Barclays’ guarantee would be temporary. If the UK bank took any losses, presumably it would be made whole upon the creation of the spinco bad bank, drawing on the financial backing to which the government had convinced Wall Street to commit. However, UK stock exchange rules required shareholder approval even for Barclays to extend this guarantee. Barclays unsuccessfully sought a temporary US government guarantee for the assets that would go to spinco. But Paulson, supported perhaps with trepidation by Bernanke and Geithner, was resolved not to provide financial assistance under any guise – no matter how fleeting, no matter how low the risk that the US government would ever emerge on the hook for a penny.
In the end, after Lehman went bankrupt, Barclays bought the assets they wanted at a knockdown price. Why on earth was Paulson so insistent about not bailing out Lehman? The good-fun version is that he absolutely loathes Fuld (a fact no one disputes), and that as a former CEO of Goldman Sachs, was perfectly happy to see its angriest rival implode. Even people who don’t subscribe to this view don’t think that under the same set of circumstances Goldman Sachs, Paulson and Geithner’s former employers, would have been allowed to collapse. It is likelier, however, that Paulson’s policy of non-intervention was ideological in basis. Paulson was a committed believer in capitalism and the free market. The rescue of Bear Stearns had involved government guarantees to J.P. Morgan which had entirely contradicted everything he believed about ‘moral hazard’, and about the way in which failed companies should be allowed to fail. He had received an almighty shoeing from the media for not acting on his beliefs. Now he had a chance to re-establish his free market credentials, to teach a lesson about moral hazard, to let his actions speak louder than words, and to make sure that the banks definitively got the point about what ‘market discipline’ looks like in practice. (As for ruining Richard Fuld’s life – tant pis.) So he took the opportunity. At a press conference the day after Lehman went under, he squared his sizeable shoulders and said: ‘I never once considered that it was appropriate to put taxpayer money on the line when it came to Lehman Brothers.’ You can tell a man is serious when he uses the most threatening, the most gravitas-laden word in the modern lexicon: ‘appropriate’.
The Treasury knew there would be a kerfuffle; what they weren’t expecting was a systemic meltdown. It soon turned out that the decision to let Lehman go under was the biggest economic misjudgment in modern American history. With enviable shamelessness, the men behind the decision to allow Lehman to fail began to change their explanations for what had happened. They now claim that they lacked the legislative instruments to take over the bank, for technical reasons to do with Lehman being a holding company, and therefore not under the direct legislative control of the Treasury. This explanation puts Lehman in a different category from Bear Stearns, AIG, and Fannie Mae and Freddie Mac, not to mention the subsequent bail-outs – but never mind. (In the case of Bear Stearns, the Treasury got around various legal problems by lending bail-out money not to Bear, but to J.P. Morgan, the bank that was trying to buy it.)
So the decision to let Lehman collapse was a disaster – but in a sense the specifics of the decision don’t matter. It seems highly likely, given the ideological currents that were running so strongly through Washington and elsewhere that, at some point, one of the failed banks would have been allowed to go bust. For the free-marketers, the idea of endless bail-outs was just so obscene that the temptation to walk the walk of market discipline would somewhere, sometime, have proved too great to resist. Lehman did not create the reality of Too Big to Fail, it merely exposed it to general view. There was a brief moment when the general horror at the new state of affairs seemed likely to lead to change; but as stock markets and liquidity have recovered, that moment is receding, and we seem to be settling back into the status quo ante, with a few cosmetic changes about bonuses. It has been a masterful fight-back by the big banks. We the paying public can’t do anything much except admit defeat and settle back for the next set of bills. In the meantime, perhaps we should try and think of a name for the new economic system, which certainly isn’t capitalism: that, remember, is all about ‘creative destruction’, and the freedom to fail. That’s exactly what we don’t have. The most accurate term would probably be ‘bankocracy’.