Lehman: The Day the Music Stopped Playing
“We may not have an economy on Monday.”
Those were the words of Ben S. Bernanke, the Chairman of the Federal Reserve on September 18, 2008, three days after the US government presided over the bankruptcy of Lehman Brothers – a 158 year old financial institution that had grown to become the symbol of American Capitalism. This singular event, along with other associated factors contributed to the 2008 financial crisis that affected not just Uncle Sam, but the entire global economy. To the uninitiated, the first question that might come up is how can the collapse of one institution, albeit a major one, cause a financial collapse of this scale? Furthermore, at what point in time did the Great American Dream of owning a house and entering a cycle of upward mobility, turn into this volatile bubble of uncertainty? To answer these questions, and many more of a similar kind, we need to study the historical timeline of the events, developments and decisions leading upto the crisis. Before starting to analyse the timeline, one would be remiss to not point out that the 2008 economic collapse was not caused solely by the decisions of a singular investment bank or a singular governmental institution at one specific point of time. The catalysts for the catastrophe were an orgy of fragile, speculative and impervious decisions taken at various points of time not just by private banks and investment groups, but also by government officials and institutions.
In terms of its intrinsic characteristics, the banking industry is different from other commercial industries in the sense that it requires a certain degree and type of trust that is not reflected, or required in other macro aspects of the economy. Walter Bagehot, a British journalist in the late 19th century, famously wrote in his work Lombard Street that the banking requires “[an] unprecedented trust between man and man” (and in his era, unfortunately, there were only men). In simple terms, this trust stems from the simple concept of deposits and loans. If an individual does not trust the bank with his/her money, they will not maintain their deposits and as a result the banks will not have enough liquidity to provide loans. In this regard, Bagehot continues to state that,
“...when the trust is weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it”.
Human beings have a tendency to make judgements on a particular issue by relying (sometimes entirely) on the proxy signs associated with the particular issue under the assumption that the signs reflect the nature of the issue in its entirety. However in doing this, they end up placing their trust exclusively on the subjective aspect of signs, rather than the objective judgement on the issue – ignoring the fact that their selection of proxies could be incorrect, or even rendered obsolete by changing circumstances. Furthermore, if the proxy signs, say the report of a rating agency, end up providing inaccurate information about the condition of an economic institution, such as a large bank, the results could be devastating. In fundamental terms it can be argued that it was these layers of tranches of false or proxy signs that led to the collapse of institutions such as, but not limited to, Lehman Brothers. The signs go as far back as the 1980s.
The Rhythm To further understand the collapse, it is important to understand the growth of the shadow banking system. This new system, operating in parallel with the traditional commercial banks, contributed towards the feverish growth of the housing market in the United States. The inter-institution competition lowered the cost of mortgages in the US housing market. To the Federal Reserve, it was a more dynamic alternative to the conventional banking system. For the politicians, it was a way of providing cheap credit to their constituents that gave them the illusion of property ownership. Most importantly, for the speculator, it was an easy way to bet on this artificially created boom.
The underlying assumption in all this was that if such institutions collapsed, traditional banks would provide the necessary support, especially given strong property prices – what no one realized was that the houses themselves were overvalued and would not even generate enough to pay the principal, let alone interest. Beyond the Federal Reserve, there had been considerable governmental legislation that was intended to be a stopgap against traditional banks taking excessive risks. The Federal Deposit Insurance Corporation, established under the Glass-Steagall Act of 1933 was one such measure. This was supposed to provide an alarm to banks when their capital requirements would run afoul, and be the last line of defense for depositors, in the event their bank collapsed. It was not even half as well capitalized as was required in the aftermath of Lehman.
The Congress also allowed the Federal Reserve to cap interest rates that banks could pay depositors. This rule, called Regulation Q, ensured that the banks were stuck with offering close to 6% on most deposits. By the 1970’s, these consistently meagre interest rates provided the perfect platform for institutions like Merrill Lynch to offer higher returns on seemingly similar investments. These investments allowed the depositors to invest in “safer risks”. Customers could now buy shares that were redeemable daily at a stable value. The depositors preferred these to the low interest rate term deposits, without realizing that these were not secured by FDIC.
Enraged by this competition, traditional banks approached Congress for help. Congress, in response, passed multiple legislations, including Garn-St. Germain Act of 1982, among others, effectively allowing banks to move away from the 30-year, fixed-rate mortgages to adjustable rate mortgages(ARMs) – the commercial home loan industry was born. For the banks, these ARMs offered an interest rate that had a floating relationship with the money that they were paying to attract the depositors. Although this protected the banks from interest rate squeezes due to inflation, it transferred the risk associated with the mortgage and other such deposits to the borrower.
In the years that followed, markets became more deregulated. The late 1980’s and early 1990’s provided empirical evidence of an impending commercial bank failure in the US Financial Sector. In 1984, the federal regulators rescued Continental Illinois, America’s 7th largest bank. During the hearing on the rescue of Continental Illinois, the Comptroller of the Currency, Todd Conover stated that the regulators would not have let the 11 largest “money central banks” to fail. This received a curt reply from Rep. Stewart McKinney, who coined a phrase that has become synonymous with crises. Representative McKinney said,
“We have a new kind of bank. It’s called ‘too big to fail’ and it is a wonderful bank.”
To address this “too big to fail” problem, the Congress enacted the Federal Deposit Insurance Corporation Improvement Act (FDICIA), under which federal regulators were mandated to intervene early. Clearly, in the Continental Illinois Case, the institutions did fail. FDIC, which should have resolved the issue by producing the least cost to its deposit insurance fund, had failed. To quote the Report of the 2008 US Financial Crisis Inquiry Commission (hereafter the FCIC Report) on the causes of the economic crisis, the 1991 legislation sent a clear message,
“you are not too big to fail, unless you are too big to fail.”
That brings us to the three critical factors that contributed towards the Armageddon of 2008 – the falling interest rates, changes in the mortgage market, and the role of ratings agencies. By the end of 2000, the US economy had grown for 39 quarters (almost 10 years), straight. The housing market, still expanding due to lower interest rates and greater mortgage credit, was in a league of its own. However, a slowdown trickled in from the beginning of 2001 – the dot com bust had begun. The Federal Reserve’s Open Market Committee (FOMC) – the body that decides interest rates – decided to stimulate spending in the economy and therefore lowered short term rates aggressively. It set itself a target of 1% interest rate under Chairman Alan Greenspan(pictured), whose philosophy of picking the pieces after a recession, while ignoring its causes is now known as the ‘Greenspan Put’. As a result of the Greenspan Put, interest rates soon reached 1.75%, the lowest in 40 years and stayed lower until 2004. This recession of 2001 was perceived to be relatively mild, with the GDP falling by a meagre 0.3% from March to November. But something was amiss.
All through 2003, relatively strong American companies were borrowing for short time periods (<90 days), at an interest rate of just 1.1%, compared with the 6.3% that they had to pay three years earlier. The biggest impact was on home ownership. By the same year, home buyers on the 30-year fixed-rate mortgage, could get these mortgages for 5.2%, compared to 8% in early 2000s. Furthermore, unless interest rose, the Adjustable Rate Mortgages made it more affordable for buyers to obtain larger houses with minimum initial payments. ARMs market share, as a percentage of total loans issued, rose from 4% in 2001 to 21% in 2004, contributing to the increase in household wealth, at a time when the savings rate was declining. Despite the 2001 recession, the financial populace had faith in the economy. In a different but related sector of the economy, the mortgage market was undergoing significant changes. Commercial banks had started to aggressively compete with Fannie Mae and Freddie Mac - the publicly traded profit making securitization agencies, which until then had implicit government support – in the securitization of home loans market. By 2006, Wall Street securitized close to one-third more loans than Fannie and Freddie. Among these private Mortgage Backed Securities, 71% were either subprime or Alt-A, barely safe to trade.
Thomas Maheras, a former CEO of Citi Markets in a testimony to FCIC said,
“Securitization could be seen as a factory line…as more and more of the subprime mortgages were created as raw material for the securitization process…more and more of it was of lower and lower quality. And at the end of the process, the raw material going into it was actually bad quality. It was toxic quality”.
The subprime mortgages rose to about 20% in 2005 and most of them were hybrid. These hybrid ARMs had lower interest rates in the first few years of their cycle, providing flexible payment schedules help borrowers justify their payment credibility. After a few years, these rates would significantly increase, leaving borrowers with few options. A creditworthy borrower could refinance his/her loan into an interest rate based mortgage. Those unable to refinance, had to sell off their homes to repay, or be dispossessed. In a testimony to Congress, David Berenbaum, from the National Reinvestment Reinvestment Coalition stated,
“These exotic subprime mortgages overwhelm borrowers when interest rates shoot up after an introductory time period.”
To banks, these ARMs were simply a way to strip equity from low-income borrowers. The credit rating agencies also played a pivotal role. They were required by everyone, banks needed them to determine the amount of capital to hold, while investors used their expertise to quantify risks. The Securities and Exchange Commission had already made them mandatory for margin trading requirements in 1975. In addition, BASEL II capital requirements, though not fully implemented by US banks, permitted lower capital requirements when higher rated securities were being held. Their appeal was easy enough to see, pre-rated securities greatly reduce the costs and time involved in researching each security being traded. In addition, a triple A rated MBS was as safe as a triple A security – creating an aura of invincibility around them. However, the ratings methodology was sloppy.
Moody’s for instance, followed this three step process. First, the total losses in the entire mortgage pool were determined. These estimates were used to determine the scale of junior tranches required to protect the senior tranches from taking losses. Finally, minor modifications were made to the deal to account for riskier loans. These were not always scientific, as a result, by mid-July 2007, when housing prices had declined by just 4%, Moody’s conducted a massive downgrade of the tranches on July 10, 2007. Of all the mortgage backed securities that had a triple-A rating in 2006, Moody’s downgraded three-quarters of them to junk (worthless). Overnight, trillions of dollars were turned into smoke as no one could offload these securities. More importantly, the decision cast a shadow on all MBSs in the market, threatening the stability of the money rush that was propelling the whole system forward. The Song By early 2008, Bear Stern, which was relying extensively on short-term funding and highly risky mortgage assets collapsed. SEC was also complicit in the collapse as it failed to asses and/or restrict risky activities, which in turn allowed for insufficient liquidity. As September 2008 approached, markets witnessed the structural puncture in Fannie Mae and Freddie Mac. This was caused by a number of risky practices undertaken to compete with Wall Street’s expectations of high and rapid growth. These bodies had also increased their mortgage activities and were virtually supporting the collapsing mortgage market. There was no option, but for the taxpayer to take the losses and bail them out. Both Fannie and Freddie were nationalized, ostensibly for a temporary period – which continues till today. The fall of Bear Sterns in March had put Wall Street on notice. A list was prepared to see who would be next in line. Lehman, Merrill Lynch, JP Morgan, and Citi, were all queued up for disaster. As the biggest and the most leveraged, Lehman was next in line. In order to avoid a possible liquidity crisis affecting the largest securities firms since 2007, Lehman had started borrowing from the Fed’s new Primary Dealer Credit Facility (PDCF). It also tried to improve its capital position by reducing real estate exposures. Now, in light of the recent collapse of the major firms, regulators started conducting “stress tests” on entities such as Lehman. On 25th June 2008, the regulators found out that Lehman would need approximately $15 billion more in their liquidity pool to survive a loss of their entire secured and unsecured borrowings. Furthermore, by mid-June, most of Lehman’s borrowings were based on borrowing against nontraditional securities, which were not financed by the PDCF. This was worrying news for everyone and a call was finally made to the White House.
In early September, high level executives from Lehman Brothers informed JP Morgan, Lehman’s repo-clearing bank about their third-quarter results, which reflected a loss of $3.9 billion, highlighting the possibility that payments owed to them by Lehman might never come. As expected, the reaction to this from JP Morgan was not pleasant, and given the size of payments owed, JP Morgan too, was put on the list. Lehman attempted to sell their investment management division, Neuberger Berman, to the Korean Development Bank in order to raise capital. By this time, the Treasury Secretary and former Goldman Sachs boss Henry Paulson (pictured below) had begun convening meetings of all Wall Street Bankers, barring Lehman, to find a solution to the liquidity crisis. The problem? There was barely enough private money to save one bank, let alone all of them. Until then, the White House had been adamant against the use of public money to save the banks. On September 9, as news broke that Korean Development Bank was no longer planning to by Neuberger, Lehman’s stock plummeted by 55%. Before the market opened on the next day, Lehman announced its $3.9 billion third quarter loss to the public.
In an early Friday evening of September 12th, the Treasury Secretary Henry Paulson met with high level executives and came to a consensus that only a private sector buyout could save Lehman. The executives knew that if Lehman failed, Merrill Lynch would be next and a chain reaction would envelope all of them. Fortunately for Merrill, a last minute deal was reached with Bank of America to buy the former at $29 per share – a haircut but one small enough to avoid death. Merrill would live to see another day.
As with Lehman, the situation was bleak but a light from across the Atlantic gave some hope. Barclays, the British bank, appeared to show interest in buying out Lehman. The deal, required Barclays to guarantee Lehman’s obligations associated with the sale until the transaction was complete. Under British law, this guarantee required a Barclays’ share-holder vote, a process that would take about 30-60 days. A waiver could be secured, but one would have to go as high as virtually the British Prime Minister. The unprecedented step of securing a waiver was too much for a company attempting to keep public confidence in itself, so Barclays decided to withdraw. Following this decision, the only way to save Lehman was a US government buyout, which would never come. On 15th September 2008 right before midnight, Lehman Brothers filed for bankruptcy under Chapter 11, Title 11 of the United States Bankruptcy Code – the largest ever in the country’s history. On the same day, the Dow Index that is used to reflect how the American publicly owned companies have traded on a given day, plummeted by close to 500 points. This wiped off some $700 billion from retirement plans, government pension funds and other investments. In regard to Lehman itself, the bankruptcy affected close to 8,000 subsidiaries, with assets and liabilities of $600 billion, with even greater consequences for Lehman’s creditors. Harvey Miller, the bankruptcy counsel for Lehman Brothers, described this as,
“the largest, most complex, multi-faceted and far-reaching bankruptcy case ever led in the United States.”
Over the coming few days, White House would realise the fatal mistake of letting Lehman fall. The list had not vanished, as Lehman fell and its assets were calculated, the fall in the market turned even Lehman’s sound assets to pieces of paper. All companies to which Lehman owed debt had nothing to recover it from, the real estate market had frozen and so even Lehman’s posh offices could not be sold. Overnight, the American economy was frozen with fear. The White House had to call the Congress to sanction the biggest ever bailout in American history. The Emergency Economic Stabilization Act of 2008 gave the initial authorization for spending $700 billion (almost half of the then GDP of India). Citigroup, Goldman Sachs and a host of others had to be given injections of money, virtually making the American Government their owner – so much for capitalism. This was not the end, the Troubled Asset Recovery Program was soon launched for another $400 billion and a number of other assets were bought by the government to keep the market level. Fannie and Freddie came under public ownership, never to return to the private sector. As President Obama came to office in January 2009, he would enact another bailout for the troubled auto-sector, making the exact cost of the recession on the American exchequer impossible to calculate.
The End The crisis of 2008, which also included the takeover of Merrill Lynch on the same day as Lehman filing for bankruptcy, and the failure of American Investment Group(AIG) in late September, had extremely strong aftershocks in the American and global financial apparatus. As per some estimates, about $17 dollars were lost in a time span of 21 months. Families that relied on rising housing values become stuck in heavy mortgages that exceeded the rate at which the housing rates fell. Millions of families entered foreclosure, defaulted on their mortgage payments, or simply “returned the keys” to the bank. For years to come, the ripples of the 2008 crisis were felt by individuals, small and big businesses, government regulators and policy makers all around the world. While various governments took both short and long term measures to ameliorate the situation, the Financial Crisis of 2008 remains one of the most well documented cases of a global economic collapse.
About the Author
Aditya Tamar is a final year Electronics and Communications Engineering student at SRM, Kattankulathur, Tamil Nadu. He has had an excellent academic record throughout his schooling and has been actively involved in a number of co-curricular and extracurricular activities. Aditya aspires to be an Astrophysicist, and when he is not getting sucked into solving fundamental questions related to Black Holes (pun intended) and Galaxies, he actively takes part in Model UN Conferences and Debates. Furthermore, he is an avid football fan, with his allegiance currently being split between his favourite player and his favourite club. Aditya has always had a penchant for world politics and in his articles, you can expect cogency in analysis and research.