What we’ve learned from Lehman

Ten years ago, Lehman Brothers were over the precipice plunging to disaster that for a short while took the entire global financial system with it. After filing for bankruptcy, it sent a shockwave of inauspicious events across the planet that crippled financial markets all over the world, triggered a run on money market funds that accelerated a cash crunch that destroyed millions of jobs.

The worst economic catastrophe since the Great Depression began.

We now revisit the events that led to the ruin of one of the largest investment houses in the world and the contagion effect it left – some of which still lingers today and will continue to do so for the foreseeable future.

If there is one lesson to be learned from Lehman’s collapse, it is that ‘nothing is too big to fail’ or is it? As Laurence Ball further explains in his book, “The Fed and Lehman Brothers” – he maintained that The Federal Reserve could have come to the rescue of Lehman but chose not to because the government and the regulators did not understand the historic levels of damage that a Lehman bankruptcy would do to the economy.

Of course, after Lehman we now understand. Extrapolating from his book, the main takeaway from the collapse of Lehman Brothers could be summed up in the following paragraph:

In the autumn of 2008, all the major investment banks, Lehman Brothers, Bear Stearns, Goldman Sachs and the rest were in a delicate state for the same combination of reasons. First, they all had massive investments in real estate that generated losses when the housing bubble burst. Additionally, they were highly leveraged so that once they started losing money on real estate, their already depleted levels of equity fell even lower and investors started becoming more concerned that they might be unviable. The third factor that proved decisive was that these companies were so heavily dependent on very short-term, often overnight, borrowing to keep their business afloat. So, when people started to get anxious about the possibility of collapse, we essentially had a twenty-first-century version of a bank run. The investment banks were cut off from their sources of funding and could not obtain the cash they needed to continue operating.

Lehman has left a sprawling number of damaged institutions and establishments – some of which still endure today. It wiped out about $1.4 trillion of economic output that will never be recovered – a loss that weighed heavily on the working class and retirees after erasing extensive values from their pension funds.

Warren Buffet aptly puts that if there are any lessons to be learned from Lehman, one is that we are all connected to each other like close-knit dominoes. Moreover, that we should be wary of that domino that is about to fall as it affects everybody.

Professor Ball in his book also notes that the Fed as the lender of last resort could have saved Lehman and the world could have been a different place today.

But we will never know for sure. However, it seems pretty apparent that the whole financial crisis probably would have been quite a bit less dangerous. As far as Lehman Brothers is concerned, it’s feasible that if Lehman had pulled through the disaster, it could still be an independent company today. It’s also feasible that Lehman would have had to be wound down over time. However, one thing is quite obvious: We would not have had this chaotic bankruptcy.

Professor Ball further expounds that: One big lesson is that the Fed should be prepared to do its job as the financier of last option. We don’t know when the next financial calamity will happen. [Gordon Brown Britain’s former Chancellor & Prime Minister feels another a ‘crash’ is overdue]. Last time the catalyst was subprime mortgages, the next time it will be something different. Important is that at some time there will be one more big financial company in which people lose confidence. Therefore, we need the Fed to be prepared to provide liquidity. It’s very troublesome whether that will happen because many people have taken away a flawed lesson. The worry is that the next time there is a crisis there will once again be political pressure on the Fed not to assign any funds. Also, the Dodd-Frank Act goes in the wrong direction in one aspect because it puts additional legal restrictions on the Fed’s ability to lend. Their hands may be tied. The details are a little bit complex. However, if we had the same occurrence again today and there were companies in a similar position to what Lehman was in, and in the same financial situation, it’s conceivable that under the current regulations it would be illegal for the Fed to come to the rescue.

Also, to keep in mind, Hank Paulson was then Treasury Secretary. An individual steeped in banking as a former boss of Goldman Sachs. The conflicts of [self-serving] interest even now are difficult to ignore.

So, after ten years have we really learned anything at all from the collapse of Lehman Brothers? Can we still reflect on having that confidence in our institutions and the Fed?

Of course, now we should know. But do we?

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