The Lesson of Lehman

On the anniversary of the fall of Lehman, it is natural to analyze the historic events.  It often takes many years to draw the right lessons from history.  Sometimes it never happens.  For example, there are still debates about Vietnam.  Some see the mistake as engaging a ground force in Asia.  Some see the problem as involvement in a civil war without popular support for our position.  Still others saw the failure as a lack of commitment to win.

There is a danger in drawing lessons from a single case.  The biggest risk is fighting the last war — thinking that the next challenge will be like the last.

Concerning Lehman, we see three different perspectives of interest:

• Public policy.  What went wrong, and what should we do?
• Economic policy.  Did the events represent a failure for economists?  What changes in approach or methods are needed?
• Investor policy.  What can an investor learn from these events — the lessons?  What opportunities were created?

The Public Policy Issue

Here at “A Dash” we normally stick to issues that will help investors.  Occasionally we comment on public policy, our sweet spot of expertise.   Today’s article focuses on public policy.  In future articles we shall look at economics and investing.

There was a fragile situation — call it “the tinder.” 

Despite the 1998 warning of the failure of Long Term Capital Management, the permitted leverage of many financial institutions was too high.  Some of these institutions were investment banks, and some were hedge funds.  In all cases there were relatively modest returns on specific trades, magnified many times by borrowing.

The securitization of mortgages was a good idea, poorly implemented.  There is nothing wrong with the concept.  The implementation involved complex securities given undeserved ratings by private agencies.  Everyone in the process — borrowers, lenders, rating agencies, investment banks, and purchasers — was part of a greedy process.  The government also had a role through a failure of regulation.

This was a dangerous situation, but one that had existed for many years.

Then there was “the match — lighting the tinder.”  It first came in the collapse of Bear Stearns.

When will someone notice that various interests had a huge profit potential in stimulating disaster?  Someone bought 55,000 30 puts in Bear (the equivalent of 5.5 million shares) with the stock trading at 65 with only ten days to expiration.  These puts could be profitable only if the company failed — the stock declining by more than 50% in a few days.

Some market participants were in a position to accelerate the failure — pulling funds, refusing short term loans, and bidding up credit default swaps.  This should be the subject of an SEC inquiry, but it is not.

Let us be completely clear.  Certain parties profited hugely from the failure of Bear, the failure of Lehman, and the resulting market collapse.  These were people who sought the collapse of the system.  It is fine to take insurance on such a collapse, but quite another thing to help make it happen.

The SEC claims to be expert when it comes to “insider trading” but the staff consists of programmers and lawyers.  How can we get their attention?  It is a great PhD dissertation topic, but that will come too late for the next crisis.

The story was repeated over the summer of 2008 with similar put buys in Morgan Stanley, Lehman, Merrill, and Goldman Sachs.  There was money to be made.

The unregulated credit default swap market could be easily manipulated, since trading was so thin.  A selected group of CDS’s was used in the ABX index.  This index was the basis for marking to market the holdings of many financial institutions.  Why did we, as a nation, permit a thinly-traded and unregulated private index to determine the asset values for many institutions?  There was no regulation in place for the CDS marketplace and we had a slavish adherence to the FASB mark-to-market regulations.

The Result

In these circumstances every financial institution was a target.  Some claim that the government should have stepped in — somehow.  The Bush Administration has repeatedly asserted that there was no legal basis for intervening in the Lehman failure.  The Lehman credit quality, damaged by the ABX marks, did not measure up.  The Fed could not legally lend.

Skeptics should note that even after the Lehman fall, many questioned — and still do — the aggressive government intervention.  Imagine that action had been taken without clear legal authority.

As we know, the Lehman failure was used as the basis for the TARP legislation, which had many flaws.

• It came too late.
• It targeted troubled assets, but the implementation did not deliver on that problem.
• It occurred in the lame duck period of the Bush Presidency, paralyzing government for months.

There are many critics of the policy makers, but the real problem is an inherent feature of  democratic government.

Taking dramatic new initiatives requires popular support.  People do not think in the abstract.  Until the danger is clear, public support is lacking.  Without any popular support, the leadership challenge is extreme.

Briefly put, the US political system could not address this situation without clear-cut evidence of a threat to the nation.  Even when the evidence came, many characterized the reaction as a Wall Street bailout.

Democracies are not very good at dealing with complex problems, where specific expertise is required.  This is why such issues are frequently delegated to agencies with some independence and some oversight.

The Obama Challenge

President Obama seeks to establish better financial regulation.  Unfortunately, there is little evidence that his experts have accurately analyzed the problem.  This means we may not get a strong solution.  Can we hope for Congress to point out the shortcomings?

Is it too much to ask for control of CDS trading?  Some recognition that private indices should not be the basis for lock-step public policy evaluations?

The Obama team seems to lack people with specific market expertise, who can link events to the public policy issues.

This article is Part One.  We plan to look at the economic and investor implications as well.