Sep 11

5 Years After Lehman Brothers: Still a Whodunit


Here we are, five long, winding years after the demise of the venerable Lehman Brothers investment banking firm (recaps and outlooks by Bloomberg and Institutional Investor). What have we learned from that event, the beginning of the Great Recession, the most recent financial crisis? And, just as importantly, like a good mystery novel, whodunit: Who was the firestarter that ignited the financial storm that brought down Lehman, and, with it, started the Great Recession?

What have we learned? Perhaps obvious to all of us now, but not as obvious in mid-2008:

– The Fed is NOT infallible. All this Greenspan-speak about letting the market discipline itself only goes so far. After a while, the market moves to extremes (in both directions) and sometimes intervention can be a good thing. Since 2008, we’ve been arguing about what kind of intervention (monetary and/or fiscal related, and how much). That is an argument that will undoubtedly continue, because we also have learned…

-Economics is NOT a science. It is basically a social science with a lot of mathematical formulas used to ‘approximate’ reality. To paraphrase what we say at SAA during our own analyses, “Just keep repeating: It is only a model, it is only a model.” Alas, economists have tried to take on a position in society similar to physicists. Sorry, folks, but when reality is impacted by human nature, it has difficult following ‘natural laws.’ We’ve got a better chance of understanding quantum mechanics than micro or macro economies. Think about that last sentence and you will see how difficult economic forecasting and policymaking is, which also relates to another learned concept.

– Those rocket scientists in Wall Street might have served society better by keeping staying rocket scientists. Back to the problem with modeling human behavior, only this time tied to valuing complex securities. One bad assumption like: ‘house prices in the US can never go down more than post World War II experience’ can ruin a rocket scientists day…although not for long, because he or she can always get a new job at one of those…

– “Too Big To Fail” banks. Yes, we thought that failing banks are supposed to be taken over/reorganized by the FDIC, with bad assets purchased by the Feds and good assets and deposits purchased by a healthy bank. We were partially correct, as that happened time and again with non-TBTF banks. It is only those large enough to have outsized market, and more importantly, political influence that were automatically saved via TARP. No need to go into the abuses on that program, since Neil Barofsky, the TARP Special Investigator, tells us all about it in “Bailout: An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street.” (include Amazon link) Most book titles are hyped up by the publisher to sell books. No hype needed here. And, that may cause some in government to say…

– “You never want a serious crisis to go to waste.” That sums up the focus of many in government, who automatically assume increased regulation will be better for the economy, for consumers and, most importantly, for themselves (as they rake in contributions from both sides of an issue). Does more government regulation help or hurt the overall economy? Once again, this is an ‘it depends’ answer, further clouded by the fact that economics is NOT a science. There are no petri dishes to test the impact of a given regulatory change before implementing it. And, that means any change in regulations is an experiment to some degree. Doesn’t this make you feel a bit like a guinea pig? Which reminds me…

Whodunit? Who was the fire-starter of the financial crisis?

My number one candidate is FASB, the Financial Accounting Standards Board. Let’s harken back to 2008, the first calendar year that FAS 157, “Fair Value Measurements” became effective. In essence, FASB had finally decided (after numerous comment periods, etc) that banks would have to mark to market assets (including their loan holdings available for sale, or impaired), putting the change in value on the income statement for all to see.

As stresses started to move through the sub-prime mortgage market (mortgages issued just two and three years ago were starting to re-set at onerously high rates), the banks were forced to face reality and unable to shy away from FAS 157. One of the most levered, Bear Stearns, became the ‘canary in the coal mine’, going out of business in a shot-gun marriage arranged by the Fed to J.P. Morgan in March, 2008.

At the CFA Institute Annual Meeting in May, 2008, one of the sessions focused on FAS 157, where panelist and chairman of FASB, Robert Herz put the controversies in perspective, by noting that mark-to-market was just an “implementation problem.” Right-o, Bob.

Stresses in the mortgage market grew, and we all know about the Lehman story in September, 2008.

Oh, and by the way, if you think accounting was not the fire-starter? After Congress passed a law requiring the SEC to study the issue in October, the SEC, in December, said mark-to-market should not be changed and that mark-to-market was not a cause of the financial crisis. Well, we all can trust our government to be forthright and honest, right?

In March, 2009, Congress stayed on this issue and heard from the not-so-prescient Mr. Herz, warning him to re-write mark-to-market or Congress will do it for him. That may have been the scariest warning during the entire financial crisis.

Four days later. Four days later! The FASB proposed changes to mark-to-market that let banks abandon the required mark downs of sub-prime mortgages.

(It is notable that during the past week of activities, the S&P 500 had reached its nadir for recent history, having dropped about half in value from its previous high. From henceforth, the S&P 500 recovery had begun.)

So, was it really sub-prime mortgages that were the fire-starter of the financial crisis, or was it the way banks were forced to account for them? I believe it was the latter and with that, I think another important lesson has indeed been learned for the future….maybe.

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