•The financial crisis of 2007-2010; was it simply the result of lax regulation, or
were a range of factors at play? (50 marks).
In its analysis of what went wrong during the financial crisis of 2007-2010, the Turner
review determined that it was a global story of macro trends mixing with financial
innovation to create an explosive mix of growing debt, sophisticated credit
securitisation and cavalier behaviour in the major Western banking systems. It raises
fundamental theoretical issues around market efficiency and rationality and given that
it is a global financial market and that there is no global government, it is difficult to
assert that it is simply the result of lax regulation.
Nonetheless, the radical deregulation process that began in the late 1970s led to the
integration of modern financial markets. There are key structural flaws in this New
Financial Architecture (NFA)1 that certainly helped generate the crisis.
This essay intends to outline the key deregulatory acts in the US that facilitated the
enormous growth of the financial markets. Rather than examine the ideological shift
that has occurred over the past half-century, it will analyse how the deregulation and
lax regulation fuelled three critical, structural developments; unhealthy financial
innovation, perverse incentives and dangerously high, system-wide leverage. The
financial crisis was created by this “new world” of leverage, deregulation and
‘financial innovation’. With sufficient regulation these developments would not have
mutated into the chronic problems that they became, and therefore lax regulation was
to blame for the crisis.
The process of deregulation
In the aftermath of the Great Depression, it was universally believed that unregulated
financial markets were inherently fragile, subject to manipulation and corruption by
insiders and capable of triggering deep economic crises and political and social
unrest. Commercial banks were accused of being too speculative in the pre-depression
era. Banking became greedy, sloppy and objectives became blurred.
A strict financial regulatory system worked effectively to protect the USA from these
dangers. This framework was based on the financial market theories of endogenous
Crotty, James, Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’
Cambridge Journal of Economics 2009, 33, p567
1
financial instability advocated by John Maynard Keynes. His theories propelled the
shift from light to tight financial regulation.
The Glass-Steagall Act (Banking Act) and Securities Act of 1933 were passed to
address the failures of the financial system.2 These set up a regulatory firewall
between commercial and investment bank activities. Financial giants, such as JP
Morgan, were seen as a problem and, as a consequence, forced to cut their services
and a large source of their income.
The Securities Exchange Act of 1934, along with the Investment Company Act of
1940 and the Investment Advisers Act of 1940, created a regulatory framework that
successfully held off abuses and boom-and-bust financial cycles.3 Combined, this
regulatory framework limited the commercial banks securitising activities and limited
the affiliation between commercial banks and investment banks. For instance, only
10% of commercial banks’ total income could stem from securities- however an
exception allowed them to underwrite government-issued bonds. It was prudent and
sensible regulation to protect the consumer from the risks of the banking sector.
The economic crises of the 1970s and early 1980s led to both a paradigm and a policy
regime shift. Efficient financial market theory began to dominate economic thinking
and this eventually facilitated the transition to a new globally-integrated, deregulated,
neoliberal, capitalist environment.
The limitations the Glass-Steagall Act (GSA) imposed on the financial sector sparked
intense debate over how much restriction was healthy. The Federal Reserve, under
Alan Greenspan’s control, engineered the whole deregulation of the US banking and
financial system. Simultaneously, laws preventing the merger of banks in different
states were repealed, as was the insurance/banking split. “Merger Mania” finally
pushed the GSA to its very limits and consequently, in November of 1999 Congress
repealed the GSA with the introduction of the Gramm-Leach-Bliley Act (GLBA).This
was a critical development because it eliminated restrictions against affiliations
between commercial and investment banks. Furthermore, it allowed the banking
institutions to provide a broader range of services, including underwriting and other
dealing activities. It is widely regarded as the most pivotal and historic act of
Gilani, Shah, How Deregulation Eviscerated the Banking Sector Safety Net and Spawned the US Financial Crisis. Money
Morning, 13th January 2009
2
3
http://www.huffingtonpost.com/mitchell-bard/one-lesson-from-the-1930s_b_216901.html
deregulation in the ‘modern economy’, and many trace this single moment as the
beginning of the financial crisis of 2007-20104.
A year later, the Clinton administration introduced the Commodity Futures
Modernisation Act (CFMA) that was designed to exempt futures and derivatives from
regulation. In particular, credit default swaps (CDS), which are contracts that require
one party to pay the other in the event that a third party defaults on some obligation,
could no longer be regulated by states as insurance or gambling.
In addition, capital requirements for investment banks were also significantly
weakened. In 2004 the SEC unanimously voted to permit the net capital rule change
that allowed investment banks to significantly increase their leverage5.
At the same time as the Federal Reserve was introducing fairly drastic deregulation,
the Bush administration was expanding mortgage lending and increasing
homeownership across the USA. The American Dream Down payment Act of 2003
implemented many of Bush’s recommendations, and subprime lending, financed by
mortgage securities, dramatically increased.
Paul Mason, economics editor at the BBC, describes the knock-on-effect. “In the
space of twelve months, Gramm’s legislation laid the basis for four crucial
developments in US finance that would, within a decade, sink the system: deregulated
investment banks, expanded subprime mortgage lending to the poor and ethnic
minorities, a planet sized derivatives market, and the fusion of banking and
insurance”
The introduction of the GLBA, CMFA and the net capital rule had distinct
implications for financial institutions across the USA. This report will analyse the
emergence of 3 critical developments in the structure of the banking industry;
financial innovation; high system-wide leverage and perverse incentives. It will
conclude that these structural flaws in the environment resulted in the financial
collapse of 2007-2010.
Financial Innovation.
4
Mason, Paul Meltdown, The end of the Age of Greed 2009 p56-57
http://newsandinsight.thomsonreuters.com/Securities/Insight/2012/07_-_July/
Is_deregulation_to_blame_for_the_financial_crisis_/
5
The years prior to the crisis saw an extraordinary acceleration in financial innovation
which developed new instruments and systems to be used in the lending and
borrowing of funds. These changes, which include innovations in technology, risk
transfer and credit increased available credit for borrowers and gave banks new and
less costly ways to raise equity capital6. These fuelled the bubble that caused the
collapse, partly because they actually increased the availability of credit and partly
because they hid the risk that was inherent in the system. This innovation could have
been regulated.
The very low interest rates of 2001-2006 were hugely lucrative to the banks.
Combined with a falling stock market in the early 2000s, banks became awash with
cheap money. Shah Gelani described how “Wall Street went to work manufacturing
all manner of products to squeeze extra yield out of this ultra-low-interest-rate
environment”7.
Banks became more creative and enticed new and less creditworthy home-buyers into
the market with exotic mortgages, such as “interest-only” loans and “optionadjustable rate” mortgages.8 Secondly, freed by deregulation, the banks found new
business by converting consumer debt into tradeable securities and then selling these
securities on. This work resulted in a huge distribution of derivatives; particularly
mortgage-backed loans, that increased the instability of the entire system before 2007.
And two new financial products; CDOs and CDSs grew enormously and their
complexity allowed them to avoid the safeguards in the system. The Financial Times,
at the end of 2007, explained the situation well: “A plethora of opaque institutions
and vehicles have sprung up in America and European markets this decade, and they
have come to play an important role in providing credit across the system”.9
The deregulation of CDSs meant that banks could effectively buy insurance against a
mix of subprime and prime loans, called a Collateralised Debt Obligation. This
process meant that risks were bundled together, averaged out, reduced and then
finally, moved off balance sheet. According to
Source 1A
6
http://www.investopedia.com/terms/f/financial-innovation.asp
7
http://moneymorning.com/2009/01/13/deregulation-financial-crisis/
CDO issuance in billions($)
Whalen, Charles. The US Credit Crunch of 2007. A Minsky Moment. The Levy Economics Institute of Bard College No,92,
in billions($)
2007 p14.
8
Gillian Tett and Paul. J Davies Out of the shadows: How banking’s secret system broke down. December 16 2007. Financial
Times Article (http://www.ft.com/cms/s/0/42827c50-abfd-11dc-82f0-0000779fd2ac.html#axzz2QdvioNXN)
9
CDO
issuance
Borio, “the main manifestation had been the extraordinary expansion of credit risk
transfer instruments, which permitted the transfer, hedging and active trading of credit
risk as a separate asset class”10 Essentially, the CDS became an risky process that
allowed investment banks to expand their lending business without violating any
regulation.
Demand for CDOs was strong in the boom because buyers could borrow money
cheaply, house prices were rising, returns were high for banks and the products
carried top ratings11. The global market for CDOs had been $271billion in 2005,
growing to $370billion in the early months of 200712. Similarly, CDS’s grew rapidly
during the years before the crisis; by 2007 their coverage exceeded $60trillion. As
trillions of dollars in risky mortgage-related securities spread through the US financial
system, and into much of the global financial system, in the mid 2000s, the financial
system became ever more vulnerable to a deflation of the housing bubble.13 This
vulnerability could have been avoided if there had been stronger regulation of the new
banking methods, or indeed, if the stronger regulation of previous decades had been
maintained.
Unfortunately, the party stopped, and the consequences of financial innovation and
deregulation came home to roost. The prices of subprime mortgage CDOs fell
dramatically in 2006, indicating higher perceived default risk of the underlying assets.
New York University’s Nouriel Roubini observed that CDOs “were new, exotic,
complex, illiquid and misrated by the rating agencies. Who could ever be able to
correctly price or value a CDO model?”14 Unease, panic and defaults plagued the
credit system. Suddenly, Structured Investment Vehicles (SIVs), set up to handle
CDOs, were calling on their parent banks to make good their losses. Next, the credit
ratings agencies unleashed a spate of downgrades15. Eventually, by February 2009 it
Borio, Claudio, The Financial turmoil of 2007-?: a preliminary assessment and some policy considerations. Monetary and
Economic Department, BIS Working Papers, March 2008
10
Crotty, James, Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’
Cambridge Journal of Economics 2009, 33, p567
11
12
Mason, Paul Meltdown, The end of the Age of Greed 2009 p96
David M, Kotz (2009) The Financial and Economic Crisis of 2008: A systemic Crisis of Neoliberal Capitalism. Review of
Radical Political Economics 2009 41: 305
13
14
Roubini, N. 2008. ‘How will financial institutions make money now that the securitization food chain is broken?’
15
Blackburn, Robin, The Subprime Crisis New Left Review. March 2008, p68
is estimated that almost half of all CDOs
issued had defaulted16. The high
ever
Source 1B
default rate of CDOs had an
enormous impact on credit
Default rates
of CDO assets
protection firms like AIG, who had
insured investment banks like
Lehman’s against default on CDOs
on massive scale, not understanding
the true underlying risk. Suddenly,
what began as a housing crisis
plagued other markets.
Financial innovation, before the financial crisis, proceeded to the point where
important structured financial products were so complex that they became inherently
non-transparent and dangerous. Gillian Tett, of the Financial Times, contrasted the
myth and the reality of these complex financial innovations during this era:
“Innovation became so intense that it outran the comprehension of most ordinary
bankers- not to mention regulators. As a result, not only is the financial system
plagued with losses on a scale that nobody foresaw, but the pillars of faith on which
this new financial capitalist were built have all but collapsed.”17
Not all financial innovation is destructive. Many of the new financial instruments
have been introduced to increase credit and homeownership across the US in
particular and this is a desirable goal. But some of these products were misleading and
designed to be so. It is clear that better regulation could have been applied.
Deregulatory acts meant that banks developed innovative ways to make more money,
and they appeared attractive and safe because it was difficult to ascertain the real level
of risk. Regulators should have ensured that these new products made both cost and
risk transparent if the catastrophic bubble was to be avoided.
High system-wide leverage
In a speech in June 2009, Barack Obama described how a “culture or irresponsibility”
was an important cause of the crisis and it is difficult to see how culture could have
16
Financial Times. 2009. Half of all CDOs of ABS failed. 10 February.
17
Tett, G. 2009. ‘Lost through destructive creation, Financial Times, 10 March 2009.
been controlled by regulation18. But this culture manifest itself in an unprecedentedly
high level of corporate and consumer borrowing, and this level of borrowing could
have been limited or regulated.
The Federal Reserve slashed interest rates from 6.5% to 3.5% in the first 8 months of
2001, and the in the aftermath of the 9/11, pushed them down to 1%. As Paul Mason
described, “money, if you could borrow it, was effectively free”19. US household
consumption grew disproportionately to US household income and as a result, US
household debt grew significantly before the collapse (illustrated below by Source C).
This dramatically increased the vulnerability of the financial system
Easy credit conditions combined with
Source 1C
governmental homeownership policies
contributed to a substantial increase in
subprime borrowing. Subprime mortgages
are, by definition, higher risk lending as
there is a higher chance of default. So, the
dramatic expansion in these mortgages,
particularly 2004-2006, inherently meant
that the financial system became
vulnerable to toxic/riskier debts.
Research by Raghuram Rajan indicated
that: “Starting in the early 1970s, advanced economies found it increasingly difficult
to grow...the shortsighted political response to the anxieties of those falling behind
was to ease their access to credit. Faced with little regulatory restraint, banks
overdosed on risky loans". Subprime lending had risen from less than 5% of mortgage
lending in the US in 1994 to more than 20% by 2006. 20 This is important because this
meant there was substantially more risky borrowing throughout the system.
Arguably, more destructive risk taking behaviour took place in the banks themselves.
As already discussed, the “Net Capital Rule” replaced the 1977 net capitalization
rule’s 12-to-1 leverage limit. In its place, it allowed unlimited leverage for Goldman
18
http://www.cbsnews.com/8301-503544_162-5093760-503544.html
19
Mason, Paul Meltdown, The end of the Age of Greed 2009
http://www.nytimes.com/2012/10/17/business/economy/income-inequality-may-take-toll-on-growth.html?
pagewanted=all&_r=0
20
Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. These
banks ramped leverage to multiples of 20-, 30-, even 40-to-1. Stephen Labaton of the
New York Times declared: “The exemption would unshackle billions of dollars held in
reserve as a cushion against losses on their investments. Those funds could then flow
up to the parent company, enabling it to invest in the fast-growing but opaque world
of mortgage-backed securities; credit derivatives, a form of insurance for bond
holders; and other exotic instruments.”21
In loosening the capital requirements, which are supposed to provide a cushion during
turbulent economic times, the agency also decided to allow the big investment firms
to use their own computer models to evaluate the riskiness of investments,
“essentially outsourcing the job of monitoring risk to the banks themselves”.
Over the following years, all the big investment banks of USA took advantage of
these looser requirements. This extreme leverage leaves very little room for error. By
2007, the financial system had become, to use Hyman Minsky’s famous phrase,
‘financially fragile’22.
Leverage is a double-edged sword that is a powerful ally during boom times, but can
quickly become your worst enemy during the ensuing bust. The collapse or bailouts
of some of the most highly regarded financial institutions –Fannie Mae, AIG ,
Lehman Brothers and Merrill Lynch- was principally due to leverage and the reduced
capital requirements. Infectious leverage, therefore, became one of the root causes of
the financial crisis.
So whilst the culture and behaviour cannot be directly regulated, the environment of
credit, which encourages that risk-taking behaviour, could have been. It should have
been possible to manage the gap between consumption and earnings in the Western
world by reducing the availability of credit. Instead, the regulators reduced the capital
burdens on banks, allowed interest rates to reduce and eventually created the credit
boom which delivered the subprime crisis.
Perverse Incentives
21
New York Times. 2008. Agency’s ’04 Rule Let Banks Pile Up New Debt. Published: October 2, 2008 by Stephen Labaton
Crotty, James, Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’
Cambridge Journal of Economics 2009, 33, 563-580
22
It is reasonably clear that the sustained period of economic growth immediately
preceding the crisis led the leading players to become significantly less cautious, and
this risk taking behaviour was incentivised, encouraging innovative new products to
leverage balance sheets to the limit. This was a third contributory factor that could
have been avoided if regulation had been stronger.
Barack Obama has joined eminent economists, in claiming that the problem was
precisely that bankers knowingly took excessive risks, pushed by two perverse
features of the system. Firstly, banks were considered too big and too important to
fail, and secondly, the short-term nature of the pay systems meant long term risk was
broadly ignored. These perverse incentives often resulted in imprudent business
decisions.
Firstly, the advocates of the NFA had declared that financial institutions would
instinctively be risk-averse because failure would result in losses and bankruptcy.
However, in the build up to the 2007 financial crisis, a situation of moral hazard
emerged whereby financial institutions had a tendency to take risk, knowing that the
potential burden of this risk would be borne by others. As a consequence,
compensation structures of the banks gave bankers an incentive to disregard risk. In
good years, they stood to make huge amounts of money; in bad years, even if the
bank lost money, they would still make healthy sums. This gave employees the
incentive to take excessive risks because they could shift their potential losses to
shareholders. This disconnect between compensation and bank performance results in
a “heads I win” and “tails you lose” bonus system.23
This hazardous environment began with the Federal Reserve’s bailout of Long-Term
Capital Management (LTCM) in 1998. With around $126billion in assets and widely
regarded as too big to fail, LTCM set the precedent for the Federal Reserve’s bailouts
of Bear Stearns, AIG, Fannie Mae and Freddie Mac during the crisis. The LTCM was
an early warning signal of the same problems that plagued during the 2008 financial
crisis. Martin Wolf (2008a) aptly put it, no other industry but finance “has a
comparable talent for privatising gains and socialising losses.”24 It has therefore been
Kirshnan Sharma, (2012) Financial Sector Compensation and excess risk taking- a consideration of the issues and policy
lessons. DESA Working Paper No.115
23
24
http://www.cato.org/sites/cato.org/files/serials/files/cato-journal/2009/1/cj29n1-12.pdf
argued that the banks did not act responsibly because they believed they did not have
to bear the consequences of their risky actions.
Thus, inadequate control of moral hazards often leads to socially excessive risk-taking
—and excessive risk-taking is certainly a recurring theme in the current financial
crisis.25 It would clearly have been better to control the banks through regulation
rather than to pay for their failure.
Secondly, the short-term pay structures also played a prominent role in creating an
environment that focused on short-term goals and profits. The compensation
structures of many of the world’s largest investment banks institutionalised shorttermism and undermined the incentive to take a more responsible longer-term view.
The absence of any delayed compensation structure only gives managers an incentive
to focus only on the period to their next bonus.26 Record breaking profits 2004-2007
in the financial industry meant more bonuses and incentivised more risk-taking
behaviour. Raghuram Rajan argued that “by paying huge bonuses on the basis of
short-term performance….banks create gigantic incentives to disguise risk-taking as
value creation”.27
Therefore, the global financial crisis of 2007 can also be partly blamed on the
remuneration policies within financial institutions. According to Turner (2009) “There
is a strong prima facie case that inappropriate incentive structures played a role in
encouraging behaviour which contributed to the financial crisis”. Executive pay
linked short-term profits to bonuses, had no consideration for exposure to risktaking28.
There is little doubt that pay levels incentivised executives to pursue high risk
strategies. Since the crisis, there is a widespread view that whilst pay linked to
performance is vital, it is also necessary for rewards to be withheld until the risk taken
in the short term is fully understood. If the high street element of banks had been
either separated or secured, the “casino” element of banks could have been allowed to
suffer the consequences of failure. If banker’s bonuses were affected by later losses,
the risk taking would reduce.
25
http://www.cato.org/sites/cato.org/files/serials/files/cato-journal/2009/1/cj29n1-12.pdf
26
Kevin Dowd Moral Hazard and the Financial Crisis page 144
27
Financial Times (2008) Regulators should intervene in banker’s pay by Martin Wolf. Published 15th January 2008
28
P.Gregg, S.Jewell et al. 2011. Executive Pay and Performance: Did banker’s bonuses cause the crisis? P5
Conclusion
There was nothing simple about the financial crisis of 2007-2010 and there were a
wide range of factors at play. The explosive combination of enormous and growing
debt level, new financial product which was complex and poorly understood, and
lucrative and unrestrained reward for risk taking meant that a crisis was inevitable.
But each of these ingredients could have been controlled by regulation and if credit
control had been tighter, products made simpler and reward more moderate, the boom
and bust of the period would have been much reduced. Instead, dazzled by a belief
that the free market solution would protect itself and deliver growth, the regulators
stepped aside and the conditions for the crisis were left uncontrolled. Therefore, the
root of the crisis began in the 1970s with the introduction of the neoliberal, freemarket capitalism which consequently pursued intense deregulation.
b)In light of your discussion in part a), answer the following question: Could
Lehman Bros.’ collapse have been
avoided if it had followed a different
business model? (50 marks).
Lehmans Historic
Share Price (h p://
bespokeinvest.type
pad.com/bespoke/
2008/06/lehmanleh-the.html)
The financial crisis of 2007/8 had a
devastating effect on all of the Worlds
banks and most of the world’s major
economies, and it is clear that regardless of the business model which might have
been adopted by Lehman Bros, it would have been unable to avoid serious
consequences. But the fact is, Lehman Bros collapsed in the same environment in
which other similar banking operations survived, and it is illogical to believe that this
collapse could not have been avoided. This section is going to analyse how Lehman
Brothers’ business strategy resulted in its own demise.
The business model adopted by Lehmans from 2002, under the leadership of Chief
Executive Richard S.”Dick” Fuld meant that it was in the worst possible position as
the environment changed. Its business model focused on a ruthless growth strategy
that invested in illiquid, innovative assets on an enormous scale primarily through
unsustainable leverage. And it had a corporate pay structure that incentivised risk-
tt
taking behaviour like no other player. If the cause of the crisis, as discussed, was
increased and unsustainable credit driven by highly leveraged banks finding
innovative ways to take greater risk, then it is entirely unsurprising that Lehman Bros
fell first and fell hardest. This report concludes that there were 2 structural flaws to
Lehman’s business strategy. I plan to explain how Lehman became more highly
leveraged than its competitors and pursued financial innovation more rigorously
primarily because of a prideful, disillusioned management incentivised by short-term
pay structures.
Financial Innovation
This following section will analyse how Lehman’s business model aimed at achieving
rapid growth, but the banks investments were primarily weighted towards illiquid
assets such as mortgages29. By not investing so heavily in financially innovative
products, that have proven lethal since the collapse, Lehman Brothers may have
avoided bankruptcy.
Traditionally an investment bank, Lehman Brothers rapidly advanced into new areas,
including asset management services, proprietary trading and capital market. It
quickly expanded into new products that boosted income at the expense of taking on
substantially more risk30. It was the higher leverage, allied to the more significant use
of new, innovative and ultimately high-risk product that created the fatal flaws in the
Lehman strategy.
In particular, Lehman’s strategy was to invest heavily in 2 markets which have proven
to be deadly and illiquid; Mortgage-Backed Securities and Credit Default Swaps.
When housing prices were booming, mortgage-backed securities were one of the
hottest investments on Wall Street. The ravenous appetite for these securities, and the
rich commissions reaped by those selling them, encouraged the underwriting of everriskier loans that failed when the housing bubble popped.31
Recognising the opportunities of MBS trading, Lehman rapidly expanded these
activities from 2000-2009. Lehman’s acquisition of BNC Mortgage and Aurora Loan
services eventually resulted in Lehman securitizing $146,000,000,000 in MBSs in
29
http://jenner.com/lehman/docs/debtors/LBEX-DOCID%201401225.pdf
30
Lehman Brothers Case Pack
31
http://articles.latimes.com/2012/apr/27/business/la-fi-compensation-20120427
2006 alone32. This was a dramatic 10% increase from 2005 and dramatically more
than rivals. Eventually in 2007, Lehman Brothers would become America’s largest
underwriter of property loans
Another factor adding to Lehman’s catastrophe was their involvement in the CDS
markets. Lehman was accused of packaging MBSs into Collateralised Debt
Obligations, performing Credit Default Swaps with insurers such as AIG and
therefore effectively self-eroding the value of these securities. Paul Mason explained
how CDSs “never worked as an insurance policy against default; but they did work as
a new way of moving liabilities off-balance sheet”.33 CDSs are notoriously illiquid,
complicated, and non-transparent and widely represent what Warren Buffet described
as “weapons of financial mass destruction.”34
As interest rates rapidly increased and house prices dropped, a substantial decline in
the subprime market set in. By 2006, default rates on subprime mortgages became
dangerously high; increasing to 7.5% from lows of 2.4%. Lehman’s wide exposure to
the MBS and CDS markets meant that the investment bank suffered cataclysmically
as defaults on subprime mortgages became problematic
Lehman’s exposure to subprime defaults is well demonstrated by source 2b. In 2008,
Lehman’s assets were substantially more vulnerable to a housing collapse compared
to competitors. Mortgages accounted for 60% of their asset portfolio. Lehman’s
subprime lending arm, BNC mortgage, quickly shut down in 2007and its toxic
lending quickly unravelled. In 2008, Lehman announced a $2.5billion write-down due
to defaults on commercial real estate- substantially greater losses than rival.35
Lehman’s executive decisions focused on unprecedented growth that eventually
meant Lehman was critically exposed to innovative markets that have, in hindsight,
proven illiquid, unstable and hazardous. Unfortunately, their decisions to actively
trade in the CDS market, insuring their risky and toxic CDOs, eventually had
catastrophic consequences in other markets.
High(er) Leverage
32
Duncan, Sawyer. 2012. Causes of Collapse: The Failure of Lehman Brothers Holdings, Inc. The University of Georgia, page8
33
Mason, Paul. Meltdown. The end of the age of greed. Page 87
34
http://www.creditwritedowns.com/2008/10/lehman-brothers-primer-on-credit.html
35
Why Lehman Brothers Collapsed. Cliff D’Arcy on 14 September 2009. ARTICLE
Another deadly element to Lehman’s business strategy was its increasing leverage in
the run up to the crisis. Lehman Brothers' bankruptcy was a direct result of its highrisk and aggressive leverage policy. As already discussed in part a) leverage for the
industry increased significantly and was a key driver of improved profitability before
the crash. So, in the run up to the financial crisis of 2007, Lehman substantially
increased their leverage ratio in order to increase their lending activities and, in turn,
increase their profits.
Following the SEC amendment governing investment bank leverage in 2004, Lehman
retained significantly less capital on reserve to protect against losses or defaults.36 The
Net Capital Rule meant a “relaxation of the leverage limit for investment banks from
$12 to $30 per $1 of capital”37.
Lehman’s business model focused primarily on unprecedented, rapid growth. This
meant expanding the net balance sheet and leverage.
Therefore, a destructive element of Lehman’s ambitious strategy was that it became
too highly leveraged compared to the financial industry. Before 2007, for instance,
Lehman swelled its balance sheet by almost $300 billion through the purchase of
securities often backed by residential and commercial real estate loans. But in the
same period, the firm added a miniscule $6 billion in equity.38 As a result, Lehman’s
leverage ratio increased 28% from 2004-2007, consistently retaining a higher leverage
than competitors. 39 Another element of Lehman’s financial policy that proved
destructive was their short-term debt financing. In the period leading up to the
company’s bankruptcy filing, Lehman was relying on up to $200billion of short-term
financing per day.40 By Feb 2008, Lehman were operating a short term debt ratio of
up to 54.59%, so any minor depreciation in their assets was going to have an
enormous impact on the efficacy of the firm.41 Lehman Brothers had extremely high
quantities of subprime mortgages in their securitisation pipelines and once doubts
36http://clubs.cob.calpoly.edu/~cmiller/552/cases%20without%20teaching%20notes/Lehman%20on%20the%20brink.pdf
37
Duncan, Sawyer. 2012. Causes of Collapse: The Failure of Lehman Brothers Holdings, Inc. The University of Georgia, page11
38http://money.cnn.com/2008/09/15/news/companies/lehman_endofwallstreet_tully.fortune/
39
http://jenner.com/lehman/docs/debtors/LBEX-DOCID%201401225.pdf
Lehman Brothers Holdings Inc, et al, Debtors, Chapter 11 Case No. 08-13555(JMP). United States Bankruptcy Court,
Southern District of new York (2010)
40
41
http://www.slideshare.net/rakeshsancheti/fall-of-lehman-brother
were raised about the accuracy of the ratings and about their value, short-term lending
to Lehman dried up- literally overnight.
Lehmans also manipulated statements and accounts to deceive investors and used
techniques to reduce its reported leverage. Lehman used a scheme called Repo 105 to
deliberately undervalue its liabilities, and this also had an impact on their leverage
ratio. It was a trick allowing Lehman to sell packages of mortgages, Treasury bonds,
Eurobonds, even Canadian government instruments, on a temporary basis at the end
of an accounting quarter, with an obligation to buy them back a few weeks later. It
made Lehman’s balance sheet look healthier than it was. This allowed Lehman to hide
almost $50billlion worth of assets.42 Other investment banks did not actively partake
in Repo 105 transactions as persistently as Lehman Brothers, and this strategic
decision made Lehmans much more vulnerable to a credit or liquidity crisis. In fact,
Goldman Sachs and Morgan Stanley, competitors with Lehman who survived the
financial sollapse, said they have never used any such transactions.43
Ultimately, Lehmans high leverage ratio meant that the company was insufficiently
protected from the collapse of the subprime market. Regulation limiting leverage
ratios may have lessened the magnitude of the subprime crisis as this essay has
already argued. But in the absence of regulation, Lehman’s chose a strategy that
delivered higher leveraged debt than its competitors, when it would have been better
protected had it chosen to maintain a better capital positions. Unfortunately, because
of its extraordinary growth strategy, Lehman had primarily weighted most of this
enormous leverage towards illiquid assets such as mortgage backed securities and
CDSs44.
This next section will analyse how these executive decisions were directly encouraged
by Lehman’s executive pay structure.
Perverse Incentives
As part a) discovered, perverse incentives were a major cause of excessive risk taking
behaviour. This section is going to analyse how Lehman’s executive pay structures
incentivised their management, under Dick Fuld, to pursue a ruthless growth strategy
42
http://www.guardian.co.uk/business/2010/mar/12/lehman-brothers-repo-105-enron
43
Financial Times (March 13, 2010) Lehman File Rocks Wall-Street. By Francesco Guerrera and Henny Sender
44
http://jenner.com/lehman/docs/debtors/LBEX-DOCID%201401225.pdf
that was highly leveraged and that invested heavily in risky markets. The executive
decisions to increase issuance of MBSs and to increase leverage were directly the
consequence of a pay structure that incentivised Lehman’s leadership to take much
more risk in a much more dangerous environment. Therefore the underlying weakness
of Lehman’s business strategy was that its direction was too strongly influenced by a
prideful, incentivised executive.
Of course, there is nothing unusual about outrageous pay structures in the financial
industry. What was unique to Lehman was the effect that their pay structures had on
their management’s business decisions. The huge bonuses meant that their executive
management mercilessly pursued short-term growth in fragile markets. Wide
exposure to the subprime collapse and unsustainable leverage were directly the
consequence of pay packages that incentivised Lehman’s management to pursue
short-term, limited growth. The structure of executive compensation at Lehman, from
2000-2008, shows executives were incentivised to improve short-term earnings at the
cost of excessively high risk of large losses in the medium term.45
As a result of prosperous times, Lehman Brothers paid out around $1billion to their
top executive team in cash bonuses and equity sales between 2000 and 2008 which
they did not pay back following the collapse. The top executives at Lehmans almost
expected to earn between $8million-$51million each through cash, stock and other
compensation in 2007, months before the bankruptcy of their company. Between 2000
and 2007, Lehman paid Dick Fuld a total of $350 million, an astounding sum for a
company Lehman's size.46
Lehman pursued a rapid growth strategy from 2006. Driven by huge bonus structures,
Lehmans management sought 13% annual growth in revenues supported by “an even
faster increase in the firm’s balance sheet, total capital base and risk appetite”.
Lehman’s management quickly ramped up its illiquid investment portfolio
manipulating their risk tests, raising and exceeding all types of risk limits.47 As
already discussed, in the run up to the financial crisis, Lehman became one of the
largest underwriters of illiquid securities. This allowed greater revenues, greater
profits and greater bonuses. Kentaro Umezaki illustrated Lehman’s risk taking- “the
Bebchuk, L.A., Cohen, A & Spamann, H. (2009) The Wages of Failure: Executive Compensation at Bear Stearns and Lehman
2000-2008. The Harvard John M. Olin Discussion paper Series, pp1-27
45
46
Kevin Dowd Moral Hazard and the Financial Crisis page 151
47 Anton
Valukas Report
majority of the trading business’s focus is on revenues, with balance sheet, risk limit,
capital or cost implications being a secondary concern.”48. Lehmans decision to ramp
up leverage was only to continue with excessive, unsustainable growth that
guaranteed profits and bonuses, for the executives, in times of prosperity.
There have been numerous studies suggesting that pay arrangements at the large
investment banks incentivised their executives to take excessive risk. In particular, a
2009 study by Harvard University, looked at the pay structure at Lehmans “Although
there is a possibility that the executives decisions could be due to their failure in
recognizing risks, the role of their pay arrangements in influencing excessive risktaking behaviour cannot be dismissed.”49
Therefore, this essay argues that Lehman’s executives were incentivised to pursue a
higher risk strategy, by taking a more aggressive view of the risk than its competition.
Implementing short-term pay structures meant that Lehman’s executive had no
incentive to consider long-term risks which eventually encouraged enormous leverage
and dangerous financial engineering.
Conclusion
The short answer to the question of what caused Lehman’s collapse is to lay blame at
the feet of Ben Bernanke and Henry Paulson. As representatives of the Federal
Reserve and US Treasury, they held the fate of Lehman in their hands. It is undeniable
that a bailout would have saved Lehman. In 2006, they had found a way to bail out
Bear Stearns from a similar position, so if the will to support Lehman was there, they
could have also helped Lehman.50
Of course it is true that the collapse of Lehman Brothers was avoidable if a different
strategy had been adopted. There are numerous examples of investment banks
recognising and avoiding the “credit-fuelled craziness”. JP Morgan for example took
prudent actions and resisted the temptation to leverage up meanwhile some
investment banks such as Lazard and Evercore Partners in the US did not participate
48
http://www.bloomberg.com/news/2010-06-11/lehman-probe-lesson-avoid-big-trouble-by-shunning-stupid-e-mail-terms.html
Bebchuk.L, Cohen et al “The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008” Yale
Journal on Regulation, Vol. 27, 2010, pp. 257-282
49
Rikard Smistad (2011) The Failure of Lehman brothers: Was it preventable? If so, How? Recommendations for going forward.
SMC University
50
in the securitisation of mortgages at all.51 Whilst the first part of this paper rightly
concludes that the crisis itself could have been avoided if stronger regulation had been
in place to control credit, complexity and reward, it is clearly true Lehman could have
avoided bankruptcy because many causes of the Lehmans collapse stem from
Lehman’s own internal management decisions.
The moral hazard environment embedded at Lehman Brothers was out of control.
Instead of “creating value” the practices of financial engineering/innovation, huge
leverage, aggressive accounting and dodgy credit rating have enabled the executives
at Lehman to walk away with the loot. Being unconstrained by risk management and
a lot of the time plainly ignoring it, corporate governance and financial regulation,
Lehman’s executive pursued an unsustainable growth strategy that resulted in the
collapse of one of the world’s fourth largest investment bank.
Lehman’s business model, more so than the rest of Wall Street, relied on leveraging
up equity and using all the debt to accumulate a giant portfolio of securities. Its failure
was the result of an antiquated, risky strategy that depended on macroeconomic luck.
That strategy was self-serving as it grossly overcompensated greedy employees for
being in the right place at the right time.52
Lehman’s collapse was the result of 2 factors; the change of the economic
environment and the risky business model adopted. Assisted by the lack of financial
regulation it was an enormous oversight of the risks involved.
Lehman pursued a business model that was more highly leveraged, more innovative
and rewarded risk taking more generously than all its competition at a time and in a
market in which all these things were already overheating. Fuld’s business approach
even advocated accounting malpractice similar to the Enron scandal of 2001.Nothing
was to stand in the way of the success he expected. Even as the market collapsed, he
was convinced of the veracity of a counter cyclical growth strategy. Lehman Brothers
were operating a policy that meant that they were the Lemming at the front. It is
therefore unsurprising that they were the first to go over the cliff.
Jeffrey Friedman (2009) A Crisis of Politics, not economics: Complexity, Ignorance and Policy Failure. Critical Review
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52http://money.cnn.com/2008/09/15/news/companies/lehman_endofwallstreet_tully.fortune/
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