A year and a half ago, I ate breakfast with Dick Fuld, then the CEO of Lehman Brothers, at the firm’s midtown headquarters. Fuld had called me in to try to stanch the rumors that his firm—which had triumphed over all of the competition, all the Goldmans, Morgans, Merrills, and Citigroups, in the global bond business—would soon be buried under an avalanche of bad debt.
After years of struggling as a second-tier fixed-income house, Lehman had jumped to the head of the pack, establishing itself as the banker to the world, with a huge deposit base and a seemingly unassailable lending position. Fuld was determined not to let any silly nonsense, like rumors about a shaky capital position or a faltering book of business, bring him and his all-powerful firm down.
I told Fuld that the shorts seemed to be certain that Lehman was on the verge of collapse. I said that the only way to stop them was to provide far greater transparency about the company’s health or ask the SEC to reinstate the uptick rule, a tool once used to keep unscrupulous short-sellers from essentially destroying a company by talking down its value in order to make their own bets pay off.
But Fuld obviously wasn’t interested in my suggestions. He dismissed them out of hand. What he really wanted was simply to strong-arm me into believing that all was well at Lehman. He also had another agenda. He wanted to know who was out to get him. Who had to be punished for their short-selling sins. He was like a one-man House un-American Stock Activities Committee. He wanted me to name names. Who was doing this to Lehman, the best fixed-income house in the world? Who was doing this to him, the man who had survived so many putsches and coups and disasters? Who?!
The cavernous dining room suddenly seemed crowded, claustrophobic even. Fuld’s ego had filled the place to beyond capacity, a veritable fire hazard of pride and paranoia. When I left the room I wished I had been back at my old hedge fund joining the gnashing, growling bears, knowing that there were still 43 juicy points between the closing price that day and the Götterdämmerung that this once-legendary firm now faced.
We all know what happened next. The world was right, and Fuld was wrong. Lehman’s mountain of bad debt was exposed, the government refused to come to the firm’s rescue, and, on September 15, the formerly mighty financial giant filed for bankruptcy, nearly dragging the global economy down with it. So what have we learned from Lehman’s demise? Pretty much everything that’s important about Wall Street, so let’s go down the list.
Lesson one: Shadow banks are time bombs. A year ago in this country, we had two banking systems: the regulated one, in which banks were subject to Federal Reserve scrutiny (maybe not enough, but certainly some), and the far more important and powerful one, the shadow bank system made up mainly of Lehman, Merrill Lynch, Morgan Stanley, and Goldman Sachs. While the regulated banks were forced to make reports to the government and were subjected to bank examinations, shadow banks were pretty much required to tell us only what they wanted us to know, and nothing more. They issued earnings statements four times a year, like other public entities, but never broke out how they really made their money or how much capital they had or how much leverage and inventory they were taking on or how much credit they were willing to give clients. In Lehman’s case, we knew next to nothing at all, which turned out to be catastrophic. At its peak, Lehman may have been the biggest lender on earth, without anywhere near the capital on hand to protect itself or the system if the loans went sour. Only no one knew it at the time, and Lehman wasn’t required to tell.
That’s all over now. Although the SEC, the Federal Reserve, the Treasury Department, and other regulators were oblivious to Lehman’s power and the reach of all the shadow banks when they closed the firm, they are painfully aware of the cost of such cluelessness now. Since the Lehman debacle, the government has taken over AIG, the quasi-shadow bank disguised as an insurance company. The Feds used a howitzer to wed the unregulated beast that was Merrill to the somewhat more tamed, at least by relative comparison, Bank of America. Even Goldman and Morgan Stanley were forced to seek the Federal Reserve umbrella to save themselves, an umbrella that dramatically cut the amount of leverage they could employ, at least until they paid back the loans. In the past year, the shadow banking system went from being bigger and more important than the regulated banks to being nonexistent. We now know pretty much everything we need to know about how the big banks operate. There are no more surprises to be had, at least no giant ones. There are no more Lehmans lurking that can almost destroy the system again.