Lesson two: Banks shouldn’t loan more money than they can afford to. One of the great hallmarks of the Federal Reserve under Alan Greenspan was his ability to create massive amounts of credit to get the economy moving and keep it forever growing. Greenspan favored financial engineering that allowed institutions to lend out a lot of money on very little capital, depending on the magic of the free market to weed out the bad borrowers and lenders and keep only the good ones. But when you join the wonders of financial engineering with unregulated shadow banks, you create a world in which there is no penalty to lending money to anyone and the government is helpless to stem the tide. Lehman was perhaps the greatest financial engineer of our time, pioneering and packaging all sorts of exotic mortgage-backed securities and other financial products that you could buy and borrow against, allegedly with the safety of treasuries but with higher interest rates. Because of that chimerical imprimatur, something that the ratings agencies, Standard & Poor’s and Moody’s, gave their seal of approval to, Lehman was willing to lend firms as much as 30 times the value of every dollar they had under management to buy its mortgage products. When the bonds soured because of the housing crash and Lehman’s hedge-fund clients couldn’t pay the firm back on their loans, banks throughout the system cut off Lehman’s credit, knowing that the firm could never afford to finance the toxic assets it had to take back from its clients as collateral.
Lehman’s demise spelled the end to reckless highly leveraged lending. The Federal Reserve and Treasury have since made it clear that banks must raise their capital levels and cut back on lending losses. To meet the Fed’s demands, banks have to take in more cash and lend a lot less, making sure the money they do lend is given only to people with very good household balance sheets and companies with long records of being able to pay back their debts. In a year’s time, we have gone from a world where you could borrow $30 million to buy toxic mortgage bonds with just a million dollars in your pocket to a world where a million bucks in the bank might allow you to get a $500,000 mortgage to buy a house if you can prove you can keep your job. The standards have gotten that tight. And if you do make too many bad loans, the Feds will seize your bank and put you out of business. Yes, tight credit may slow the pace of the recovery in the short run, but it’s a dose of stringency the system sorely needed.
Lesson three: Moral hazard is not a policy, it’s a suicide pact. On the eve of Lehman’s collapse, in a series of weekend meetings, Fuld’s lieutenants told then–New York Federal Reserve head Tim Geithner and then–Treasury Secretary Henry Paulson that if the government let Lehman collapse, a trillion dollars in credit could vanish overnight, financial institutions worldwide would experience liquidity shortages, and even ATM machines might not work because companies and people would panic and pull their money out of financial institutions. Paulson and Geithner wouldn’t listen. They wanted to be tough guys and show that they weren’t going to kowtow to Wall Street anymore. They were worried about the moral hazard of having to bail out still one more errant universe master. They should have been worried about the nuclear hazards of not doing so, because, on this point anyway, the Lehman folks were right. When Lehman went under, banks worldwide experienced colossal withdrawals as everyone from corporate treasurers to individuals transferred money out of their cash accounts into treasuries. Worries of moral hazard proved penny-wise and ton-foolish as almost every major banking institution, not just in America but worldwide, needed capital to make up for the post-Lehman withdrawals. Of course they should have bailed out Lehman that weekend—and then put hurricane fences around the remaining shadow banks and get them under control gradually over time. Trillions of dollars and millions of jobs were vaporized when Lehman was allowed to go under, and the financial world’s radiation sickness still lingers.
Lesson four: The shorts are too powerful. Lehman didn’t collapse because of the shorts; it collapsed because it made billions in overly risky loans. But the shorts did play a significant role in the downfall of the firm because they never let the stock lift or stabilize long enough to give the beleaguered outfit the time it needed to find a buyer or deep-pocketed investors. If the SEC brings back the uptick rule and rigorously enforces another measure known as the naked short regulation—and I expect it will do both soon—the investing playing field will have been leveled between the shorts and the longs and the markets will be far safer and honest for all, especially retail investors, than they have been in years.
Lesson five: A few good banks is better than a lot of bad ones. In the wake of Lehman, we now find ourselves with just a handful of banks left standing that have huge deposit bases and lots of capital—JPMorgan Chase, Wells Fargo, Bank of America, Morgan Stanley, and Goldman Sachs. Although it’s wise to be skeptical of concentration, the upside of this situation is that the banks that are left are reliably solid. Having passed the Fed’s stress tests and being subject to far tighter regulation and greater transparency than before, they should be able to handle even the most profound downturn that could await us. They should also see their net worth build up at a rapid pace. The bad loans they have had to write o≠ are peaking, the new loans they’re making are more reliable, and they have less competition. The Lehman legacy, ironically, could be a better, stronger, humbler, more trustworthy banking system. While we certainly took a difficult, painful, and avoidable path to get there, it looks like there might be something positive to celebrate on this dubious anniversary after all.