Lehman’s Lessons Learned

Illustration by André Carrilho

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.

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.

See Also
Career Advice for Dick Fuld and Other Unemployed Financial Titans

James J. Cramer is co-founder of TheStreet.com. He often buys and sells securities that are the subject of his columns and articles, both before and after they are published, and the positions he takes may change at any time. At the time of this writing, he owned Wells Fargo, Bank of America, and Goldman Sachs for his charitable trust, ActionAlertsPlus.com. E-mail: jjcletters@thestreet.com. To discuss or read previous columns, go to James J. Cramer’s page. Get all of James J. Cramer’s stock picks via e-mail, before he makes the trades, by subscribing to Action Alerts Plus. A two-week trial subscription is available at thestreet.com/aap.

Lehman’s Lessons Learned