Lehman and the end of the era of leverage
Lehman Brothers survived the American Civil War, two world wars and the Great
Depression, but today, Monday, the firm that set the standard in fixed income
markets will be liquidated. Potential losses are so toxic that none of the
major financial institutions was willing to acquire it.
Lehmanís demise follows the failure last week of the two American mortgage
guarantee agencies, Fannie Mae and Freddie Mac. It is remarkable that the US
authorities, exhausted from their efforts to bail out the mortgage guarantors
and other firms, have left Lehman to its fate.
An enormous hoax has been perpetrated on global financial markets during the
past 10 years. An American economy based
on opening containers from China and selling the contents at Wal-Mart, or
trading houses back and forth, provides scant profitability. Where the
underlying profitability of the American economy was
poor, financial engineering managed to transform thin profits into apparently
fat ones through the magic of leverage.
The income of American consumers might have stagnated, but the price of their
houses doubled during 1998-2007 thanks to the application of leverage to
mortgage finance. The profitability of American corporations might have slowed,
but the application of leverage in the form of mergers and acquisitions
financed with junk bonds multiplied the thin band of profitability.
Wall Street and the City of London rode an unprecedented wave of profitability
by providing overpriced leverage to consumer and corporate markets. Led by the
financial engineers at Lehman, the securities industry grew an enormous
infrastructure of staff, systems, and financial exposure. They were so
successful that when the music stopped, there was no way to liquidate this
mechanism gracefully. It only could be allowed to collapse.
The Great Crash of 2008 has entered a new phase, judging from the market
opening in Europe and US equity futures prices. Lehmanís failure and the sharp
decline at other financial firms, notably American International Group (AIG),
the worldís largest insurer, have pushed equity values down to their lost
levels of the year.
As I wrote on May 20, the proximate cause of the Great Crash is the enhancement
of poor returns to capital through leverage. The decline of returns to capital,
though, stemmed from a global imbalance of supply and demand for capital in
response to the rapid aging of the world population. The aging pensioners of
Europe and Asia must find young people to pay interest into their pensions, and
they do not have enough young people at home. Germans aged 15 to 24, on the
threshold of family formation, comprise only 12% of the country's population
today and will fall to only 8% by 2030. But one-fifth of Germans now are on the
threshold of retirement and half will be there by mid-century.
In effect, Americans borrowed a trillion dollars a year against the expectation
that the 10% annual rate of increase in home prices would continue, producing a
bubble that now has collapsed. It is no different from the real estate bubble
that contributed to the Thai baht's devaluation in 1997, except in size and
It is easy to change the financial system, I argued in my May 20 essay. The
central banks can assemble on any Tuesday morning and announce tougher lending
standards. But it is impossible to fix the financial problems that arise from
Europe's senescence. Thanks to the one-child policy, moreover, China has a
relatively young population that is aging faster than any other, and China's
appetite for savings vastly exceeds what its own financial market can offer.
There is nothing complicated about finance. It is based on old people lending
to young people. Young people invest in homes and businesses; aging people save
to acquire assets on which to retire. The new generation supports the old one,
and retirement systems simply apportion rights to income between the
generations. Never before in human history, though, has a new generation simply
failed to appear.
The world kept shipping capital to the United States over the past 10 years,
however, because no other market could absorb the savings of Europe and Asia.
The financial markets, in turn, found ways to persuade Americans to borrow more
and more money. If there weren't enough young Americans to borrow money on a
sound basis, the banks arranged for a smaller number of Americans to borrow
more money on an unsound basis. That is why subprime, interest-only,
no-money-down and other mortgages waxed great in bank portfolios.
It is tempting to see in the failure of Lehman Brothers and the forced merger
of Merrill Lynch with Bank of America a failure of "corporate culture". In the
case of a great financial firm that has weathered many storms, the failure of a
business culture contains more information. Credit markets connect what we do
today with what we plan for the future. Because the future is uncertain we must
have faith in the outcome, which is why the word "credit" derives from the same
Latin root that denotes belief in the religious sense. We require a certain
degree of trust in our counterparties. It is the job of the great financial
firms to create trust between borrowers and lenders and establish a link
between the present and the future.
It is of small account in the great scheme of things, but in the sad, strange
little world of business studies, Lehmanís culture was held up as an exemplar,
a beacon to the ambitious and avaricious. Lehmanís demise is a minor event next
to the travails of Americaís mortgage guarantee agencies, which required a
government bailout last week, to be sure, but it is a landmark in the
unraveling of American corporate governance.
By a charming coincidence, the two great securities industries failures to date
occurred at the extreme antipodes of the corporate cultural spectrum. Lehman is
the second great American securities firm to fail this year, following the
March demise of Bear Stearns, the shards of which were swept up by J P Morgan
Bear was a group of scrappy outsiders, led by Jews of no social pedigree. Jimmy
Cayne, the firmís president, never finished college and began his career
literally trading scrap metal. Bearís managers played bridge, and prided
themselves on having no corporate culture except a piranhaís instinct for the
next trade. A book of memos by Bearís former CEO Alan Greenberg circulated some
years ago, including a lampoon in which the Bear chief categorized his
competitors who had bit the dust over the years according to the management
philosophy each had embraced, eg, "total quality management" and other
shibboleths. Bear proudly rejected corporate culture and management philosophy
as a matter of scruffy pride.
At Bear, partners ran their own businesses and hid their best methods from
their colleagues to prevent anyone from cutting in on their action. The
favorite method of management communication was the one-minute phone call.
Lehman held meetings to plan the meeting that would set the agenda for the
meeting that would make the decision, and of course every department and
interest had to be represented. That was called "teamwork". As a result, all of
Lehmanís resources were mustered for the projects to which the firm set its
Tongues clicked across Wall Street when Bear went down for the last time.
"Nobody liked [Bearís] Jimmy Cayne," a senior fellow at Lehman Brothers
offered, "but everybody likes [Lehman Brothers CEO] Dick Fuld. Cayne was not
our class, dear; the jumped-up refugee from a junkyard had risen too high and
received his comeuppance. The Federal Reserve opened its lending facilities for
commercial banks to securities firms for the first time in history, the day
after Bear Stearns went down. Lehman and others were the beneficiaries of
official largesse that was not offered to Bear Stearns."
Everyone may like Dick Fuld, who presides over a socially-connected,
politically-involved, army of networking specialists who have one of Wall
Streetís best stock of favors done and collectable in return. But no one likes
Fuld well enough to buy his firm, which apparently has been rejected at any
prices by a Korean bank, by Barclayís Bank of the UK, and finally by Bank of
Earlier this year, the American authorities allowed financial institutions to
mark their books at fictitious values, in the hope that eventually prices for
mortgages, consumer debt structures, corporate structured instruments and so
forth would come back. If the authorities had forced the banks to mark to the
existing market bid, all of them would have been insolvent.
The trouble is that the fundamentals are getting worse, not better - the prices
of all this structured product aren't coming back and cash flows in some cases
are being impaired. Six percent of American mortgages are delinquent, and
recovery on liquidation seems to hover around 50%, rather than the 98% level
that prevailed when home prices were rising. The longer you wait, the worse off
you are. Everyone looked at Lehman's portfolio, compared it to the market bid,
and realized that they might have a black hole of losses. The same is true of
Washington Mutual, the American thrift institution likely to go next to the
The failure of Lehman and Bear Stearns does not reflect the breakdown of a
particular kind of corporate culture. As noted, the two firms embodied
radically diverse views of corporate culture. What took both firms down,
rather, is a sudden break in the chain of expectations between the present and
the future. Todayís savers no longer can have any confidence that they will
earn enough to fund their retirements by putting money at risk. They have
discovered that in one form or another, their investments have fed a securities
market bubble rather than the creation of value.
Market participants are responding by running away from risk, as well they
should. That is the stuff out of which great crashes are made. The
bouncing-ball pattern of declining stock markets was marked by bear market
rallies each time the American and other governments stepped in to bail out the
latest victim. The US governmentís ability to influence events, however, seems
exhausted. The Treasury and Federal Reserve canít bail out everyone. After
Lehman, the insurer AIG and Washington Mutual may be next to fail, followed by
several regional banks.
I see no solution except to allow American households to begin the painful
process of rebuilding their balance sheets, which implies a slowing economy for
the next two years. It is too late to stop the
Great Crash of 2008. The question remaining is how best to pick up the