Lehman’s Lessons Learned
One year later, what the collapse of the banking colossus has taught us.
*
By James J. Cramer
* Published Sep 13, 2009
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.
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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.
Lehman’s Lessons Learned
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.
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
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