Chapter 22. Lessons from Lehman

“So I’m the schmuck?”

Richard Fuld, CEO of Lehman Brothers, on learning a rescue deal had fallen through¹

The Lehman Brothers bankruptcy triggered a market melt-down. The U.S. government tried to show that it would no longer bail out risk-taking at every turn, only to find that it had left it too late to do so. As a result, money market funds suffered a “bank run,” which paralyzed markets across the world.

The events of September 14 and September 15, 2008, Wall Street’s lost weekend, passed into popular culture almost the moment they happened. It was the weekend when Lehman Brothers, the fourth largest U.S. investment bank, filed for bankruptcy; Merrill Lynch, the third largest, sold itself to Bank of America; and American International Group, the world’s biggest insurer, begged for government support. Within months, whole books had already been published about it. Movies will doubtless follow. As the principals’ version of events has steadily reached the public, it has become clear that this succession of events might easily have been different.

But how did Lehman get into such a state and how did its fall trigger the most synchronized financial crisis in history? Its bankruptcy was part of a belated United States attempt to deal with the moral hazard that it had allowed to build up since the bailout of the Long-Term Capital Management hedge fund in 1998, only to find out that it was too late to do so because moral hazard was so entrenched that it could not be uprooted without triggering disaster. The replacement of insured banks with money markets had created the risk of a bank run. In addition, the money markets provided leverage to finance deals, meaning that any such run could swiftly create multiple disasters in multiple markets.

The first key event of the Lehman debacle came on Sunday, September 7, when the U.S. Treasury secretary Hank Paulson nationalized Fannie Mae and Freddie Mac, taking action before it was utterly necessary. Confidence in Fannie and Freddie was oozing away, but there was no particular reason to expect a move that weekend. Many, including the companies’ own executives, were surprised that it happened.

Debt-holders were protected. Foreign governments had bought Fannie and Freddie’s bonds in the belief that they were as safe as Treasury bonds and the United States was politically bound to honor these obligations. But shareholders, including “preferred” shareholders who had superior rights to holders of ordinary shares, were wiped out. Many small U.S. commercial banks held the preferred stock, which they had treated as a safe investment, so this knocked their already precarious finances. Paulson was trying to show that he was at last stamping out the moral hazard created by the LTCM rescue and he succeeded. The perceived risks of holding bank stocks escalated.

The next question was who would be next? The obvious answer was Lehman, the smallest remaining investment bank. It was sitting on credit losses, like Bear Stearns before it, and it directly owned a big portfolio of commercial real estate, which appeared likely to suffer losses. As with Bear Stearns, traders shorted the stock while buying default insurance. This did not cause Lehman’s demise, but it did determine the timing.

Lehman was incapable of opening for trading on September 15. If a bank had been found to play the role JP Morgan had taken with Bear, a rescue would probably have happened—but amid much confusion and miscommunication that dramatic weekend, no buyer came forward.² Therefore, Lehman was left to go bankrupt.

This decision led to disaster. But a look at what happened next suggests that rescuing Lehman in September 2008 would merely have postponed the reckoning—the system was primed for collapse. Beyond their belief that the financial system would benefit from a demonstration that taking bad risks could have consequences, Paulson and many of his colleagues appear to have believed that companies would have contingency plans in place, as it was six months after the fall of Bear Stearns.

But they did not have such a plan. Hedge funds who banked with Lehman found their money frozen, hamstringing them. Unable to raise cash, they sold their other assets, causing havoc in previously unconnected markets.

True panic arrived after New York markets closed on Tuesday, when the Reserve Fund, which had pioneered money market funds four decades earlier, admitted that its Primary Fund held $785 million in now worthless bonds issued by Lehman. This was far too big a gap for the management company to make up, so the fund announced that it could only pay its investors 97 cents for each dollar they had invested. In other words, it “broke the buck.” Only weeks earlier, Reserve’s chairman had told his investors that he was “boring [them] into a sound sleep.” Adding insult to injury, investors would also have to wait at least seven days for their money.

Almost simultaneously, the government announced that it was lending $85 billion to AIG and taking a controlling stake in return—another virtual nationalization. This was terrifying because of AIG’s role in using credit default swaps to guarantee debts. Effectively, its insurance allowed most of the big banks in Europe to pretend that the debts they held on their balance sheets were worth far more than they could fetch in the market. Without AIG’s insurance, the credit investments sitting in European bank vaults and in U.S. investment banks like Goldman Sachs would no longer be rated AAA and would fall in value. Under the Basel regulations, that would mean that the banks would have to find more capital to back them. Thus, failure by AIG would jeopardize the solvency of the European banking system.

Financiers understood the implications better than the public at large. These events implied a risk that customers would put their bank cards into ATM machines and no money would come out, that companies would fail to pay their workers the next week, and that credit cards would cease to work. The economic consequences were close to unimaginable. If AIG needed so much help, they understood that such an inconceivable disaster was close.

All of this triggered outright panic when markets opened on Wednesday. Investors wanted out of money market funds, while the money market funds themselves wanted out of anything that did not have a U.S. government guarantee. The result was a market bank run. That week, the money held in institutional money market funds fell by $176 billion—and the assets of funds not restricted solely to government securities fell by $239 billion. The stampede to buy Treasury bills pushed their rate down to 0.02 percent, its lowest since 1941. Security had never been so expensive. In such conditions, no company could fund itself.

It was now clear that money funds’ repeated interventions to stop any fund from “breaking the buck” had convinced investors that they were no riskier than bank accounts. A small loss of 3 percent was enough to shatter that belief. Money market funds had to a great extent gained their prominent position because, unlike banks, they did not have to pay for deposit insurance. The run after Lehman showed that they were just as susceptible to runs as banks had been before deposit insurance.

And indeed, the government’s response to the money market fund run and to the AIG crisis was effectively to offer deposit insurance after the event. They paid AIG’s contracts in full (involving the payment of more than $22 billion to banks) and offered federal guarantees on money market funds.

This was a retreat from the attempt to take a stand against moral hazard. But investors’ reaction in the days after Lehman showed that the moral hazard in the system had grown to become overwhelming. Fannie and Freddie’s preferred stockholders, Lehman’s counterpar-ties, the Reserve Fund’s clients, and AIG’s clients had all assumed that their investments were guaranteed. Such comfortable assumptions were so widespread that allowing any more failures would have made the situation far worse; Lehman’s demise proved that it was already too late to deal with moral hazard, and that the market had grown too reliant on its belief in government help.

That left politicians no choice but to revive confidence by bailing out reckless institutions and re-injecting moral hazard into the system. This would provide just the cheap money and overconfidence needed to inflate another bubble. Investors knew this.

The end of that September week saw one of the biggest rebounds ever as the government’s response took shape. Short-selling was banned and then Paulson announced a plan to spend $700 billion buying up toxic debt. Stock markets ended the week higher than they had started. That rebound showed the market trusted its politicians. The next question was whether that faith was justified.

In Summary

Lehman’s collapse proved:

• It was too interconnected to be allowed to fail.

• Money market funds were vulnerable to a bank run.

• There was too much moral hazard embedded in markets to risk letting a big bank fail. It forced governments to re-create moral hazard.