How Lehman Blew Up the City of London

Now that the horse has left the barn and is in the next county as far as the damage of overly lax financial industry regulations is concerned, a lot of people are in favor of having tougher rules. Even Tyler Cowen, who hews to the conservative side of the political spectrum, cites lax supervision as one of three major culprits in our economic crisis:

The third component has been weak governance and oversight. That includes inadequate control and monitoring by shareholders, regulators, creditors, accounting systems and ratings agencies, among others. Most people, including informed insiders, simply did not understand the systematic risk that financial institutions were accepting…

The end result was that both markets and governments failed miserably — at the same time and on the same issues. With hindsight, it is easy to argue that regulation should have done more, but in most countries, governments were happy about rising real estate and asset prices and didn’t seek to slow down those basic trends. (You’ll note that greed doesn’t play an independent role in this explanation because greed, like gravity, is pretty much always there.)

I have to quibble a bit with Cowen on the greed issue, since a cottage industry sprang up in the 1990s to justify outsized pay to CEOs and certain types of knowledge workers, so that compensation that would once have been deemed as outrageous came to be seen as normal.

Put it another way: when a former Goldman Sachs co-chairman, John Whitehead, lambasts Wall Street pay levels and calls for Goldman to cut compensation, you know there is something wrong.

But back to the main thread. While there has been some general talk about simplifying and consolidating the financial services regulatory framework, there has been perilous little discussion of specific measures, beyond some obvious ones, like putting more products on exchanges and subjecting mortgage brokers to licensing and supervision.

One reason for little progress, even on the conceptual level is it takes time, thought, and a lot of study to devise sound, lasting regulations. It requires both focusing on the right broad objectives and then getting the details right. The securities regulations implemented in the Great Depression (the Securities Act of 1933 and the Securities Exchange Act of 1934) were well though out, well integrated programs that have stood the test of time surprisingly well. Indeed, what undermined these laws was that their effectiveness in promoting deep liquid markets, which in turn mean that relations with shareholders are anonymous and arm’s length (even with extensive disclosure, a public company cannot tell its shareholders as much as a private firm would to venture capital investors for competitive reasons). Thus, governance, as Columbia professor Amar Bhide pointed out in a 1994 Harvard Business Review article, is inherently deficient in public companies.

But nevertheless, consider the 1933 and 1934 Act’s aims:

1. Provide frequent, timely disclosure about financial condition and results, top executive and director backgrounds, shareholdings, and compensation

2. Discourage insider trading

3. Prevent market manipulation

Elaborate and detailed regulations were devised to further these goals in order to protect investors against abuses by companies and broker/dealers.

John Hempton illustrates a case of how seemingly hoary US regulations worked well, and by contrast, the UK’s blind embrace of deregulation has done lasting damage to London as a financial center.

The case study is the Lehman bankruptcy. In both the US and the UK, the firm had hedge funds as customers. Hedge funds often take margin loans against their holdings. A broker has a customer sign an agreement giving the broker broad authority to loan (“repledge”) those securities. The broker needs to do that to fund the loan.

Here is where the fun bit comes in. The US has pretty tough rules on the use of these securities, while the UK had none, and it is becoming clear that Lehman abused its latitude in the UK, and the damage is considerable. From Hempton:

The US had huge problems with broker-dealers in the 1930s…Enter the US Securities Exchange Act of 1934. This is one piece of depression era legislation that survives and thank the Good Lord for that.

What the broker dealer act does is (a) ring fence the US broker dealer and (b) limit the amount that the broker dealer can borrow against your securities and the amount of collateral it may take.

I am hardly a lawyer – so take the bush lawyer caveat – but the way it works is that the broker dealer may not borrow against your securities to finance their own business, only client business. So Lehman Brothers US broker dealer could take collateral of securities and if they had 100 million out on client margin loans the most that they could raise using client securities is 100 million and not a brass razoo more. This is really important because it meant that client assets were not used to finance Lehman’s disastrous commercial real estate and other businesses.

Moreover when you deposit a million dollars at the broker dealer and give them the right to repledge those securities they can only rehypothecate 140 percent of your outstanding balances…

So (provided the broker is not acting criminally) you should get the bulk of your money back if the broker dealer fails. And provided the capital requirements are adequate (and they mostly are) the broker dealer won’t fail. Even the Drexel Burnham Broker Dealer did not fail….

The result. Whilst Lehman brothers went bust Lehman US broker dealer did not. This pretty well saved the US hedge fund industry.

Europe however was a different story. Lehman Europe failed – and the clients of the European broker dealer (read a good proportion of the London hedge fund community) are now queuing as unsecured creditors of Lehman. Many funds have folded. Far more have been nicked. Whilst the US hedge fund business is currently looking dazed, confused and a little problematic the UK business is on life support.

In some sense this is the end of the City of London.

I am on record as saying the UK took Maggie Thatcher to heart and deregulated financial activity to such an extent that the whole UK market worked without capital…

But now with the biggest bank in the world by balance sheet (Royal Bank of Scotland) effectively nationalised and the and a large part of the UK hedge fund community lying with open veins it looks a little stupid.

This puts in a different light the 8 billion dollars that Lehman London transferred to the US when it was failing. I stand open to correction – but I would guess that the money was obtained from client accounts from the European/London broker dealer. It is certainly being investigated by Lehman clients. This is a scandal of the first order allowed by an insane lassis faire approach to financial regulation.

So here is a plea for US Depression style financial regulation. Some of it (such as the Broker Dealer regulation) was well thought out and should be duplicated. (Some of it was less sensible…)

If I have a plea to my home country (Australia) after the Opes Prime debacle – a copy of the US 1934 Act would be a good start.

As for London – I am sorry, but it is a wreck. Maggie Thatcher you stand condemned.

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  1. bg

    Is it any coincidence that the Minsky cycle seems to be about 70 years – which is about the amount of time that humans can hold a memory, before they start to repeat the same mistakes? My dad lived the depression. I did not. And until now I didn’t believe it could happen again. He would not have been surprised, but he is no longer here to instruct.

    Dutch Tulips, south sea bubble, … Each had government bailouts and re-regulation. I think our grandchildren will find our ideas quaint too.

  2. Richard Kline

    *HAhaHAhaHAhaHAhaHAaAaAaAaAaaaa!* I know, I know, some innocents have lost real dough, but I can’t help—*HAHHAHHAHHAHHAHHAHHHHHAAAAA!* _And it was all legal_! whatever the ethics. The only place you will _ever_ see a true Sodominte’s Circle is in the center of the capital marketplace.

    It took nearly a generation for Margaret Thatcher to bankrupt her country, but she got her way—and we see where it leads. Bleed-out into blackness . . . .

  3. a

    “Is it any coincidence that the Minsky cycle seems to be about 70 years – which is about the amount of time that humans can hold a memory, before they start to repeat the same mistakes?”

    Well, it looks that way, except that in the old days Panics occurred more frequently (about every 20 years, or once a generation). But maybe the severity of the Great Depression caused less risk taking for more time, and thus increased the length of the cycle.

  4. Nick von Mises

    Gordon Brown set up the FSA, stripped the BoE of its regulatory role, and just generally ran the economy for eleven years with the cack-hand of government.

    And MAGGIE gets the blame?????

    Yves, I don’t know how close you are with UK politics but “blame Maggie for everything” is a cottage industry of it’s own for the left-leaning. Won’t be long before the history books have Maggie shooting Archduke Ferdinand.

  5. Yves Smith


    The quote is from John Hempton, but I don’t necessarily disagree. Thatcher was the loud and forceful advocate of deregulation. She put the pendulum in motion and I have no doubt would have approved of the financial services deregulation measures.

    If you haven’t seen the BBC video series “The Century of the Self” yet, it is a must view. It sets out how deliberately mass culture was shaped by Thatcher and Reagan around these issues, and how the left became hostage to them (among many other things).

    This post has links to all the segments in the series.

  6. Richard Kline

    So Nick von M., heap all they disdain upon ‘New Labour’ for the running dogs they’ve been; they deserve every fleck of spittle. But they took up Old Iron Drawers’ program because that was the only way to get into power. Her cadre were the push for the Big Bang, and the ‘conceptual,’ not to call it even pseudo-intellectual, force behind freeing capital from its chains in Britain. There’s enough blame to go around, but strike at the root and see it for what it was.

  7. wintermute

    The City of London watchdog – the Financial Services Authority employs 2,700 people at an average of £77k per annum.

    None of them saw the credit crisis coming! They didn’t even investigate Northern Rock until the week it melted down.

    So now their CEO wants more staff paid even more money. Gee. They might have a chance of spotting the depression coming in 2009/10.

  8. Timothy

    Hi Yves, I manage a fund in London and our PB contract has exactly the same 140% limit on rehypothecation: not sure what exactly went on with Lehmans but it was not standard PB procedure (have used several through my career).

  9. dearieme

    “I have no doubt [she] would have approved of ..”: oh, Yves, come, come. You couldn’t hang a cat on that evidence.

  10. Anonymous

    Maggie Thatcher quote: “Society doesn’t exist!”

    So enough said on that score, let the dead lie quietly – Oh God, is she still alive?

    As for bg’s seventy year Minsky cycle (it’s a bit off issue), it is in fact 80 years (1928 – 2008, remembering the stock market peaked in Europe in 1928), and if you go back another 80 years you arrive at 1848, which was also a big financial/economic crisis time(though not in the USA). But really this cycle shows itself up in the history of ideas even more -1848 marked the beginings of socialism, 1928 the beginnings of fascism. And of course 1768 marked the beginnings of Whiggism and the American Revolution.

    What will we remember 2008 for?

    Aghh! This is all dinner table talk… but it is Sunday.

  11. &#%@*

    Everyone knows that Reagan and Thatcher came to power in response to the excesses of over-regulation.

    Therefore, this crisis should be blamed on too much regulation…which of course, paved the way for the dearth of regulations which paved the way for this mess.

    If you don’t like this post, know this:

    It’s a response to the previous posters. So blame them.

  12. Chris

    The AIG story seems to be quite similar to what is reported here about Lehman.

    I think this account from yesterday’s Washington Post kind of enriches the view Paul Kedrosky was circulating a couple of weeks ago.

    AIG’s default swaps were engineered by their London-based financial products unit.

    As for Brown versus Thatcher and stuff, please remember, Brown was appointed to be Blair’s number 2 precisely because he was NOT qualified to be Prime Minister and was therefore no threat to Blair. He was appointed Prime Minister because he was Blair’s number 2, and therefore next in line. That’s just the British way of doing things.

    When he was number 2 he helped create the present mess to support Blair. Now he is in the job he was never qualified for he is metamorphosed into the genius who will clean up his own mess. This probably means who will be held to account when the real mess he made becomes public.

    So you see, the issue is not one of personalities at all, but rather one of process. Tragic? Comic? I guess it all depends on how the outcome will be perceived.

  13. Matt Dubuque

    The so-called “Washington consensus”, likely judged to be the KEY foreign policy initiative of both the Clinton and Bush and forced upon countless nations against the will of their peoples, is clearly dead.

    The Global South celebrates its demise, not a moment too soon.

    It’s time to take back the planet.

    Matt Dubuque

  14. Thingumbobesquire

    Well, since we’re on the subject of what was done to quell speculative excess in the 1930s, the 800 lb gorilla in the room happens to be Bretton Woods. Why? What led to derivatives (recently rightly referred to in Congressional testimony as the latest incarnation of Bucket Shop practices) engulfing the world monetary system? It was none other than the end of the system of settling imbalance of trade among nations in gold. After the Nixon administration pulled the plug on this in 1971 the scene was set for a global casino of currency speculation. One bubble after another was created and blown out. Now we are at the point of either attempting insanely to further hypothecate our economies or to return to the Bretton Woods system of stability.

  15. Anonymous

    I have recently been rewatching the 7up series, which is a fascinating documentary if you take it for what it’s worth. The first three in the series are somewhat hijacked for me by John, an openly determined traditionalist and judgmental moralist, who over the course of the 14 years between 7 and 21 seems to have used his considerable brain power to develop apologia for the instincts and inculcation that were present when he was seven.

    One of the most compelling possible answers to the question of “why do obviously intelligent humans (the true cream of the crop) often have completely and diametrically opposed beliefs and ideologies” is that intelligence is as much a barrier to development as it is a facilitator, in that the combination of intelligence in an extremely complex world allows cognitive dissonance to work overdrive (i.e., to completely crowd out any dissenting views from the spectrum of the plausible).

    Of course, those who have spent their lives trying to justify their initial distaste for regulation are going to blame this crisis on *too much* regulation, in much the same way that many still think that tax cuts are the solution to every problem, even budget deficits. If you have a hammer, every problem is a nail. There seems to be no end to the true lunacy (correctly defined as doing the same thing and expecting a different result) that can be the end result of this feedback loop of high intelligence and cognitive dissonance.

    As a student of epistemology, I think it’s fairly clear that I don’t *know* who is to blame here. But many have been saying, for nigh about thirty years, that Thatcherite policies would lead to this. They made logical, factual arguments and were shouted down for decades as the global credit bubble grew ever larger. They may not have been right. We should not overlook that correlation is not always causation. But for now, I will give them the benefit of the doubt. I may not *know* who is right, but I have to go forward based on my evaluation of the arguments in the light of the facts, and I am not currently siding with the *over-regulation* crowd.

  16. Bill

    If this crisis is the price we had to pay for ending the nuttiness Labour rule in the 1970’s, then it is a price well worth paying.

  17. Anonymous

    Where the Nazis failed, the hedge funds succeeded. By wiping out the wealth of millions of people, especially pensioners, you destroy their property. In many cases you destroy their livelihood. The Nazi’s weren’t necessarily trying to destroy the property in London, as much as terrifying the populace to weaken their resolve to fight on. Their aim was capitulation. Put in financial terms, that is what the masters of the universe are now manifesting.

  18. pow wow

    Well, in the ‘fingers crossed’ department, there seems to be at least some possibility that the U.S. Congress will actually listen to, study, and then proceed to publicly and democratically debate and enact the best ideas from a variety of government and non-government expert witnesses who are finally being invited to testify in full committee hearings, which are being pulled together during this campaign hiatus of Congress-as-a-whole. Putting on ice, perhaps, though way too late, the sort of secret, lobbyist-written, industry-rewarding, “leadership”-negotiated deals that have bypassed open Congressional hearings and honest debate to go straight into law in our corporate-financed, Party-leadership-ruled Congress of Parties-Not-Members, for far too long.

    Here’s the first of a number of promised hearings that (the apparently-conscientious and acting in good faith) Chris Dodd held last Thursday in the Senate Banking Committee (the committee members present for this hearing besides Dodd were Senators Crapo-ID, Akaka-HI, Brown-OH, Casey-PA, and Menendez-NJ); Dodd said he hopes to hear soon from two former Republican chairs of the SEC, in addition to Arthur Levitt’s testimony on Thursday:

    That Senate hearing is still being replayed by C-SPAN, and is available in its video archives, here:

    Likewise, here's the line-up for the first meaningful committee of jurisdiction hearing (in HFSC) held since the Paulson Panic – scheduled for this Tuesday at 10:00 a.m.:

    “This hearing will focus on the extent to which an outdated and weak regulatory system contributed to the current market turmoil and whether adoption of a stronger and more robust financial regulatory system could contribute to a more rapid recovery in the financial markets and the economy.”

    Witness List & Prepared Testimony:

    Panel One
    The Honorable Alice M. Rivlin, Senior Fellow, Metropolitan Policy Program, Economic Studies, Director, Greater Washington Research Project, Brookings Institution

    Dr. Joseph E. Stiglitz, Professor Columbia University

    Mr. Joel Seligman, President, University of Rochester

    The Honorable Manuel H. Johnson, JohnsonSmick International

    Panel Two
    The Honorable Steve Bartlett, President and Chief Executive Officer, The Financial Services Roundtable

    Mr. Edward Yingling, President and Chief Executive Officer, American Bankers Association

    Mr. T. Timothy Ryan, Jr., President and Chief Executive Officer, Securities Industry and Financial Markets Association

    Mr. Mike Washburn, President and Chief Executive Officer, Red Mountain Bank on behalf of the Independent Community Bankers of America

  19. Aaron Krowne

    Ah, the eternal folly of a fractional reserve system. Since it’s not real money, why stop at lending the same credits out only once?

    Don’t congratulate the US too much; over here they gave a wink and nod to de facto fraud like Citigroup’s $2 trillion of off balance sheet SIVs and VIEs.

    Seems like, as long as the government approves of this general system, they will find areas in which to allow enough credit hypothecation to generate at least a short-term “wealth effect”.

  20. Anonymous

    When was the last time the world had a completely fiat monetary system?
    Precisely. Would it really be surprising that the result might be orders of magnitude worse than than the civilizational meltdown in the first half of the 20th century. Couldn’t happen? How do you prove denial of the future?

  21. Matt Dubuque

    Matt Dubuque

    Anonymous at 1215:

    In terms of the 7 up series, you will likely remember the “sudden” transformation in 49-Up of the little East Ender miscreant who in 7-Up stated that fighting is a necessary part of life.

    In 49-up he had now turned around his life and bought a little “palace” in Spain…. it now looks highly likely that the property he purchased was part of the Spanish real estate bubble.

    Can’t wait for 56 up to see how that story plays out!

    Matt Dubuque

  22. Glory's List

    I think things will definately get worse in London, i.e., all eyes will soon turn from the Lehman train wreck to the Madonna-Ritchie train wreak. The fallout is expected to be considerable I’m afraid, and expect no bailout:

    “Expect more ‘ugliness’ in Madonna-Ritchie split:”

  23. Glory's List

    I think things will definately get worse in London, i.e., all eyes will soon turn from the Lehman train wreck to the Madonna-Ritchie train wreak. The fallout is expected to be considerable I’m afraid, and expect no bailout:

    “Expect more ‘ugliness’ in Madonna-Ritchie split:”

  24. Ginger Yellow

    “The precedent set in that case means that individuals involved in financial transactions that were legal in the UK can still be prosecuted for violating US laws if the victims resided there.”

    Um, that’s true for any crime, anywhere. The one-way extradition set-up is screwy, it’s true, but if you commit a crime as a resident in a country, you shouldn’t be surprised if you get prosecuted for it. And the NatWest 3 were certainly no martyrs.

    On the main point of the thread, I’ve no love for Maggie, but it’s fair to say that New Labour shares just as much of the blame on this front. They’ve consistently shied away from tighter regulation of hedge funds, despite making lots of noise, because they were dazzled by the argument that fund managers would take all their tax money overseas.

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