Guest Post: Reflections on Blowups and Bailouts

By Thomas Adams, at Paykin Krieg and Adams, LLP

Denial Was Rampant in the Buildup to the Financial Crisis. Arguments that Lehman Should Have Been Bailed Out Show that Denial Continues Today

While this week marks the first anniversary of the shocking collapse of Lehman Brothers, it is also the second anniversary of the events that triggered the demise of my former company. My old employer’s passing doesn’t generate much press these days, but the extensive coverage of Lehman has reminded me of a memorable meeting I had at Lehman’s office two years ago. At the time, Lehman sat in judgment we made the case that we were fundamentally sound and would survive the mortgage crisis.

In the many articles that discuss the Lehman collapse, the most common conclusion is that the Bush Administration made a major error by not bailing out the investment bank as they had done for Bear Stearns. The financial chaos that erupted after Lehman failed could have been avoided or minimized; the argument goes, if the government had thrown Lehman a lifeline.

My company was unable to convince Lehman, or anyone else, that we were worthy of a bailout. Today, I am thankful for that. Based on my own experience, I believe a Lehman bailout would have merely delayed the inevitable and, even worse, helped the company and the financial community avoid owning up to the many mistakes that had been made in the prior years. The fact that so many people continue to argue that a Lehman bailout was necessary, leads me to conclude that denial is still a big issue in the financial and political worlds.

In the years leading up to 2007, my company was an active participant in the mortgage backed securities (MBS) and collateralized debt obligation (CDO) markets. In fact, these were the areas I oversaw. I built my nearly 20 year career on being a careful and conservative analyst and I ran my groups accordingly. I wasn’t a cowboy and I always avoided the excesses that some folks in our industry embraced. I thought that this would protect me and my company against any downturns in the market.

In September of 2007, following the failure of the Bear Stearns hedge funds and the downgrade of billions of dollars of sub-prime MBS by the rating agencies, the market sentiment for the MBS and CDO business was souring rapidly. My company was receiving frequent inquiries from investors and clients about our financial condition. Our explanations of the rigorous analysis we used for MBS and CDO bonds were being met with increasing skepticism and, despite our efforts, the market was losing confidence in us. Our ability to get new business was being adversely affected.

We embarked on a series of meetings to assure people of our soundness and expertise. One of the big meetings we had in September of 2007 was with Lehman Brothers. Although the meeting was intended to be a big picture presentation on the overall financial condition of our company, the Lehman analysts were only interested in asking about our MBS business. I was charged with responding to their questions and I was grilled for over two hours on the details of our portfolio. As the meeting progressed, the mortgage traders fired increasingly hostile questions at me regarding particular bonds. Across the room, several analysts began whispering to each other and grinning. I continued my presentation, explaining how careful we were when we took the bonds on and how thorough we were when we reanalyzed the bonds, but my audience was hardly listening. One analyst asked how we could have possibly taken some of these deals into our portfolio.

A few days later, an investment bank published a report suggesting that our company might be seriously undercapitalized. As at the meeting, the report suggested that our MBS portfolio showed that we were foolish and much weaker than our competition. The report and our unsuccessful meeting with Lehman marked the beginning of the end for our company. Isn’t it odd, I mentioned to one of my co-workers, that Lehman and this report gave us such a hostile assessment, when both banks were big issuers and investors in the same MBS? Were they really that much smarter than we were?

Over the course of the next few weeks, our company struggled to address the market’s loss of confidence and announced plans to seek additional capital to get us through the market dislocation. Privately, however, I was losing confidence in our ability to survive. As we did more and more analysis on our portfolio, I began to realize that, even though I had been careful and conservative when I took those MBS and CDO bonds on, I had been wrong about their quality and value. I became concerned that the problems we saw in our MBS and CDO portfolios might infect the entire financial community. My dreams were haunted by visions of a massive financial crisis, bank failures, layoffs and a return to the bad old days of the late 1980s.

Despite my worries, the rest of the world seemed unconcerned. The stock market and New York City real estate prices were hitting record levels. Our competitors and other financial institutions assured the market that they were well capitalized and only the weakest players, such as my company, would be in trouble. Our management, though concerned, remained convinced that our company would survive.

The stress of trying to reconcile these competing views took a toll on me. I was out for a week with vomiting, headaches and fever. When I returned to the office, I continued to work hard on our analysis and tried to find solutions to our travails, but I no longer believed that we would survive. Eventually, my bosses lost confidence in me and began freezing me out of meetings and internal discussions. By December, I was informed that I would be let go as an example of accountability for the mistakes. By January, I was on the street and my long career in the industry, of which I had been so proud, came to an unceremonious halt. A few weeks later my company was downgraded and effectively out of the business, as well. Though my future was uncertain, I was relieved to be free of the stress of living in a world overrun with false optimism and denial. I blamed myself for my mistakes but I resolved to learn from them and move forward.

In January of 2008, most of the world still viewed the crisis as an isolated issue. Many people in the market would continue to blame the issues on just small segments of the market, such as sub-prime mortgages. As I talked to people in the industry, I was amazed by the finger pointing and denial, despite the problems they would soon be facing themselves. When Bear Stearns blew up in March of 2008, the dynamics of denial quickly triumphed again. Lehman aggressively assured the market that they were fine and much different from Bear Stearns who was, by implication, much weaker and more reckless than they had been. As the market seemed to take this blow up and subsequent issues in stride, I began to wonder if my fears of a coming doomsday were just another mistake I had made.

Eventually, the problems at Lehman mounted and they, like my former company, were no longer able to fend off the skeptics. Despite a relatively peaceful interlude after Bear Stearns collapsed, the broader world finally began to realize the implications of the issues that had been triggered by the sub-prime crisis. Many people were shocked when company as large and savvy as Lehman was brought down by problems in the previously obscure sub-prime MBS. The collapse triggered a panic throughout the global markets. I, on the other hand, was surprised it had taken so long for people to realize the extent of the problems in the market.

Of course, I am sorry that Lehman didn’t survive. I wish my former company hadn’t collapsed, as well. It took me a while but I eventually realized that I, and my company, had made a number of serious errors and we would have to pay the price for them. The sub-prime mortgage problems that emerged in the summer of 2007 were serious for the entire market, not just the weakest players. Avoiding and denying did little to make these same mistakes go away for Lehman. A bailout may have further delayed the final reckoning, but the truth was that they had made many mistakes on a large scale and they, or the taxpayers, would ultimately have to own up to them. Without Lehman’s failure, I have no doubt that many people would have continued to argue that the problem was isolated. In fact, the issues of bad investments, excessive leverage, inflated valuations and bad risk management (among others) reached virtually all corners of the global financial universe. Lehman’s failure exposed the depth of both the crisis and the rampant denial. In addition, the collapse finally forced the financial and political communities to own up to their mistakes. This, I believe, is the important less to remember as we mark the unfortunate anniversary of Lehman’s collapse.

Thomas Adams is an attorney at Paykin Krieg and Adams, LLP and works as a strategic consultant and expert witness on issues relating to the financial crisis. He previously worked at FGIC, Ambac, Moody’s and Thacher Proffitt and Wood. Tom can be reached at tadams@pka-law.com or thomasadams3@mac.com.

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11 comments

  1. Hugh

    I don’t know how to react to this post. On the one hand, it is a personal and interesting take by an insider on housing and financial debacle. On the other, I have to wonder what you were thinking. In 2005, economics wasn’t even a focus of mine yet even then I could see the housing bubble and the problems that the financing of it posed. Yet you are saying that you thought that your positions were salvageable even after the bubble burst on August 9, 2007 with the BNP Paribas induced panic. I very much agree with the idea that the cascade of financial disasters continued to be viewed as isolate events, not just by markets but worse by the Fed and Treasury. The inaction of these last two in the face of the mounting crisis was unconscionable. As for Lehman, I could have cared less if it survived or failed. But I could say the same about any of the investment banks. Bear Stearns and Merrill were sold. Goldman was bailed out by the AIG deal, and then a week later it and Morgan Stanley were bailed out again by being allowed to convert to bankholding companies although they were nothing of the sort.

    I wrote about this in a post in another place yesterday. Why was Lehman signaled out? Why when part of the rationale for selling Bear Stearns was that it posed a systemic risk was Lehman let to fail when it was larger, the economy was dicier, and the systemic risk greater? And more importantly why was it let to fail the way it was? It is not so much that Lehman needed a bailout. It is that it needed to be dealt with. It seems incredible to me that Paulson and Bernanke didn’t know about who had exposures to Lehman. They certainly knew that Goldman was exposed to AIG because they had Lloyd Blankfein there at the table with them. But with Lehman they didn’t even bother to ask? They couldn’t assume that money markets such an important part of shadow banking were involved, and what the ramifications might be for them in an uncontrolled collapse of Lehman?

    Rather than dealing with the problems in the financial system in an aggressive, but responsible way, Paulson and Bernanke threw a grenade into the machinery. It did not need to be done. It should not have been done. You say it might have been better that way. I disagree. The system was corrupt. Now it is both corrupt and damaged. I see nothing to keep us from sliding into depression in a year or two. How is this better?

  2. ndk

    A very interesting retelling of the story from a perspective new to me. Thanks for that.

    The fact that so many people continue to argue that a Lehman bailout was necessary, leads me to conclude that denial is still a big issue in the financial and political worlds.

    I can see why you would conclude that, but I’m a little more cynical than you. Recasting the entire disaster as little more than a failure to save Lehman is the best way, by far, that major financial firms can ensure their survival as monolithic entities with Federal backing.

    They’ve framed the debate successfully, and with the pitiful reforms cast out of Washington in hollow voice and lack of action, they’ve got their indefinite guarantee too.

    All I can do is applaud, and wait until the next incident. It was really well played.

    1. john bougearel

      ndk,

      your insight is profound,

      They [the ganksters, WS and Washington] have “framed the debate successfully”…

      The only problem was the failure to save Lehman…
      Had that been averted, the whole crisis could have been averted.

      And if you believe that I have a golden gate bridge to sell you

  3. craazyman

    What financial or political communities, pray tell, have owned up to “their” mistakes.

    Maybe I’m too cynical, but it seems to me a lof of folks are owning up to other people’s mistakes — or giving the “mistakes were made” sort of dodge — while sucking even harder on the public tits for whatever milk they can still swallow from them. After all, we live in a bailout nation where deadbeat bankers get taxpayer dollars for bonuses and anyone trying to save an honest buck gets less than zero real yield so the banks can “earn” their way back to health, with all their “talent” safe and cozy again.

    We still have the Helicopter Man running the Federal Reserve for Round 2 and some of the chief bubble enablers running the Treasury and Administration economic policy. We still have the same bad debt, but Wall Street has cleverly transferred it to taxpayers and their children while keeping all the bonus money they made on it and they’re ramping back up the machine as we watch, confident of Bailout Part 2 if need be. What has been learned, except that Mr. and Mrs. John Q. Public are easy sheep to shear and to sharpen back up the blades for another chop or two?

    Yes, job stress sucks and it can wreck your health. But not even having a job, much less one that makes you a fat six or seven figure salary and bonus while you perform mathematical experiments on the public’s balance sheet to see how much of your risk you can lay off onto it, would be even worse. And you might not have the insurance to pay for a doctor or the ability to take the week off, if you had a “normal” job. It might be Jack Daniels, MD.

    Nothing personal and I appreciate the confessional, but really now, is this a view from the lofty peaks or what? Is this April 1 or are we still in September? I think it’s still September because New York plays Dallas next week. And thank God for the diversion. :) When we finally become the United States of Mexico with totally and cynically corrupt “elites” and a miserable, violent and bankrupt population, I sincerely hope we still have the NFL. I think we will, it will be our one remaining dramatic metaphor that retains a slight hint, but only a hint, of our former capacities for suppression and abstraction of instinct and sense of community, before the Gladiatorial Games finally achieved the slow return of the repressed and made merry with the weird thing called “money”. LOL.

  4. john bougearel

    Thomas Adams,

    You are losing me on this. Whether your firm had a complicity in accountability in the financial crisis means nothing. The fact of the matter is that the financial community has avoided and continues to avoid owning up not just to the many mistakes that had been made in the prior years, but to it criminality that led up to the financial crisis and beyond. Criminality in the banking community is still at large, and living large.

    “Our explanations of the rigorous analysis we used for MBS and CDO bonds were being met with increasing skepticism and, despite our efforts, the market was losing confidence in us.”

    Thomas, think about that statement, are you surprised?

    To your credit Thomas, I can appreciate your openness towards lessons learned:

    “Though my future was uncertain, I was relieved to be free of the stress of living in a world overrun with false optimism and denial. I blamed myself for my mistakes but I resolved to learn from them and move forward.”

    Still, Thomas, I am concerned when an insider like yourself can proclaim that “the collapse finally forced the financial and political communities to own up to their mistakes.”

    My concern is that your head is literally stuck in the sand. The financial and political communities have not owned up to their mistakes one iota, in fact, for the most part they have embraced and reveled in them. Well, hell, I don’t care where your head is at, but please, don’t pass on jibberish that the financial or political communities have owned up to their mistakes.

    Really.

  5. Tom

    John-
    I would agree that the most common response of the financial world is to blame others – and i believe i made mention of that. I also tried to convey my concern that the advocates of denial continue to have a strong voice, as evidenced by their vocal argument that the prior administration failed by not bailing out Lehman. The extension of this argument into the current environment is pretty dangerous in my view.

    Once could certainly argue that the government and financial community response was insufficient or misapplied, but after the Lehman failure, the severity of the crisis was finally exposed and this exposure caused a panic and a variety of overdue reactions across the financial, political and main stream worlds.

    The general population, in particular, finally saw through the “economy is fundamentally sound” nonsense which, in my opinion, lead to many overdue cultural and economic changes. And many of the lies that investors and banks, such as Lehman, Merrill and WaMu had been perpetuating, stopped working as effectively.

    of course, more could be done. It’s a fool’s game, in my view, to hope that the government will ever really take the steps needed to fix everything. I don’t think you can argue, however, that the continued denial that concerns you would have somehow been solved had Lehman been rescued.

    ndk-
    you make a good argument. however, i always am a little skeptical of the vast conspiracy arguments. from what i’ve read about the big banks and washington, and what i saw first hand at a variety of banks, insurance companies, rating agencies and regulators, most of the people involved had no idea what was hitting them and were overwhelmed, terrified, fumbling and uncertain of what to do next. there may have been a few clever people who saw through the noise, but there are a lot more who are better at re-writing history to their advantage after the fact.

    thanks for the feedback,

    Tom

    1. ndk

      Tom,

      you make a good argument. however, i always am a little skeptical of the vast conspiracy arguments.

      Me too, but I don’t consider my suggestion to be a vast conspiracy argument. It’s spreading a helpful, plausible meme and fertilizing it a bit so that it can take root.

      If you’re considered the smartest guys in the room, and you say in retrospect that it was Lehman’s failure that caused the real trouble with some carefully selected evidence to support that view, I would be surprised if that meme didn’t take off.

      from what i’ve read about the big banks and washington, and what i saw first hand at a variety of banks, insurance companies, rating agencies and regulators, most of the people involved had no idea what was hitting them and were overwhelmed, terrified, fumbling and uncertain of what to do next. there may have been a few clever people who saw through the noise…

      I totally believe that most were broadsided. Major fog of war, rapid events, powerful groupthink, hubris, and a whole lot of fear.

      but there are a lot more who are better at re-writing history to their advantage after the fact.

      Exactly. If you look back to the archives of Naked Capitalism in Sept. ’08, you’ll see most of the panic was about the failure to pass TARPv1. Remember Paulson on his knees begging Pelosi, and the shock that struck when the “no” vote went down?

      If we take the SPX as a rough proxy for financial chaos, LEH’s failure registered lightly at the time, while the conservatorship of FNM and FRE and the failure of TARP had huge impacts. dollar LIBOR went up a little, and T-bills spiked down, but the TED spread had already been sick and deteriorated much more after TARPv1 failed. And how do we disentangle the simultaneous nationalization of AIG?

      There may have been underlying forces set into motion by Lehman’s bankruptcy, and I certainly can’t disprove that today. I’m sure we’ll see deeper analysis someday, and it’ll make for thrilling reading.

      But that the debate is even framed in these terms indicates a profound victory for Too Big to Fail.

  6. Ex-Lehman

    Thinking that your superiors did not understand/know what was going on is truly naive; it was as plain as day that the CDO/MBS market was unsustainable, it was just not-PC to say so.

    The fact that you suffered over it meant that you did not have the ‘right stuff’ to work at a Wall Street institution.

    Everyone knew what was going on, at Lehman from Fuld on down, and they were just trying extract as much value (their own bonuses) as possible before the blow-up.

    The real surprise is that the regulators let this happen, now their golden goose (prospective employers after government) threatens to be popped and they are dancing like crazy to keep it afloat.

    If Greenspan is working with [John] Paulson, as I have read, can you imagine? Geithner/Bernanke/Summers all hope to be with the Citadels/Ellingtons/SACs after this, which won’t happen unless the big banks and government continue to swallow up the toxic assets that got us here and feed them back to – us.

  7. Hugh

    “there may have been a few clever people who saw through the noise, but there are a lot more who are better at re-writing history to their advantage after the fact.”

    That’s just it. You didn’t have to be especially clever to see the housing bubble or that it would go splat. All you needed were a few cursory facts and a rudimentary knowledge of math. And for the splat, a memory that stretched no further back than the dot.com bubble a few years before. After that, it was just a case of watching how the house of cards was going to fall apart, and what if anything the government and Fed were going to do to soften the fall. It happened to be Lehman that was the big event. Being an outsider, I like most could not guess that. But I was not surprised by it. When the facts came out, I was shocked at how it happened, that Paulson and Bernanke had not asked the questions that even someone such as myself would have thought were the first and most basic ones to ask.

    But no, Lehman collapsing the way it did was not a good thing. You exhibit the same callousness toward the unintended victims of these crises, the millions unemployed or financially stressed, that I see in many economists.

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