By Matt Stoller, the former Senior Policy Advisor to Rep. Alan Grayson and a fellow at the Roosevelt Institute. You can reach him at stoller (at) gmail.com or follow him on Twitter at @matthewstoller. Cross posted from New Deal 2.0
Lehman’s bankruptcy happened three years ago today. It should be quite clear at this point that another Lehman is going to happen again. Policymakers didn’t deal with the crisis of 2008-2009; they turned it into a much longer crisis with far greater lasting damage.
There are two intertwined issues with any major financial panic. One issue is liquidity — can an asset be sold or traded without significant movement in the price? Can an institution exchange its assets for assets of similar value? In a bank run, the answer is no. People are too afraid to accept that their bank deposit is worth what is in the account because they don’t trust the bank that tells them what they have in the account. The second issue is solvency — is there enough value to pay off all creditor claims? Are assets greater than liabilities, even in a liquid market?
The basic point to understand about the financial crisis is that it isn’t in fact over. The liquidity crisis of 2008-2009 was temporarily abated, but the solvency problem hasn’t been dealt with. The global financial architecture is essentially dominated by too many obligations, a.k.a. debt, that cannot be paid. This can only be addressed by a mass writedown of debts. Usually creditors don’t like being told they can’t have the money they think they have and force is required. Debtor deals are often preceded by civil wars, world wars, or depressions. But not always — sometimes a debtor cartel can force writedowns. So that’s the solvency issue.
What does this have to do with Lehman Brothers? Well, Lehman’s bankruptcy was the moment when the financial system looked feeble and insolvent. If you did not have an FDIC insured account, you could not be sure that money would be there the next day. Essentially, Lehman’s bankruptcy was the moment that the global bank run for businesses and billionaires became real. Companies that needed to make payroll, insurance companies that needed to pay out claims, corporations that funded themselves in the commercial paper markets, nonprofits and cities using auction rate securities — basically anyone with any need for liquidity — could no longer do business. Investors piled into “safe assets,” a.k.a. Treasury bills, sending the yield “down to a few hundreds of a percent.”
In the repo market, which is where the shadow banking system got much of its funding, there were margin calls because previously somewhat safe assets like corporate bonds required larger haircuts. It was, again, a giant bank run. The Fed and Treasury eventually stopped the bank run, providing enough liquidity and fiscal help to restore temporary confidence to the banking system. But the solvency crisis wasn’t solved. It has been papered over, and remains with us today, ready to rear its ugly head at any moment (see the Eurozone).
A solvency crisis is often accompanied by a liquidity crisis, which is why the FDIC tries to shut down a bankrupt bank on a Friday and reopen it on Monday under new management. You don’t want a bank run when a bank goes under. You want depositors to be made whole and, ideally, to have so much confidence the system works that the real economy is entirely insulated from financial shocks. Unfortunately, the failure to address the solvency problem or put forward a framework that insures the banking system (using a scheme sketched out by Jane D’Arista in this prescient 1991 paper titled “No More Bank Bailouts”) means that users of the financial system are nervous.
Lehman Brothers itself was insolvent, but its problems were probably common among investment banks at the time. I don’t have anything to add on why that institution went under. For that, the Valukas report on the firm’s bankruptcy provides an excellent explanation. Basically, everyone in a position of power in and around the investment bank was corrupt. Lehman had fairly reasonable risk controls; management just ignored them. Senior Lehman officer Ian Lowitt noted this in the summer of 2007, after a decision to ignore risk limits. “In case we ever forget; this is why one has concentration limits and overall portfolio limits. Markets do seize up.”
Yes, they do.
The regulators knew. As Anton Valukas, the bankruptcy trustee said, “So the agencies were concerned. They gathered information. They monitored. But no agency regulated.”
There was the failure of information sharing among regulatory agencies, about which Valukas said:
Like most Americans, I was disturbed to learn after 9/11 that various intelligence agencies did not always share information with one another. I thought we learned something from that, but apparently not.
And then there was the whole misleading investors problem, with Repo 105. But all of this was framed by a basic solvency crisis, which Tim Geithner memorialized with his comment about “air in the marks” in the bad assets on Lehman’s books. The investment bank owed more than it owned, and everyone knew it. It was a solvency crisis, that then became a liquidity crisis.
This could have been fixed. But it hasn’t been, because of an overall failure of financial-friendly economists. I’ll quote Alice Rivlin, in a “let them eat cake” moment in 2008 on the foreclosure wave that triggered the crisis.
We should not forget that a lot of good came from the housing boom. Millions of people moved into new or better housing. Most of them (including most sub-prime borrowers) are living in those houses and making their mortgage payments on time.
Why should anyone think that Lehman won’t happen again? Elites have learned nothing. This was obvious during the crisis itself, when Nouriel Roubini noted the stark difference between public and private conversations:
And while policy makers and regulators now claim that everything is on the table in terms of reforming a faulty financial system they stress in private that their preferred approach would be one of “self-regulation” and reforms undertaken by private financial institutions rather than new rules and regulation imposed by authorities.
Many people are frustrated that the response to the crisis hasn’t been stronger. But it was always obvious that the goal of the crisis measures was to get the financial elites back to ordinary business as quickly as possible. In that context, the most reasonable question in the world is, why wouldn’t Lehman happen again? We don’t have a persuasive answer to that question. And until we do, we’re still in crisis