Lehman and the end of the era of leverage

By Spengler

Lehman Brothers survived the American Civil War, two world wars and the Great Depression, but today, Monday, the firm that set the standard in fixed income markets will be liquidated. Potential losses are so toxic that none of the major financial institutions was willing to acquire it.

Lehman’s demise follows the failure last week of the two American mortgage guarantee agencies, Fannie Mae and Freddie Mac. It is remarkable that the US authorities, exhausted from their efforts to bail out the mortgage guarantors and other firms, have left Lehman to its fate.

An enormous hoax has been perpetrated on global financial markets during the past 10 years. An American economy based on opening containers from China and selling the contents at Wal-Mart, or trading houses back and forth, provides scant profitability. Where the underlying profitability of the American economy was poor, financial engineering managed to transform thin profits into apparently fat ones through the magic of leverage.

The income of American consumers might have stagnated, but the price of their houses doubled during 1998-2007 thanks to the application of leverage to mortgage finance. The profitability of American corporations might have slowed, but the application of leverage in the form of mergers and acquisitions financed with junk bonds multiplied the thin band of profitability.

Wall Street and the City of London rode an unprecedented wave of profitability by providing overpriced leverage to consumer and corporate markets. Led by the financial engineers at Lehman, the securities industry grew an enormous infrastructure of staff, systems, and financial exposure. They were so successful that when the music stopped, there was no way to liquidate this mechanism gracefully. It only could be allowed to collapse.

The Great Crash of 2008 has entered a new phase, judging from the market opening in Europe and US equity futures prices. Lehman’s failure and the sharp decline at other financial firms, notably American International Group (AIG), the world’s largest insurer, have pushed equity values down to their lost levels of the year.

As I wrote on May 20, the proximate cause of the Great Crash is the enhancement of poor returns to capital through leverage. The decline of returns to capital, though, stemmed from a global imbalance of supply and demand for capital in response to the rapid aging of the world population. The aging pensioners of Europe and Asia must find young people to pay interest into their pensions, and they do not have enough young people at home. Germans aged 15 to 24, on the threshold of family formation, comprise only 12% of the country's population today and will fall to only 8% by 2030. But one-fifth of Germans now are on the threshold of retirement and half will be there by mid-century.

In effect, Americans borrowed a trillion dollars a year against the expectation that the 10% annual rate of increase in home prices would continue, producing a bubble that now has collapsed. It is no different from the real estate bubble that contributed to the Thai baht's devaluation in 1997, except in size and global impact.

It is easy to change the financial system, I argued in my May 20 essay. The central banks can assemble on any Tuesday morning and announce tougher lending standards. But it is impossible to fix the financial problems that arise from Europe's senescence. Thanks to the one-child policy, moreover, China has a relatively young population that is aging faster than any other, and China's appetite for savings vastly exceeds what its own financial market can offer.

There is nothing complicated about finance. It is based on old people lending to young people. Young people invest in homes and businesses; aging people save to acquire assets on which to retire. The new generation supports the old one, and retirement systems simply apportion rights to income between the generations. Never before in human history, though, has a new generation simply failed to appear.

The world kept shipping capital to the United States over the past 10 years, however, because no other market could absorb the savings of Europe and Asia. The financial markets, in turn, found ways to persuade Americans to borrow more and more money. If there weren't enough young Americans to borrow money on a sound basis, the banks arranged for a smaller number of Americans to borrow more money on an unsound basis. That is why subprime, interest-only, no-money-down and other mortgages waxed great in bank portfolios.

It is tempting to see in the failure of Lehman Brothers and the forced merger of Merrill Lynch with Bank of America a failure of "corporate culture". In the case of a great financial firm that has weathered many storms, the failure of a business culture contains more information. Credit markets connect what we do today with what we plan for the future. Because the future is uncertain we must have faith in the outcome, which is why the word "credit" derives from the same Latin root that denotes belief in the religious sense. We require a certain degree of trust in our counterparties. It is the job of the great financial firms to create trust between borrowers and lenders and establish a link between the present and the future.

It is of small account in the great scheme of things, but in the sad, strange little world of business studies, Lehman’s culture was held up as an exemplar, a beacon to the ambitious and avaricious. Lehman’s demise is a minor event next to the travails of America’s mortgage guarantee agencies, which required a government bailout last week, to be sure, but it is a landmark in the unraveling of American corporate governance.

By a charming coincidence, the two great securities industries failures to date occurred at the extreme antipodes of the corporate cultural spectrum. Lehman is the second great American securities firm to fail this year, following the March demise of Bear Stearns, the shards of which were swept up by J P Morgan Chase.

Bear was a group of scrappy outsiders, led by Jews of no social pedigree. Jimmy Cayne, the firm’s president, never finished college and began his career literally trading scrap metal. Bear’s managers played bridge, and prided themselves on having no corporate culture except a piranha’s instinct for the next trade. A book of memos by Bear’s former CEO Alan Greenberg circulated some years ago, including a lampoon in which the Bear chief categorized his competitors who had bit the dust over the years according to the management philosophy each had embraced, eg, "total quality management" and other shibboleths. Bear proudly rejected corporate culture and management philosophy as a matter of scruffy pride.

At Bear, partners ran their own businesses and hid their best methods from their colleagues to prevent anyone from cutting in on their action. The favorite method of management communication was the one-minute phone call. Lehman held meetings to plan the meeting that would set the agenda for the meeting that would make the decision, and of course every department and interest had to be represented. That was called "teamwork". As a result, all of Lehman’s resources were mustered for the projects to which the firm set its priorities.

Tongues clicked across Wall Street when Bear went down for the last time. "Nobody liked [Bear’s] Jimmy Cayne," a senior fellow at Lehman Brothers offered, "but everybody likes [Lehman Brothers CEO] Dick Fuld. Cayne was not our class, dear; the jumped-up refugee from a junkyard had risen too high and received his comeuppance. The Federal Reserve opened its lending facilities for commercial banks to securities firms for the first time in history, the day after Bear Stearns went down. Lehman and others were the beneficiaries of official largesse that was not offered to Bear Stearns."

Everyone may like Dick Fuld, who presides over a socially-connected, politically-involved, army of networking specialists who have one of Wall Street’s best stock of favors done and collectable in return. But no one likes Fuld well enough to buy his firm, which apparently has been rejected at any prices by a Korean bank, by Barclay’s Bank of the UK, and finally by Bank of America.

Earlier this year, the American authorities allowed financial institutions to mark their books at fictitious values, in the hope that eventually prices for mortgages, consumer debt structures, corporate structured instruments and so forth would come back. If the authorities had forced the banks to mark to the existing market bid, all of them would have been insolvent.

The trouble is that the fundamentals are getting worse, not better - the prices of all this structured product aren't coming back and cash flows in some cases are being impaired. Six percent of American mortgages are delinquent, and recovery on liquidation seems to hover around 50%, rather than the 98% level that prevailed when home prices were rising. The longer you wait, the worse off you are. Everyone looked at Lehman's portfolio, compared it to the market bid, and realized that they might have a black hole of losses. The same is true of Washington Mutual, the American thrift institution likely to go next to the chopping block.

The failure of Lehman and Bear Stearns does not reflect the breakdown of a particular kind of corporate culture. As noted, the two firms embodied radically diverse views of corporate culture. What took both firms down, rather, is a sudden break in the chain of expectations between the present and the future. Today’s savers no longer can have any confidence that they will earn enough to fund their retirements by putting money at risk. They have discovered that in one form or another, their investments have fed a securities market bubble rather than the creation of value.

Market participants are responding by running away from risk, as well they should. That is the stuff out of which great crashes are made. The bouncing-ball pattern of declining stock markets was marked by bear market rallies each time the American and other governments stepped in to bail out the latest victim. The US government’s ability to influence events, however, seems exhausted. The Treasury and Federal Reserve can’t bail out everyone. After Lehman, the insurer AIG and Washington Mutual may be next to fail, followed by several regional banks.

I see no solution except to allow American households to begin the painful process of rebuilding their balance sheets, which implies a slowing economy for the next two years. It is too late to stop the Great Crash of 2008. The question remaining is how best to pick up the pieces.

www.atimes.com/atimes/Global_Economy/JI16Dj08.html