The natural human tendency is to think that markets are about money, but a look back at the bankruptcy of the once-illustrious financial firm Lehman Brothers should serve as a reminder that markets are fundamentally about morality.
Saturday marked the fourth anniversary of Lehman's bankruptcy—at $691 billion in assets, the biggest in U.S. history. Many Americans continue to conflate the financial markets' crash with the financial markets' crisis. In reality, there were two different (albeit connected) events.
The crash occurred in 2007, and was triggered by the popping of a massive bubble in the real estate market. Housing values came racing down, and stock prices followed their precipitous descent. But it was Lehman Brothers’ frightful bankruptcy in 2008—in the aftermath of which financial institutions would not extend one another credit—that marked a full-blown crisis.
Markets fall but they also recover—that’s why people think they are about money. They may dislike or even dread losing their wealth. But when markets recover, the joys of making money will win over enough of those who have been burned by losses. And those who had the vision and courage to invest wisely during times of distress will emerge with an abundance of wealth.
But crises offer no such assurance of recovery. The uncertainly of what lies on the other side of the crisis inspires terror, and people’s reactions are far more extreme. They withhold, even hoard money not merely because of the pain of financial loss but, crucially, because of the loss of trust.
Recall that banks, before the current era, were once the epitome of financial conservatism. They made loans to people with good credit. While one often hears that bankers themselves failed to understand the risk involved in complex derivatives securities they traded, it is hard to give credence to the idea that the shady nature of their business was unknown to them.
For one thing, Warren Buffett, whose every word is weighed by the business world, warned in 2003 that subprime mortgages were “financial weapons of mass destruction.”
But the most damning evidence of the moral culpability of the banking profession is the lingo professionals themselves used to describe the loans they gave: “NINJA loans” for those with no income, no job or no assets; “liar loans” for customers making absurd claims about their qualifications that bankers happily overlooked; and “stretch loans” for those who would need to use more than half their income to pay their mortgages.
Banks, like the now-defunct Washington Mutual, took on enormous debt relative to equity. Fears of excessive leverage, perhaps dulled by a sense that the government would not let them fail, were overshadowed by the appetite for enormous annual bonuses.
When the real estate bull market started to tank, bankers knew from their own loan portfolios that their counterparties owned dubious assets that were nearly impossible to value. The market crash that began in 2007 accelerated in early 2008 with the collapse of Bear Stearns triggered by near total losses in two hedge funds owning subprime securities. A rapid-fire government-engineered sale of Bear Stearns to JPMorgan Chase headed off an immediate crisis.
But the ensuing near depression we experienced was the result of a steady contraction of credit. Countrywide Financial and numerous other lenders could no longer obtain financing starting in 2007.
San Francisco Fed President Janet Yellen, in a 2009 speech, explained how this process worked at the level of individual businesses throughout 2007 and 2008:
“Once this massive credit crunch hit, it didn’t take long before we were in a recession. The recession, in turn, deepened the credit crunch as demand and employment fell, and credit losses of financial institutions surged. Indeed, we have been in the grips of precisely this adverse feedback loop for more than a year. A process of balance sheet deleveraging has spread to nearly every corner of the economy. Consumers are pulling back on purchases, especially on durable goods, to build their savings. Businesses are cancelling planned investments and laying off workers to preserve cash. And, financial institutions are shrinking assets to bolster capital and improve their chances of weathering the current storm.”
But the withdrawal of liquidity Yellen describes reached an all-time high—as measured by the TED spread, which signals the reluctance of financial institutions to lend to one another—with the Lehman bankruptcy on Sept. 15, 2008. That spread, normally ranging between 10 and 50 basis points, reached more than 300 basis points with news of the firm’s failure, attaining a high of 457 basis points on Oct. 10.
Credit became unavailable throughout the economy, as Yellen stated. Europeans, who initially mocked our subprime crisis, stopped laughing as credit disappeared there as well. A full-blown systemic banking crisis was at hand, the root of which was a lack of trust. Banks would not lend to one another (in Europe they still fear to do so). Knowing all too well the dodgy assets on their own books, they feared they would not be repaid.
There has been unending discussion since the crisis, blunted by the Fed’s massive, unprecedented and astute injection of liquidity into the financial system, about the proper role of regulation. But the ever-increasing morass of financial regulation —from Sarbanes-Oxley down to Dodd-Frank—never has nor ever could keep pace with the determination of those who will not be separated from lavish bonuses.
There must be strong and sensible rules, but no regulation can substitute for absence of individual moral restraint. From the banker securitizing toxic loans down to the retail broker obtaining a mortgage for a financially unqualified borrower, the breakdown that led to Lehman consisted of countless individual wrongs that came to be seen as business as usual.
America’s founders understood and repeatedly warned that political freedom—and free markets—depended on moral responsibility. “Avarice, ambition, revenge, or gallantry, would break the strongest cords of our Constitution as a whale goes through a net,” John Adams said.
The Lehman Brothers bankruptcy marked the low point in a financial crisis from which America has not fully recovered, and bears lessons we’d do well not to forget: that when trust disappears from the marketplace, business withdraws from the marketplace.
Financial advisors have seen this numerous times—from the conflicted research to the defective products like auction rate securities that brokerage firms have peddled through them.
Conscientious advisors understand that it is nearly impossible to repair a client relationship that has suffered a breach of trust. They must therefore take to heart that the buck stops with each individual.
The market maxim “buyer beware” is insufficient. For a market to function, “seller beware” has to be our first line of defense against a future crisis.