Dow Down

Lehman Brothers collapsed the day after my son Matt’s 14th birthday, so I have both happy and sad memories of “Lehman” weekend. When Lehman failed, I was transitioning from a comfortable job as a product development executive to become lead portfolio manager for a multibillion-dollar suite of asset allocation funds. Lehman’s bankruptcy was one of the critical events within the global financial crisis, and will forever be synonymous with the crisis.

There is both good news and bad news to share in reflecting upon the 10-year anniversary of the fall of Lehman. The good news is that the financial system is stronger in many ways today. The bad news is that important lessons from the crisis have been forgotten or ignored.

The Good News:

Banks in the U.S. have far less leverage than was the case 10 years ago. Lehman had a leverage ratio of more than 31 to 1 in 2007, with a balance sheet packed with commercial real estate, subprime mortgages and hard-to-value mortgage derivatives.

Lehman’s tentacles extended throughout the financial system. Wall Street firms, government-sponsored entities, mutual funds, hedge funds and insurance companies were widely represented among Lehman’s creditors. Many regulators and financial institutions were unaware of how vulnerable the financial system was to a single counterparty. Further complicating the situation, an outdated regulatory system made it unclear what the government could or couldn’t do to respond to the potential failure of a systemically important nonbank financial institution.

The financial system is considerably healthier today. Ten years ago Citibank had 35 to 1 leverage; today Citibank’s leverage is about 10 to 1.  Ten years ago, regulators and executives running financial institutions had incomplete information about counterparty risk and used fairly primitive “tools” to assess risk. There is considerably more transparency about counterparty risk today, and risk management resources are vastly improved. The combination of lower leverage, higher capital ratios and better transparency about risk makes the financial system considerably safer.

Credit standards for mortgages are much higher, and mortgage investors are better-informed.  “Ninja” loans to borrowers with “no income, no job and no assets” were commonplace in the years leading up to Lehman’s bankruptcy. Although some sophisticated investors understood the inner workings and composition of mortgage securities in the years leading up to the crisis, far too many relied on ratings from one of the “big three” credit rating agencies. Ninja loans are thankfully a thing of the past, as banks have toughened their credit and documentation standards. Many mortgage investors have also learned from past mistakes, de-emphasizing the role of credit ratings in their investment process.

The Bad News

Incentives still trump ethics. Steve Eisman, immortalized in the book and movie The Big Short, has shared his crisis-related perspective that “incentives trump ethics every time.” Executives, investors and politicians are rewarded for the short term, and often have “left the party” when the bill for economic imbalances comes due.

Not much has changed in this regard since the crisis. Commercial and investment bankers are still compensated today for loans and deals that may sour in the future. Although mortgage lending standards have improved, corporate credit standards have declined in recent years. Corporate debt levels have steadily risen against the low interest rate backdrop, and “covenant-lite” loans are becoming far more commonplace. Government debt is also increasing at a rapid pace. The U.S. budget deficit is projected to reach $1 trillion a year within the next two years. Total federal debt is projected to be nearly $29 trillion in a decade, approaching 100% of GDP. The budget imbalances caused by entitlement growth, tax cuts and stimulus will likely be a problem for future office-holders to address long after today’s leaders have left office.

Banks thought to be too big to fail during the crisis are even bigger today. JPMorgan has $2.5 trillion of assets today and Bank of America $2.3 trillion, about four times Lehman’s crisis-era $600 billion of assets. Freddie Mac and Fannie Mae remain in government conservatorship and some degree of political limbo. Some of the tools used to stabilize the financial system after Lehman failed have been eliminated by Congress, which could potentially be a problem during the next financial crisis.

Investors haven’t learned their lessons from prior bubbles. Investors may be destined to repeat mistakes of the past, making different variations of the same mistake over and over again. Bitcoin fever has spread to Boston: a prominently displayed gas station sign says “Bitcoin sold here.” Argentina, a country perpetually in default, completed an oversubscribed offering for a century bond last year. Some investors in the U.S. may eventually be burned by the reach for yield in “covenant-lite” leveraged loans and high-yield bonds. American investors aren’t alone in reaching for yield, as the Chinese authorities are cleaning up problems in dubious “shadow banking” wealth management products.

Closing Thoughts

Despite the meaningful progress made since the fall of Lehman, it is important to address more of the lessons from the Lehman failure and the global financial crisis. Misaligned incentives continue to create risks, and excessive exuberance is still a behavioral tendency for investors. There are also unintended consequences associated with the extraordinary steps in response to the crisis, as resentment about the perceived favorable treatment of Wall Street relative to Main Street creates the risk that policymakers won’t have the legal or political support necessary during the next crisis.


Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.

Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.

Daniel is a graduate of Brandeis University and earned his MBA in Finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the Board of Trustees for the Green Century Funds.