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.
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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 Further complicating the situation, an outdated regulatory system made it unclear what the government could or couldn’t do to respond to the potential failure of a systemically important nonbank financial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