The Fall of Lehman: Lessons Learned (and Not)

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.