Last week, the financial world commemorated the fall of Lehman Brothers, with the fanfare of a grand centennial of a world war or the founding of a nation.
Articles and commentary dissected whether it should have been bailed out, and whether a similar fate could recur. But surely two years on is a bit premature to judge any long term consequences of such a cataclysm. As Zhou Enlai, the first premier of the People’s Republic, remarked about the impact of the French Revolution, “it is too early to say”.
As for a repeat performance, that last war cannot be refought – for one thing, the five major investment banks no longer exist. Bear Stearns and Lehman disintegrated, Merrill Lynch was absorbed by Bank of America, and Morgan Stanley and Goldman Stanley adopted shotgun commercial banking licenses to gain access to the Federal Reserve lending window. For those who suggest they might revert to their former status, an obscure provision in title I of the Dodd-Frank bill precludes large bank holding companies from “de-banking” their subsidiaries. It is nicknamed the Hotel California clause, after the Eagles’ song which described a place you could check out any time, but never leave. (article continues below)
What Dodd-Frank shamefully neglects, however, is the danger of leverage and inadequate equity cushions. That was the real culprit behind the fall of Lehman and the other institutions. Here’s my thumbnail of their Waterloo: the value of the firms’ equity, plumped up with worthless collaterised debt obligations (CDOs), turned out to be insufficient to serve as collateral for the short term borrowing needed to run their businesses.
The new American legislation merely permits the newly minted Financial Stability Oversight Council to limit leverage to 15 to one, if it determines a particular firm poses a “grave threat to financial stability.” (Before 2004, broker dealer leverage generally hovered at about 12). It then kicks the can over to Basel III. Global regulators published their own set of capital adequacy rules last week, requiring higher quality Tier One capital, gradually phased in until 2019. The net result caps ultimate leverage at 33. In 2007, according to its annual report, Lehman’s own leverage was 31, comfortably below Basel’s generous ceiling.
Vanessa Drucker is the American Editor of Fund Strategy, based in New York City. She has worked as a financial journalist for 20 years. In the 1980s, she practiced banking and securities law on Wall Street, and is the author of two business novels. Vanessa can be contacted at firstname.lastname@example.org.