Demise of Lehman Brothers or the Financial Empire Has No Clothes

One year ago, Lehman Brothers collapsed and we had blood on the floor of all the major stock exchanges. The global stock markets wiped out $2.85 trillion -- more than 6 percent of its value -- in a scant three days. Warren Buffet’s 2003 warning about Wall Street's fancy derivatives being financial weapons of mass destruction had indeed come true. Yet, one year after Lehman Brothers collapsed and the entire global financial system coming within an inch of tipping into an abyss, nothing seems have changed.

Much of what happened to the US economy, which later spread to the rest of the world, remains largely opaque to most people. All that they know is that the collapse of the real estate bubble somehow affected the whole financial sector in the US, which later cascaded into the global financial system. And to prevent what all the experts predicted was a rush down a precipice, astronomical amounts of money -- $600 billion in the US alone – had to be “given” as bailouts from the public exchequer. As the real economy came to a screeching halt bringing back the spectre of the Great Depression of 1929, another $775 billion was pumped into the system as “economic stimulus”. All those, who routinely rail against subsidies for the poor as propping up inefficiencies in the market place, found nothing wrong with Government bailouts for the billionaires. Subsidies for the poor are obviously a luxury, while the rich need subsidies for sheer survival!

The key issue that emerged out of the near death experience of the global economy is that some financial institutions have now become to big to fall. At best of times, they suck the surplus out of the real economy to declare huge profits. At worst of times, their losses have to be picked up by the tax payers, as their fall would completely seize up the real economy.

The fall of Lehman Brothers – a 158 year old investment banking company brought out the systemic risk in having such companies fail. Before Lehman declared bankruptcy, they had warned that their going down might also take the rest of the economy down with them, wiping out trillion of dollars in financial investments. The US czars of the economy and the leading bankers had sat down, analysed the risks and concluded that this could be contained. More importantly, after bailing out a succession of financial institutions – the mortgage financing companies Fannie May and Freddie Mac amongst others – the American public was turning against their tax money being thrown away to bail out Wall Street. Retrospectively, it is clear that those overseeing the US economy, had very little idea of the consequence of Lehman Brothers failing.

Lehman Brothers bankruptcy also showed that the global financial system was tightly interlocked – any impact in one market, particularly in the rich nations – would travel as a seismic wave across the financial system. Only countries like India and China, which were not financially fully integrated with the global system, felt the impact less.

Once Lehman declared bankruptcy, the entire money market – the money that greases the wheels of the global economy -- completely seized up. No company was willing to give money to others as they did not know how much of toxic assets including loans to Lehman was on their balance sheets. Nobody was willing to accept at face value the worth of the gilt-edged securities, backed by all kinds of guarantees from AIG, Merril Lynch, Lehman Brothers, etc. There was a run on the shadow banking sector, as all funds and individuals tried to pull their money out of the system. “Lehman’s downfall on Monday, Sept. 15, sparked a run on the $3.6 trillion money market industry, which provides short-term loans called commercial paper used by businesses worldwide to cover everyday expenses, including payroll and utilities.” (Missing Lehman Lesson of Shakeout Means Too Big Banks May Fail)

The fall of Lehman had one unintended consequence. It made clear that the state had to step in now to save the financial sector from an imminent demise. Post Lehman, AIG, which had guaranteed many of the fancy financial instruments now on the verge of default, had to be bailed out. Finally, the banks had to be re-financed with a huge infusion of cash in almost every major developed country. The bitter truth – in good times they party, in bad times we pay the bill, became clear to the people.

 

What really happened that caused the global meltdown?

 

There is a consensus on what caused the crisis. Or at least about the immediate causes of the crisis. The crisis was caused by a real estate bubble in the US pumped up by a number of financial institutions: the banks gave loans to people to buy expensive houses that they could not afford. As long as the real estate prices were going up, the home-owners felt that their asset value was going up and paid their mortgages. The loans were also back-loaded – the real bite of the high instalments would take place later and not immediately. With bursting of the real estate bubble, prices fell. For a number of home-owners, walking away from the mortgage was preferable to paying out ruinous amounts on return of their loans. It is this mass of bad mortgages in the US that acted as the trigger for the global financial meltdown.

Why should the rise or fall of the US housing market affect the rest of the financial sector, let alone the rest of the globe? Why should Iceland become bankrupt if the US home-owners decide to abandon their now too costly homes? For that, we must turn to the financialisation of the economy that has been going on for some time.

Enter the new world of finance. Here, two phenomena are closely intertwined. One is the shadow-banking sector, the other is the new financial instruments that primarily Wall Street created and the rest of the world lapped up. The crisis originated from the shadow banking sector and spread to the rest of the financial world through these new financial instruments or derivatives.

Originally, the banks were intermediaries between savings and investments. They channelled the savings of their depositors to those who needed loans for expanding their factories or other business. After the Great Depression and the run on the banks, the banks were regulated relatively strictly and also had state guarantees for their depositors. However, these guarantees are for the small depositors and not the big investors. The current crisis did not originate from the traditional banking sector that deals with the depositors, but from the shadow banking sector that is almost entirely unregulated.

The shadow banking sector, which lies at the heart of the current crisis, is where financial institutions lend to one another. Collaterals of different kinds backed up these loans. This means that against a loan given by a company A to a company B, if A gave a loan of $ 1 million, B would pledge some asset equal to at least $1 million as well as pay interest to A.

The shadow banking system does not have depositors but arranges deals between investors such as pension funds and borrowers looking for loans. As they do not have depositors, they are exempt from the banking regulations. Investment banks, hedge funds, money funds are all a part of the shadow banking system, with now familiar names of Lehman Brothers, Bear and Sterns, Merrill Lynch.

The shadow banking sector really grew from 1980's. They were protected from any kind of regulation as the neo-liberal orthodoxy was the dominant world view in finance and argued for the light hand of the market and not the heavy hand of the state. Subsequently, various firewalls that existed between traditional banking and the investment banks were removed, making the entire system more prone to risks. The traditional banks also bought into the new financial instruments as these promised much higher returns than the staid world of traditional banking. In 2008, the shadow banking sector in the US was comparable in size to the traditional banking sector, bringing out the systematic risk that such a sector had introduced in the system.

The fancy instruments originated primarily within the shadow banking system. The assets that were pledged were not strictly assets as we understand them – they could be a bunch of mortgages packaged together, and then diced up in small bundles and sold all over the world. Therefore the term mortgage backed securities. But that is only the first step. The next was to not only dice them up but also create priorities in terms of repayments. In case the repayments from the mortgages reduced, some of these shares would have priority over others -- these are called collateral debt obligations (CDO’s). And finally, the credit default swaps. Here a third party – an insurance company -- guarantees the payment in case of a default. This immediately pushes up the security rating of the instrument, as even the default is insured, making them appear as safe investment. All these instruments – mortgage backed securities, CDO’s and credit default swaps – are different forms of derivatives. The underlying asset – for example, the house – is no longer what is being pledged. A set of instruments that derive their value from other assets such as the value of the house is being bought and sold, hence the term derivative. Derivatives are also contracts whose value is derived from stocks, bonds, loans, currencies, commodities or linked to specific events such as changes in interest rates, foreign exchange rates, etc.

The market for simple, over-the-counter derivatives was $ trillion 592 or 41 times the size of the US economy and contributed more than half of some banks’ trading revenue. Once the housing market tanked in the US, the entire set of derivatives that depended on the expectations of housing prices continuing to rise and the home owners paying their mortgages, also went south. The entire set of instruments transformed to what is now being called as toxic assets.

The mortgages were not being held by banks alone. They were also held by investment banks and other financial institutions. These were the ones at the “cutting edge” of the derivative revolution, creating more and more complex financial widgets that nobody understood and everyone bought. The closely interlocked financial companies promoted these instruments, gave it various security and risk rankings, and in general had a ball in the financial markets. The only way the value of the derivatives and their risks could be quantified was through complex computer models. The quants (quantitative analysts) became central to the financial system, creating even more esoteric instruments. As they relied on the same underlying models and often even used the same software, the numbers regarding risks and values appeared the same, convincing the people that these were real values and real risks. That the financial system was not wearing any clothes became apparent only when Lehman Brothers tanked, taking down with it the global stock market.

The financialisation of the market is the result of the huge increase in the weight of the financial companies in the US economy. Simon Johnson (The Nature of Modern Finance) brings out that today, these companies now accounts for 7 or 8 percent of the US GDP. Contrast this with what Johnson says about earlier periods, “As far as we know, finance was about 1 or, at most, 2 percent of GDP during the heyday of American economic innovation and expansion—say from 1850”. If the financial sector – which essentially is an intermediary – is making so much money and is such a substantial chunk of the economy without producing anything itself, we have entered the world financialisation of the economy. In simple terms, the bigger the financial sector and higher its profits, more is the redistribution of the surplus from the primary generators of wealth. In the US, fully 40% of corporate profits came from the financial sector -- the financial sector was sucking up the surplus from even the rest of the capitalist class. The complex financial instruments created are not high quality innovation as they were touted but simply devices to extract essentially high rents from the gullible. One year down the line, has anything really changed in the US? Is the worse over for the global economy or is it just a false spring? If we talk to the financial sector, the crisis is over – the stock markets have recovered and and confidence has been restored in the financial markets. The underlying causes however still remain. The regulatory set-up has yet to address the problems of the shadow banking sector, the big banks and financial institutions have become even bigger and the systemic risk is that much higher. But even these are only the tip of the iceberg. The two issues that have yet to be addressed is that the financial companies still carry a major part of the toxic assets on their balance sheets. With refinancing of the home loans not taking place, the threat of defaults and depression of the housing market in the US is set to continue. Unless the toxic assets are either removed from the balance sheets or the home owners loans re-financed, the threat to the banks will continue (Fiscal policy again? A rebuttal to Mr Krugman, Keiichiro Kobayashi). The second is that with the job losses still continuing, only its rate of loss has come down, there is every possibility of consumer spending coming down, as well as the threat of credit card loans going the housing mortgage way. If any future shock takes place in the system, the US and other Governments today, have very little capacity to ride it out.

The other problem is that despite all the criticism of the housing bubble, it did allow the expansion of the US economy (Prabhat Patnaik on the Global Economic Situation, The Crisis of the Capitalist World) which otherwise was running out of steam. The US is now set to enter into a long period of recession, the same way that Japan has been doing for the last decade and half. If they spend their way out of it, the deficit will grow and inflation will follow. The rest of the world has financed the US deficit without the dollar weakening. How much longer can this profligacy continue is the central question.

The US can not continue with its wars abroad and its huge deficit (The Financial Crisis and Imperialism: Interview of John Bellamy Foster). The drain of its military misadventures now ride on top of an economy, which fundamentally only produces armaments or rent incomes. As it fades out as a manufacturing power, the amount of rent it can funnel back to the US economy through Intellectual Property Rights or through its financial sector is also limited. This is why, in spite of the real threat posed by the shadow banking system, there is so little will to police it. Any policing will reduce this rent income, much of which originates from abroad and helps to keep the US corporate sector afloat. .

Simon Johnson has called this the growth of the two track economy – while one sector the Wall Street and the financial companies are back in business, the real economy – the workers and the common man is still down in the dumps. The financial sector has passed its crisis to the rest of the economy quite successfully. Worse, the US has managed also to pass on the toxic assets arising out of the housing crisis to rest of the world. The Indian banks would also have been in deep trouble if the plans of Chidamabaram and Manmohan Singh for financial liberalisation not foundered on the opposition from the Left. Remember the chorus from the media who were all baying for the blood of the Left for opposing financial sector reforms? Even after AIG had to be bailed out, the UPA I and now UPA II talks about liberalising the insurance sector. The ideological blinkers still affect this Government, the reality check of the global financial meltdown not withstanding. .

Interestingly, certain words are taboo while discussing the financial crisis. The US and the UK are “refinancing” their banks and not nationalising it. The Government is willing to give away the money to private banks rather than own them and be abused as being socialist and nationalising the banks. The “N” word is completely out in today's world of neo-liberal orthodoxy. Even the limited option of a limited time nationalisation of the banks is not possible to talk of in the US. .

Given that no fundamental reforms of the financial sector has been carried out, if recovery is round the corner, can another crisis be far behind? Will the US be able to pass its crisis as easily to the rest of the globe as it has done this time? Who will pay the bill to bail-out the financial institutions the next time, as they still continue to play Russian roulette with the global economy?.