Lehman Brothers Financial Collapse - Ten Years Later

By: Andy_Sutton

This will not be a long piece. It is not a memorial to Lehman Brothers nor is it an honorarium to the system that created Lehman, then crushed it along with a wide swath of American wealth and capital as well. This is not a tribute to government leaders such as Henry Paulson and others at the USTreasury who abused the trust afforded them by the American people and conducted one of the most brazen and heinous broad-daylight robberies in the history of the human race. We want you to remember what happened because, in the ten years since Lehman, not a thing has been done to prevent another episode and all the ingredients are present. The only thing missing is the trigger.

A Brief Review of Events

2008 had already had more than its share of financial turmoil. In the months leading up to 9/15/2008, Bear Stearns, Fannie/Freddie, and AIG had already had major blowouts. The stock markets were very itchy and everyone was on edge. Most who worked in the industry knew it was just a matter of time until something much more systemic took place. Up until this time, the contagion had been mostly limited to the US, with some minor external collateral damage.  We were both heavily involved in the financial/economic landscape at this time. Andy was running his investment advisory and economic consultancy firm and Graham was a strategy analyst for a major G7 central bank. We had already both come to independent conclusions that this was going to be a long emergency as coined by James Kunstler. This was not going to be a 3 or 6-month event and then it would be roses and cherries and cream for the whole world.

The system was not going to be given a hard reset, but a soft one. There are many, many individuals and organizations who were getting filthy rich off the fleecing of Americans, Europeans, and Asians alike and they weren’t going to stop the gravy train just because a few banks got out of control with their leverage. We both firmly believed going in that the banks had already been issued a guarantee of sorts that they would not be allowed to perish. Government funds (and other funds as necessary) would be used to bail them out. Except for Lehman. People always focused on why Lehman was allowed to die. They forget Bear Stearns was allowed to die. While the company died, its assets and business were transferred first to the not-so-USFed, then to JPMorgan for $10/share - $123 less than its 52-week high. A fire sale. The claim was made that the ‘fed’ couldn’t save the company and the fire sale had to happen. The shareholders got their heads handed to them. Some of you reading this might be among the victims. Make no mistake, this was a crime and was committed by criminals. Jamie Dimon, CEO of JPMorgan was never called to task for his firm’s role in the blowup of Bear Stearns.

Fast forward to September. Things had been getting quite dicey for a long while in the aftermath of Bear Stearns and it seems barely a week would go by without another rumor about someone else going down. The summer saw multiple financial icons fall out of bed with regard to their leverage problems.

The Problem with Leverage

There are still many people we talk to who don’t really understand what leverage is and how dangerous it can be. We don’t fault them; the media has never really tried to make the concept well-known and those engaging in it certainly don’t want the public to understand the risks. People might wise up, issue these firms the state bird and take their business elsewhere. So, what is leverage?

An example is in order here because it explains leverage perfectly. We’ll use as an example a private investor because they can use leverage too. The example is oversimplified by design and is amplified to help readers understand the process. It is unlikely an average private investor would even find themselves able to employ 10:1 leverage.

John Smith has a stock portfolio that is worth $10,000 when marked to market. This means if he sold his portfolio, he’d get $10,000 minus commissions and taxes on gains. He’d receive the market value. His portfolio has been doing well and he’s been earning double-digit profits for the past few years. John decides it is time to go big. Retirement is a few short years away and he hasn’t been saving as he should have been and his company just greatly reduced its formerly lavish pension plan system. John has excellent credit and he is able to secure a loan from his brokerage firm for $100,000. He plans to invest in similar assets and use the gains to repay his loan. John is now leveraged 10:1. For every dollar in his portfolio that is actually his, he owes ten dollars to his brokerage firm. John takes his $100,000 loan and invests all of it in a basket of assets. So far, so good.

Then the market has a bad week because of rumors of another AIG event and John’s portfolio is hit particularly hard, losing 15%. This means his borrowed money, which was $100,000 now has a market value of $85,000. His initial $10,000 portfolio loses 10% and is now worth $9,000. John’s brokerage gives him a call and says John must provide $6,000 within a short period of time or risk losing his collateral – the initial $10,000.

Why? Because the brokerage operates similarly to a bank in that it uses collateral to secure these types of loans. The bank sees the value of John’s portfolio going from $110,000 (adding his original portfolio to his borrowed portfolio) to $94,000 after the market drop. John is into the brokerage for $100,000 hence their demand for $6,000. That amount, all else equal, would get John’s portfolio back to the $100,000 he borrowed. If John fails to come up with the $6,000 the brokerage will essentially repossess his entire portfolio and liquidate it to make good on the loan. Even doing that, the brokerage eats $6,000 in this example.

John has now lost his entire portfolio. He didn’t have much to begin with and now even that is gone. If he had not taken out the loan and leveraged himself, he’d still have $9,000 from his initial portfolio.

People didn’t see this side of leverage though and the large banks thought they were immune because they had whiz kid algorithms and CPU power. They saw it in terms of John borrowing the $100K, investing and seeing it make 10-15%/year, and if John uses all the growth to pay his loan, he’ll be out from under it in 7 years give or take. This is what happens when people get into the mode that the market will go up forever.

The large banks, hedge funds, and other high net worth investors did much more than John though. Many of the banks that got in trouble in 2008 were leveraged 40:1 and even higher. At 40:1, even a very small downward move in the value of assets will earn you what is dubbed a margin call. Banks did and do in fact borrow from each other to conduct such activities and they got burned in 2008 because all of a sudden, those mortgage backed securities that looked so good were proven to be fraudulent because the loans that made up the MBS stopped performing. People stopped making payments. There were many reasons why, but the leverage was the proximate cause of the 2008 crisis. If there’d be much less or even no leverage involved, it would not have been nearly as big a deal. To wrap up the story on Lehman, nobody would give the firm a loan to keep it going. The rest of Wall Street shut them out, the not-so-USFed shut them out, and the USGovt shut them out. It’s ironic that the USGovt which claimed in September that it wasn’t in the business of bailing out wayward institutions suddenly went bailout crazy 6 weeks later.

We remain firmly of the opinion that the not-so-USFed, the USTreasury, and probably much of Congress too knew full well what was going on and what was going to happen. After all, Henry Paulson, the Treasury Secy was a former Goldman-Sachs CEO. There is no conceivable way he had no idea what was going on. It is very much worth noting that Henry Paulson literally disappeared from the radar after his tenure at the Treasury Department was over. We don’t believe he left because of shame, he left or was given a golden parachute and told to leave because he needed to be out of the public eye. Paulson subsequently conned Congress into handing him $750 billion to buy troubled assets (remember TARP, TSLF, etc., etc.?). Paulson immediately took the money and gave it to his former firm and other big banks. It was a robbery pure and simple.

The week the bailout took place was filled with tension. Congress voted ‘no’ to the bailout on Monday and we both got involved in talking to legislator after legislator, trying to get them to hold the line. They were under immense pressure and, sure enough, by Friday, they caved. They were told all sorts of lies by Paulson and God only knows who else. There was arm-twisting of epic proportions going on. All sorts of strings were being pulled. The country was told if the bailout wasn’t approved that the stock market might never recover, the economy would be trashed and America might fall into martial law. Ridiculous and irresponsible fear mongering by government officials. We’ll leave you with California Congressman Brad Sherman’s speech on the floor of the House of Representatives about what they were told by Paulson and his fellow robbers.

We are sure most of you remember these events, even if some of the details have faded. Why bring it up then? Surely nothing can or more importantly will be done about it now. Politicians, no matter how rotten, have a code. They protect each other. This code supersedes party lines, personal opinions, and certainly justice and the truth. We bring up Lehman because all the ingredients that were in the mixing bowl back in 2008 never left. All the elements that caused that crisis are still there. We believe the 2008 crisis, like the crash of 1929 were allowed to happen for a reason and it’s a simple one: it allowed for a transfer of wealth that, without such a catalyzing series of events, would have been impossible.

Americans haven’t to this day caught up from the blowout of 2008. The national debt has more than doubled in the ten years since, consumers have seen stagnant wages put them further and further behind, causing them to take on more debt. Consumers and banks combined have also returned to their risky financial behavior that set the table for 2008. There is a contagion in subprime auto loans and quite honestly, if you remove all the borrowed money from the USEconomy, it almost ceases to exist. Credit equals leverage and we’ve ratchet-jobbed the leverage figures through the stratosphere just to maintain a sense of normalcy. Last time we talked about normalcy bias. A quick look at the evening news tonight will be dominated by the damage caused by a catastrophic hurricane name Florence. Perhaps we should start giving our government and commercial banks nicknames too since they are much like hurricanes; risky and unpredictable.

Graham Mehl is a pseudonym. He is not an ‘insider’. He is required to use a pseudonym by the policies of his firm when releasing written work for public consumption. Although not an insider, he is astonishingly bright, having received an MBA with highest honors from the Wharton Business School at the University of Pennsylvania. He has also worked as an analyst for hedge funds and one G7 level central bank.

Andy Sutton is a research and freelance Economist. He received international honors for his work in economics at the graduate level and currently teaches high school business. Among his current research work is identifying the line in the sand where economies crumble due to extraneous debt through the use of economic modelling. His focus is also educating young people about the science of Economics using an evidence-based approach.

By Andy Sutton

http://www.andysutton.com

Andy Sutton is the former Chief Market Strategist for Sutton & Associates. While no longer involved in the investment community, Andy continues to perform his own research and acts as a freelance writer, publishing occasional ‘My Two Cents’ articles. Andy also maintains a blog called ‘Extemporania’ at http://www.andysutton.com/blog.

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