Why We Learned So Little From the Collapse of Lehman Brothers

On the second anniversary this week of Lehman Brothers’ spectacular collapse, it’s instructive – okay, frustrating and dispiriting – to see what our policymakers learned from it. Based on what unfolded then and the trillions of dollars lost, you would expect that even conservatives could now acknowledge that unregulated financial markets are not always an optimal arrangement. But that’s not how it has worked out. By now, everyone also should recognize that when markets crack-up, government is the only game in town to contain the damage and head off a repetition. Yet as a rule, conservative Washington still doesn’t see that. And by now, when virtually everyone should appreciate the dangers of over-leveraging, policymakers across the political spectrum still don’t fully get that either.

It matters, because all of this leaves the U.S. and global economies exposed to another financial crisis and the truly terrible economic costs that would accompany it.  

This is a period, it seems, when simple-minded political ideology regularly trumps economics.  After a succession of gruesome financial meltdowns over 20 years – in Japan, Sweden, East Asia, Spain, and now America and Europe – the leading ideology still offers knee-jerk reverence for markets unfettered by public standards or rules. Those now poised to take over at least one house of Congress wouldn’t support even the tame financial regulation approved earlier this year. That’s despite the fact that the new law forgoes setting common standards, rules or other meaningful regulation of most trading in large blocks of asset-backed derivatives. Those are the precise transactions which proved to be so dangerous for Bear Stearns (RIP), Lehman Brothers (RIP), Merrill Lynch (RIP), AIG and the rest of us. Just as it was before Lehman and the rest imploded, most investors and regulators still won’t know which banks are carrying out those large trades, what those trades consist of, and how heavily they borrowed to complete them.

The still-reigning ideology also won’t tolerate regulation to stop flash trading, which allows a handful of giant institutions to see incoming orders a few milliseconds before ordinary investors, and repeatedly has triggered huge, sudden share price declines. It also won’t countenance regulation of so-called “dark pools” or private deals between firms to move large blocks of securities without anybody else knowing about it. As the world learned painfully two years ago, markets that aren’t transparent become vulnerable to devastating panics when an outside shock hits them. We haven’t even been willing to direct the big banks to divest themselves of the same risky assets that crushed Lehman two years ago.    

We’re not doing much better with international regulation. This week’s news from Basel was a new agreement among the major countries to “triple” the capital reserves that banks hold against future losses. But market insiders know that these standards, along with parallel ones in our own financial reforms, won’t hold off another crisis. As the always-rigorous Martin Wolf of the Financial Times put it, “tripling almost nothing does not give one much.” The punch line is that the lame new standards don’t even take full effect until 2019. It is little wonder that bank shares rallied when the “tough” new standards were announced.

So at least until the next global meltdown, risky derivative and dark pool transactions, as well as continuing rounds of flash trading, will continue to depend on out-sized leverage and unfold beyond the purview of most investors and regulators.

There’s a final irony. The only reason that investors let banks get away with such low capital reserves, high leverage and risky transactions is that the banks and everyone else knows that if the worst happens, governments will bail them out. At the same time, the same financial institutions and their ideological fellow-travelers in Washington won’t stand for new rules that would meaningfully reduce the likelihood of another eventual bailout. That’s as good an example as any of socializing risk for private gain, and a convincing demonstration that Wall Street and much of Washington learned little from the economy’s near-death experience two years ago, this week.