BY EDWARD HADAS

The bankruptcy of Lehman Brothers 10 years ago justified one standard recommendation for economic policy: If a big financial institution collapses in a heap, be sure to keep money flowing through the economy.

It might have been more sensible simply to avoid letting a very big financial institution fail over that September weekend. Lehman could have been fully or partly nationalised, as so many other financial firms were over the preceding and following few months.

At least the response to the Wall Street bank’s demise was good. Following the near-unanimous advice of economists, governments injected equity into banks and free cash into the financial system. The drastic action almost certainly kept the Great Recession from turning into another Great Depression.

So that is one thing economists understand. But there are still many areas of ignorance. Indeed, all the big disputed questions about macroeconomics from 2008 remain unanswered.

Start with the cause of the recession. It is clear that Lehman was wrecked by a popped bubble in the U.S. real-estate market. What is unclear are the causes of this bubble, and why its popping had such global consequences.

One theory, vigorously propounded by Breakingviews contributor Edward Chancellor, is that the original sin was central banks’ low interest rates. Other experts, though, have different views, lots of them.

The list of possible problem areas starts with undercapitalised or underregulated banks, reckless or greedy bankers and the unrestrained, opaque use of derivatives. It goes on to excessive national leverage levels and uninhibited cross-border and inter-institutional flows of capital. Fans of markets blame uneconomic demands from governments while fans of governments cite unrealistic expectations for financial market stability.

There is nothing like a consensus. As a result, there is no agreement on how crisis-prone the global economy is right now. Only one thing is certain. Whatever happens, there will be tribes of economists saying, “I told you so”.

In the early post-crisis days, one idea did seem to be generally accepted, that new-fangled finance had been a big contributor to the problem. It was true that hedge funds had not lived down to the dire expectations of their many critics. However, almost everything to do with probability distributions, risk tranches and derivative instruments was highly suspect.

If there ever was such a consensus, it did not last. While the wild days of CDOs squared and triple-A tranches of toxic subprime paper have not returned, derivative markets in general are still thriving. Total daily turnover in the latest triennial survey from the Bank for International Settlements, in 2016, was 52 percent higher than in 2007. Regulators seem relaxed about the growth. They are confident that the new central clearing facilities, mandated after the crash, has removed much of the risk.

Speaking of relaxed, in early 2008 few economists were actually worrying much about bubbles and leverage. Many more were concerned with the risk of rising inflation after the price of oil had increased almost tenfold in a decade. The gloomiest prognosticators argued that the cuts in policy interest rates which had started in 2007 to counter initial financial market stresses would lead to a reprise of the stagflation of the 1970s.

As it turned out, the 2008 peak annual inflation rate in the United States was 5 percent. That was in September, the same month that Lehman collapsed. It is impossible to know whether prices would have continued to accelerate if a recession had been avoided, because economists have no better understanding of how prices and wages work now than they did a decade ago.

Indeed, the lack of inflationary pressure in most Western countries is an embarrassment to the economics profession. The leading theories hold that labour shortages and money availability push up prices and wages; so it follows that there should now be much more inflationary pressure than can be found in any developed economy.

Another big deal for many economists back in 2008 was the size of the U.S. current-account deficit. It was declining from the 2006 peak level of 5.8 percent of GDP, but was still expected to be close to 5 percent that year. There was much talk of global imbalances and the dangers of a Chinese savings glut.

As it turned out, the U.S. deficit sank almost unnoticed during the recession and the early years of recovery, falling to 2.1 percent of GDP in 2013. The gap has risen since, but not by much. The International Monetary Fund expects the deficit to hit 3 percent of GDP this year. As to what, if anything, trade deficits mean for the economy or the financial system – well, President Donald Trump is confident that he knows, but most economists are baffled.

In contrast, many economists think they do know why the recovery after the crisis has been unusually slow. Unfortunately, they disagree. Too little fiscal stimulus, too cautious monetary policy, not enough bank restructuring, underlying institutional or demographic weaknesses, consumer fears, sociological factors – the list of proposed explanations is too long to inspire much confidence in any one of them.

In sum, few of the economic fogs of 2008 have lifted. From an academic perspective, such ignorance may provide a welcome opportunity to learn more. For the rest of the world, however, it is a cause for concern.

First published Sept. 19, 2018

(Image: REUTERS/Shannon Stapleton)

BY ANTONY CURRIE, GEORGE HAY

Last decade’s financial crisis mostly put the “D” in dealmaking. Cratering markets created plenty of opportunities for less-afflicted banks to try to snap up, or take a stake in, rivals on the cheap. Many of those investments and takeovers, though, brought as much pain as progress to the instigators. Breakingviews looks back at those few that turned out to be the best – as well as some of the worst.

What so often turned deals into duds was the hope that a relatively stable lender could buy a troubled peer and turn it around. Buyers essentially bet they were facing a more or less conventional recession, rather than an epochal U.S. housing collapse that spawned a global financial crisis. In Europe, Lloyds TSB’s acquisition of HBOS in September 2008 and Commerzbank’s digestion of Dresdner Bank a few weeks earlier fall into this camp.

The Lloyds deal initially looked like a winner. The UK bank paid below book value to bump its domestic mortgage market share way above 20 percent, while the merger seemed to allow HBOS to put a recent failed rights issue and rapidly disappearing wholesale funding behind it. But a month later the combined group still wound up requiring a bailout from the government, which took a 43 percent stake. And in early 2009 HBOS announced a 10 billion pound pre-tax loss, miles above expectations. Lloyds only escaped Whitehall’s embrace in 2017.

Commerz, meanwhile, paid Allianz roughly the face value of Dresdner’s assets to become Germany’s leading retail bank. Within months Berlin had injected over 18 billion euros to prop it up. The German government still owns some 15 percent – and the bank trades at just 40 percent of book value.

Bank of America can lay claim to the worst example across the pond. In January 2008 it paid $4 billion for Countrywide, one of the largest U.S. mortgage lenders. It paid only a third of book value, so had what seemed like a decent buffer against losses. These and legal fines, though, ultimately cost BofA some $40 billion.

The wrath of regulators upended other deals, too. JPMorgan picked up Bear Stearns and Washington Mutual for around $2 billion apiece, each with assistance from the government. Bear boosted JPMorgan’s trading and prime brokerage units – and came with a new building at the time worth perhaps $1.4 billion. WaMu got the retail bank into lucrative markets in California and Florida. But the two acquired firms accounted for the majority of the $44 billion in crisis-related fines later levied on JPMorgan.

A couple of institutions stand out from the pack. Santander, then under wily Chairman Emilio Botin, struck two deals in the UK that were the essence of canny opportunism. It picked up Alliance & Leicester in July 2008 for 1.3 billion pounds. And two months later it spent 600 million pounds for Bradford & Bingley’s better assets, offloading problem loans onto UK taxpayers. At a stroke, Botin took the bank’s UK market share from 6 percent to 10 percent. The profit from its UK outpost proved more than handy when the euro zone crisis came knocking a couple of years later.

The Breakingviews pick for deal of the crisis, though, involves Morgan Stanley. It’s not the obvious one – its gradual acquisition of Smith Barney from Citi, for a total of $9.3 billion, starting in 2009. That has worked out well enough: Wealth management’s pre-tax profit over the past 12 months was almost two-thirds higher than what the two companies’ divisions managed in 2008.

But it’s Mitsubishi UFJ’s investment in the Wall Street bank that gets the accolade. It got off to an inauspicious start: The Japanese lender announced it had agreed to buy $9 billion of preferred and convertible stock on Sept. 29, 2008 – the day the U.S. Congress voted against a bank bailout, condemning the Dow Jones Industrial Average to a record one-day drop of 777 points.

The investment, though, has paid off handsomely in three ways for MUFG, which converted most of its holdings into a roughly 20 percent ownership stake. First, by ensuring Morgan Stanley’s survival in a drastically consolidated investment banking sector, the Japanese firm was able to roughly triple its money, including dividends, over the past decade, Breakingviews calculates. Second, MUFG now reaps almost a fifth of its earnings from the business arrangements the two struck – a joint-venture investment bank in Japan, access to MUFG’s balance sheet for Morgan Stanley, and access to Morgan Stanley’s global network for MUFG.

Third, the successful business partnership allowed MUFG to avoid having to spend billions of dollars trying to compete with bulge-bracket investment banks from scratch. Corporate Japan’s history of bad overseas deals – Nomura’s crisis-era acquisition of some Lehman assets, for example, makes MUFG’s success all the more notable.

First published Sept. 18, 2018

(Image: REUTERS/Gary Hershorn)

BY RICHARD BEALES

Anyone who has held shares in American International Group since the end of 2007 is still nursing a 95 percent stock-price loss. That’s even worse than fellow crisis basket case Citigroup. The insurer is, arguably, finally emerging from a lost decade after receiving a controversial $182 billion U.S. government bailout in 2008. But investors remain wary.

The disaster 10 years ago centered on AIG’s financial-products unit, which had sold huge amounts of supposedly not-very-risky credit protection on subprime-mortgage products. The consequences included a $62 billion loss in a single quarter, the final period of 2008.

Employees were vilified, and some critics labeled the bailout a conspiracy to help banks, because it enabled AIG to pay billions to trading counterparties including Goldman Sachs and European institutions like Société Générale and Deutsche Bank.

AIG offloaded assets including its historic Asian life-insurance arm AIA, which has more than tripled in value since it was floated in Hong Kong in 2010. Repaying the government in full in December 2012 was a signal achievement of the then chief executive, the late Bob Benmosche.

Revenue shrank steadily under Benmosche, Peter Hancock and, since May last year, Brian Duperreault, as successive CEOs fought to bring both continuing businesses and problematic legacy lines under control.

Duperreault is an industry guru and veteran of AIG, insurer ACE, Marsh & McLennan and Bermuda-based Hamilton Insurance. Ask around his head office in New York, and people say he is a leader who can make the company hum again and who’s assembling a stellar team.

The removal of AIG’s “systemically important” designation by regulators last year was a landmark, too. It even looks like a different company: without AIA, with a focus on stronger underwriting practices, and with ambitions to grow again. The company in July closed its biggest acquisition since the crisis – the $5.5 billion purchase of Validus, a Bermuda reinsurer with a Lloyd’s syndicate and catastrophe-bond asset manager.

Yet AIG still isn’t back to profitable growth, and the roughly $50 billion group’s shares are priced at a nearly 25 percent discount to book value, far lower than most peers. Investors don’t yet accept that the company’s dismal recent past is behind it. Maybe that’s something AIG can achieve in 2019, its centennial year.

First published Sept. 13, 2018

(Image: REUTERS/Robert Galbraith )

BY ANTONY CURRIE

Lehman Brothers should not have failed. No, that’s not a criticism of the U.S. government’s refusal to bail out the firm, thus condemning it to file for bankruptcy on Sept. 15 a decade ago. Instead, it’s a recognition of how Chief Executive Dick Fuld and his lieutenants had built a well-run investment bank – until they succumbed to hubris.

Under Fuld, Lehman navigated several crises. The Mexican peso collapse, the Asian and Russian meltdowns and the dot-com bust all hit within six years of the Wall Street firm getting spun out of American Express. Minutes after the first plane hit the World Trade Center in September 2001, executives had a team crossing the Hudson river to Lehman’s backup office. Fuld liked to tell how watching a gambler in a casino lose everything after doubling down taught him the value of caution.

He forgot it during the real-estate bubble – an asset where Lehman was a leader. That, though, bred overconfidence that seeped into other assets from commercial property to leveraged buyouts. In late 2006, Fuld and the gang approved raising the company’s risk limit by almost half – just as Goldman Sachs started cutting exposures. Within months Lehman had shot through that as Fuld, President Joe Gregory and investment-banking boss Skip McGee routinely waived limits on individual deals, as Anton Valukas detailed in his report on Lehman’s collapse for the bankruptcy court.

Those who spoke out against such moves, like risk chief Madelyn Antoncic and trading head Mike Gelband, were sidelined or removed. The top dogs’ response to the worsening crisis was so slow that plans to offload debt and bridge-equity stakes in problem deals like Archstone Property were in the “18th inning” in late 2007, in the words of former finance chief Erin Callan.

Rather than address the concerns she raised, Fuld and Gregory would caution her about her “provocative” clothing and “interrogatory style.” They were similarly tin-eared when confronted by the arguments of short-sellers. All the while, executives were using an accounting trick, Repo 105, to make Lehman’s balance sheet look healthier than it was in its final few quarters. Regulators acquiesced as Lehman raised risk limits.

So was it the government’s fault too? Fuld, for one, argues that it was, also blaming regulators and even homeowners. That question now has little relevance – the rules governing banks have changed dramatically since 2008. But Lehman wouldn’t have failed without hubris – and for that there’s still no cure.

First published Sept. 12, 2018

(Image: REUTERS/Joshua Lott)

BY GINA CHON

The firefighters of the last financial crisis are pointing out smoldering dangers that could exacerbate the next one. Ten years after Lehman Brothers failed, former U.S. officials Ben Bernanke, Tim Geithner and Hank Paulson agree that it is near impossible to predict the triggers for the next economic calamity. That makes defenses, such as a robust economy and strong institutions, all the more important.

At a Brookings Institution event on Wednesday, the trio recalled things they could have done better. Future policymakers will make mistakes of their own but can at least ensure the economy is resilient when the shock hits.

That is why Paulson, a former Treasury secretary, worries about the rising U.S. budget deficit, which he called a debt bomb. The shortfall is estimated to hit $1.1 trillion in 2019, which equates to about 5 percent of GDP. And as Bernanke, who used to be the chairman of the Federal Reserve, pointed out, the share of GDP that is spent on debt interest-rate payments will end up rising. That spells difficult budget choices in the future.

Republican tax cuts passed last year also aggravate income inequality. After-tax incomes will increase most for the top 0.1 percent, according to a March study by the University of Pennsylvania’s Wharton School. Yet the share of total household income for the top 5 percent of earners in 2017 is only slightly smaller than the lowest three quintile income brackets combined, according to a survey released on Wednesday by the U.S. Census Bureau.

Geithner and Bernanke also noted the importance of civil servants who execute policy. The success of the unique credit facilities and backstops created by the Fed and Treasury during the crisis was a function of the creativity and expertise of the government employees implementing the programs.

Under the administration of President Donald Trump, thousands of bureaucrats have left government because of budget cuts and low morale. About 15,000 are estimated to have been culled from federal payrolls between fiscal years 2016 and 2018, according to the Congressional Research Service. Last month, Trump also canceled a 2.1 percent pay raise for federal workers.

The former officials have helped put together a handbook of lessons learned from 2008. But it’s up to current and future policymakers to ensure that inequality and a hollowed-out civil service don’t hamper the next generation of crisis firefighters.

First published Sept. 12, 2018

(Image: REUTERS/Joshua Roberts)

BY TOM BUERKLE

Ray Dalio has been studying economies and markets to reveal their hidden patterns since launching a hedge fund out of his Manhattan apartment more than 40 years ago. Those efforts have served him and his investors well. Bridgewater Associates was one of the rare managers to post positive returns in 2008, and today it’s the world’s largest hedge fund with $160 billion under management.

Now he’s sharing some of the firm’s research in a new e-book, “A Template for Understanding Big Debt Crises.” He discussed the book and his outlook on today’s markets with Breakingviews Associate Editor Tom Buerkle.

You’ve written about your early mistake in expecting the Latin debt crisis to trigger a depression in 1982. What lesson did you take from that?

That the power of the Federal Reserve to lower interest rates and produce liquidity – and the power of a country’s fiscal policymakers to restructure debt if it’s denominated in its own currency – is much greater than the power of the debt to weigh down an economy, even when the debts are too large to be paid back.

The ideology in 2007, espoused by Alan Greenspan, was that policymakers can’t identify a bubble but they can clean up afterwards. Does that thinking still permeate policymakers’ minds today?

Unfortunately, yes it does. What concerns me most is that central banks don’t take responsibility for controlling bubbles when they are responsible for the debt creation that fuels them. Controlling bubbles should be as much a part of central bank mandates as inflation and growth. I’m pretty sure that the next big debt crisis will be due to one or more big bubbles that the central banks didn’t control.

I’m also worried that legislation that reduced the risks of overleverage by banks – which was good – has also reduced policymakers’ freedom to handle debt crises well. It could be against the law to do what’s necessary to save the financial system.

You mean post-crisis restrictions on future bailouts?

Exactly. There is always a group of lenders, whether it’s banks, that comes under regulation and provides protections to those who put money with them, and there is always a group of shadow banking lenders that develops outside those regulations because it’s more profitable. Existing regulations don’t make adequate provisions for handling the new forms of shadow lending and in fact restrict policymakers’ ability to handle them.

Where does debt concern you today?

I don’t see the sort of debt crisis on the immediate horizon as I saw in 2007 for 2008, but I do see serious problems two or three years down the road. The biggest risks come from multinational companies and countries that borrowed in dollars and have incomes in their local currency, so they have big asset-liability mismatches.

I think sales of U.S. Treasury bonds over the next two to three years will be so large that I find it difficult to see who the buyers will be. There are also other pockets of potential debt problems such as commercial real estate and some lower-grade corporate credits.

I’m also concerned that monetary policy won’t be as effective because the abilities of central banks to push down interest rates and push up asset values through quantitative easing will be much less than in the past. As I see it we are in about the seventh inning of this cycle so we have time, but not a lot, before the next debt crisis emerges.

The Fed’s own forecasts put the federal funds rate in the 3.5 percent range in two years’ time. A normal curve would give a 10-year yield around 5 percent. Would that be a stable equilibrium?

No. We estimate that if the bond yield was to go above somewhere in the vicinity of 3.5 to 4 percent, that would create a bear market for most asset prices and have a negative impact on the economy. I don’t think there are enough Treasury buyers in the United States, so that will mean that a large supply will have to go to buyers abroad. Most likely those sales will happen via a depreciation in the dollar. If we look two or three years out, we have a risk – a significant risk – of the markets and the economy going down because of these sorts of funding problems.

What about the risk of a Fed policy error?

I think the Fed is doing a good job in tightening cautiously. I also think that this time around, it will become a progressively more difficult job as the cycle becomes more extended. No central bank gets it perfect, which is why we always have recessions.

You write that the political consequences of crisis can be greater than the economic ones. Is that what we’re seeing with populism in the United States and Brexit in Europe?

Yes. When you have the next downturn, we will probably have greater conflict and more populism. That has historically resulted in more confrontation within countries and between countries.

Are you concerned that could happen to U.S.-Chinese relations?

Yes. Over the last 500 years, there have been 16 times when an emerging country competed with an existing power, and in 12 of those cases wars resulted. Usually an economic war precedes a military war. How the United States and China deal with the competition will be important. That’s another reason why today’s circumstances are very similar to those in 1935-40.

In the past decade, money has flowed in basically two ways: to passive vehicles and exchange-traded funds, and at the other end of the spectrum to hedge funds, private equity, private credit funds. Do you see more of the same in coming years?

These shifts look to me to be very much like the shifts between active and passive in the past. In a bull market in stocks, passive will tend to do well relative to active strategies like hedge funds or other asset strategies that don’t have systematic biases to long. Then you have a bear market and everything’s totally different and active becomes more popular.

That almost sounds like you’re wishing for a bear market.

I guarantee you that I’m not. We have equal opportunities in up or down markets. All I’m saying is every manager tends to have biases.

First published Sept. 12, 2018

(Image: REUTERS/Brian Snyder)

BY ROB COX

The biggest question left unanswered since the great financial crisis erupted 10 years ago is the following: Are some banks too big to fail? It can’t be solved because no major U.S. financial institution has come close to collapsing in the decade that followed Lehman Brothers’ failure. Only a true calamity, the conventional wisdom goes, will test the mettle of watchdogs, central bankers and politicians.

Naysayers argue that, when push comes to shove, the political and regulatory establishment will cave, resorting to variations on the taxpayer bailouts that limited catastrophes in the United States, UK and other developed economies in 2008. Supporters of reforms like the Dodd-Frank Act say the system is safer and that creditors and stockholders will bear the burden of even a mega-bank’s demise.

It’s hard to say who is right. But for first time since before things went wobbly there is some evidence to suggest one feature of the era of too-big-to-fail banks is at last coming to an end – at least in the world’s largest banking market. So far it is just a scintilla of proof contained in a recent data dump from the Federal Deposit Insurance Corp relating to the way large and small banks fund themselves.

Every quarter, the watchdog conducts an extensive crunch of numbers from all the banks whose deposits it insures. At last count, at the end of June, that came to 5,542 separate entities, a number that has shrunk every year since peaking in 1986 at more than 18,000 institutions. Back then, there were no banks with trillion-dollar balance sheets like JPMorgan, Wells Fargo or Bank of America. The 38 biggest banks, all with less than $250 billion in assets, made 28 percent of all the industry’s loans.

Over the years, through mergers and acquisitions, failures, and regulator-supervised consolidation, that has shifted dramatically. Today just nine banks control half of the entire industry’s assets. This cohort, which also includes Morgan Stanley, Goldman Sachs and Citigroup, is what regulators call systemically important – meaning they are deemed so big that the demise of just one of them might bring down the whole financial order. That’s why they received the bulk of the taxpayer-funded bailout made available during the 2008 panic.

Even though the subsequent financial reforms passed by Congress mandated they wouldn’t receive that sort of preferential treatment again, these big banks have financially benefitted from a lingering perception that they will never be allowed to go under. It is visible in what the FDIC calls their “quarterly cost of funding earning assets.” This is effectively what the banks pay for the money they use to make loans to borrowers, or to purchase interest-bearing securities like Treasury bonds.

Naturally, banks with lower funding costs should be more profitable because the difference widens between what they pay for money from depositors and investors, and what they charge for lending. Banks that do not let that so-called spread fall to the bottom line can use it as a competitive edge in the hunt for customers, undercutting banks that pay more to fund their earning assets.

For most of the contemporary history of American banking, at least as tracked by the FDIC since 1984, being bigger had no discernible benefit when it came to funding costs. Consider the first quarter of 1986, when America had a record 18,083 banks. The biggest of them, on aggregate, paid 7.59 percent to fund their businesses. Everyone else paid less, with the smallest fries paying a full percentage point less.

Apart from a few quarters in the early part of this century, that dynamic remained relatively consistent until the first cracks in the subprime mortgage market emerged. At the start of 2008, the top six banks started paying lower funding costs, at first by just a few basis points. But as the U.S. government stepped in to prop up the largest firms, that gap dramatically widened.

At the start of 2009, the six banks with balance sheets greater than $250 billion were paying just 1.06 percent to fund their assets, according to the FDIC. The 4,504 banks with between $100 million and $1 billion of assets – the largest category by number of institutions – were suddenly paying double that. The reason: Depositors and investors appeared to believe the big banks would not be allowed to fail, so their money was safer in the vaults of a JPMorgan, Bank of America or Wells Fargo.

Big bank executives made up all sorts of other reasons for the widened funding gap. It was, they argued, because big banks had vast branch and ATM networks; their mobile applications were superior; younger customers don’t want personalized customer service; and so on and so forth.

In effect, it was something like a run on the small- and medium-sized banking industry. And the disparity continued, beyond the passage of Dodd-Frank, the rollout of new capital standards and the Volcker Rule prohibiting proprietary trading. It outlasted even the era of ultra-low official interest rates.

Until now. In the most recent quarter analyzed by the FDIC, banks with fewer than $1 billion of assets paid 0.63 percent to fund their books, 1 basis point less than the nine mega-banks. That hasn’t happened since the end of 2007. The trend began with the smallest cohort of banks in the first quarter.

There are a few possible explanations. Big banks face more competition, and are therefore quicker to raise rates on interest-bearing deposits as the Federal Reserve increases the official cost of money. Customers of smaller banks, many of which are in rural communities, may have fewer choices and anyway may prize more personalized service. Perhaps, but one hopeful interpretation may be that, 10 years after the chaos, the market has come to believe that all banks can fail in equal measure.

Sheila Bair, who ran the FDIC during the crisis, thinks regulators have the tools they need to allow for large institutions to go under without impeding customers seeking mortgages or small business loans. “You impose losses on the shareholders and creditors, which is how it’s supposed to work,” she told Breakingviews in the Exchange podcast to be aired later this month. “But I think you also have the problem of just too big, and too big in terms of political influence, too big an influence of your academic institutions, too big in terms of influence over think tanks, too big, frankly, an influence over some of the media.”

The numbers are moving in the right direction, one where size no longer appears to confer a specific too-big-too-fail advantage. But only the next crisis will confirm whether she’s right on the politics.

First published Sept. 11, 2018

(Image: REUTERS/Mike Segar)