BY PETE SWEENEY

In October 2008, Shanghai, regarded as China’s most cosmopolitan city, was shuddering from the aftershocks of a Wall Street earthquake. Lehman Brothers had collapsed a few weeks prior, battering the city’s benchmark stock index, down 70 percent since the start of that year; local bourses had lost $3 trillion in value. As exports shrivelled, the port became a marine parking lot. By early 2009, the government estimated one in seven migrant factory workers had been laid off. Shoppers could see them on evening strolls, prostrated on the benches of East Nanjing Road: a slumbering threat of political unrest.

Some in Beijing argued it was time to separate China’s fortunes from the United States. Over-reliance on U.S. consumer spending, reinforced by a repressed currency, had coddled manufacturing at the expense of local consumption. Confidence in Washington’s financial regulation also now seemed ill-advised. Some local financial institutions, having been allowed to start trading New York stocks in 2006, now faced massive losses, and it looked like fancy American derivatives were to blame. The experience soured a generation on free markets.

Yet China could not simply walk away from the American financial system. It had little choice but to keep buying U.S. treasury bonds, for example, given the lack of secure alternatives. “We hate you guys,” Luo Ping, an outspoken senior banking regulator, said in a 2009 speech in New York. “But there is nothing much we can do.”

Over the following decade, Beijing tried to cut its dependence on American consumers, capital markets, and currency. Perhaps not hard enough.

Inequity

Part of the reason for official complacency was the success of the government’s 4 trillion yuan ($580 billion) stimulus package. In China, there was no banking collapse, no wave of defaults, no proletarian revolt; GDP growth stayed over 9 percent. Surplus labour was put to work building railways and airports. Capital flight was arrested, and the central bank locked up the exchange rate. Many believed Beijing had proved its model superior.

Printing money proved addictive, however. Non-financial corporate debt rose sharply, touching $20 trillion at the end of 2017, according to Bank for International Settlements data: 160 percent of GDP. Tackling that is a challenge now complicated by the need to hold funding costs down to offset the impact of Trump’s tariffs, even as the Fed steadily hikes rates.

Chinese officials will also regret stalling the campaign to promote the yuan. According to SWIFT data, the currency of the world’s largest trading nation was used for less than 2 percent of international payments in August, three-quarters of those in Hong Kong. Unable to fundraise overseas in their own currency, Chinese corporates have become major dollar borrowers. Even President Xi Jinping’s Belt and Road initiative is being funded in part with dollar bonds. The yuan has now fallen back to nearly 6.9 per dollar – below the level it was locked into in 2008.

Domestic stock markets seem stuck in a time warp too. The Shanghai composite index remains down around 50 percent from its pre-crisis peak, where the S&P 500 has nearly doubled. With key reforms to market architecture on hold, Chinese equity and fixed-income instruments don’t reliably track economic growth or corporate performance. Nor are they sufficient to meet China Inc’s funding needs. So serious investors remain wary of them, as do Chinese technology stars like Alibaba, which listed in New York. The system thus remains over-dependent on bank loans, as it was in 2008.

Officials can take comfort in their cultivation of internal demand; it is now a far bigger driver of growth than exports, and has provided a thick economic cushion thus far. But consumer confidence is being tested, and falling share indices suggest punters don’t believe they are immune.

Regardless, without robust equity and bond markets, and a currency worthy of its trading stature, China will struggle to insulate itself from side-effects of U.S. monetary and trade policy. And it hasn’t built them. Regulators might have done so when conditions were accommodative: now it will be harder, and riskier. Trump’s trade war is based on questionable economics, but if he can rattle investors in the Middle Kingdom this easily, it’s hardly the American model that is to blame.

First published Sept. 28, 2018 

(Image: REUTERS/ Alexander Ryumin)

BY ANTONY CURRIE 

Buying Merrill Lynch has been a qualified success for Bank of America. The $310 billion mega-lender bought the Thundering Herd essentially over a weekend in the depths of the 2008 crisis for $50 billion. Merrill’s retail brokerage has worked out well. But the M&A and equity franchises, which are about to get a new boss, have faded under the BofA brand.

BofA’s 17,000 or so financial advisers – most a legacy of the Merrill deal – have become a jewel in the crown for the bank run by Brian Moynihan. The pre-tax margin on the brokerage unit in the first half of this year, for example, was a whopping 28 percent.

How the investment bank has performed is less clear cut. BofA ranks fifth so far this year in each of the league tables for selling new shares and advising companies on dealmaking, according to Thomson Reuters data. But combine the bank and the then independent Merrill back in 2007, and they would together have reached the top of the equity capital markets ranking and the fourth spot in M&A.

In today’s context, BofA’s ECM bankers brought in about $600 million in revenue in the first half of this year, three-fifths of what top dog Morgan Stanley managed. Its M&A advisory top line was similar, coming in at less than half what Goldman Sachs raked in.

That doesn’t make BofA’s former Merrill businesses a flop – they’re in the same ballpark as Citigroup’s. Both banks have taken a realistic approach since the crisis. Christian Meissner, the BofA investment-banking chief who is stepping down after eight years, got his firm to focus on profitability over size, slashing the division’s client list to 5,000 from 12,000.

Moynihan’s shop is routinely a top-three player in debt underwriting and lending, often putting it among the industry’s best fee-earners. The overall division, which includes transaction services, earned an enviable 20 percent annualized return on allocated capital in the six months to June.

The fairly modest revenue figures for equity sales and M&A in recent years, though, help to discredit the pre-crisis theory that commercial banks with huge balance sheets could dominate Wall Street. Matthew Koder, who is set to replace Meissner, would need to come up with something special to change that.

First published Sept. 20, 2018

(Image: REUTERS/Lucas Jackson)

BY PETER THAL LARSEN

Banks were the first institutions to fall in a decade of lost trust. The crisis that reached its climax with the failure of Lehman Brothers a decade ago swept away the notion that financial leaders could be relied upon to safely run their firms. Since then central bankers, politicians and the media have also faced growing public scepticism. The malaise shows no sign of lifting.

Rereading news reports from 2008, the biggest surprise is the credibility they granted to the chiefs of large banks. Even as their financial institutions threatened to collapse, investors, regulators and the media still attached enormous credence to what top bankers had to say.

This aura of plausibility reflected a deep belief that the people running large banks had a better idea than anyone else of the risks that their institutions faced. It was not just credulous fund managers and reporters who subscribed to this view: it was embedded in financial regulation. The Basel II framework that was being rolled out as the crisis struck explicitly encouraged banks to develop their own risk models, and dangled the promise of lower capital requirements to those that did.

With hindsight, of course, this view was mistaken. Banks not only took foolish risks, but were often also in the dark about the dangers they faced. In one telling example from early 2007, Switzerland’s Federal Banking Commission asked UBS about its exposure to subprime U.S. mortgages in the investment banking division. UBS replied that the unit had a net short position. The bank eventually wrote off tens of billions of dollars on subprime-related securities. The Zurich-based group simply did not understand what it owned.

The credibility of bank executives was comprehensively shredded by the vast bailouts that followed Lehman’s collapse. Subsequent scandals reinforced a public image of bankers as greedy and selfish, pocketing hefty bonuses as taxpayers picked up the tab for their recklessness. These days, most bank executives keep lower profiles and rarely speak in public. Those that do occasionally stick their heads above the parapet, like JPMorgan Chief Executive Jamie Dimon, are often met with intense criticism.

But bankers are not the only institutions suffering from a trust deficit. Western governments gambled their fiscal credibility to prop up banks. The policy helped to avoid a deeper slump, but at the expense of lasting public anger that helped fuel the election of U.S. President Donald Trump, the Brexit referendum, and the rise of anti-establishment political parties in Italy and across the European Union. Most of these movements thrive on distrust of established institutions and the technocrats in charge. Central banks like the Federal Reserve, which did more than anybody else to fight the global recession, have faced intense scrutiny of their crisis policies, the effects of very low interest rates, and the extent of their independence.

The news media is a more recent casualty. Technology has eroded traditional business models, while the rise of social networks has fundamentally changed the way consumers access information. The media is the least trusted major institution, according to the annual barometer compiled by Edelman, and is distrusted in 22 of the 28 countries tracked by the public relations firm.

These developments reflect deeper shifts in public attitudes to institutions that predate the financial crisis. Richard Lambert, the former editor of the Financial Times, recalls that during a banking crisis in the early 1970s, NatWest – then one of Britain’s top lenders – responded to rumours that it was in trouble by issuing a statement dismissing the idea that it might need official support. To Lambert’s surprise, the statement was believed, and the crisis passed.

By 2008, such emphatic assurances tended to be met with greater scepticism. Today, any bank that feels the need to publicly confirm its stability risks comparisons with securities firms like Bear Stearns and Lehman, whose bosses insisted they were sound days before they failed.

For banks whose business model depends on preserving the confidence of creditors and depositors, the trust deficit is a source of deep concern. Lenders have more capital than in 2008 and are more tightly regulated. But their dependence on computer systems and susceptibility to cyberattacks add new vulnerabilities. The only consolation is that when it comes to lacking trust, they are not alone.

First published Sept. 21, 2018

(Image: REUTERS/Alessia Pierdomenico)

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)