October 2018 Market Commentary
Written September 21, 2018
There’s an old joke that goes something like this: on Wall Street, the biggest lie is…”this time, it’s different.”
September 15, 2018 marked the 10th anniversary of the collapse of Lehman Brothers. The collapse led to the largest bankruptcy filing in U.S. history. As Lehman held over $600 billion in assets, this triggered a 4.5% drop in the Dow Jones Industrial Average - the largest since September 11, 2001. It was devastating to the U.S. financial system, and created a ripple effect that was felt globally. The events that led up to that fateful day are a fascinating tale of a perfect storm.
Although many factors contributed to the financial crisis, in large part it was the massive amounts of lending that people simply couldn’t afford to pay back. That risky lending was the snowfall on the mountain. Many economists think the avalanche was triggered on November 15, 2007. The Statement of Financial Accounting Standards 157: Fair Value Measurements¹ (SFAS-157), known as the ”mark-to-market” accounting rule, had been implemented in 2006. This required financial institutions to update their pricing on illiquid securities. Instead of carrying those securities on their balance sheets at cost, financial institutions were forced to change those securities’ values to what they would be worth if sold that day. Seems innocuous enough, but here’s the fallout from that rule. Write-downs of credit default swaps, mortgage-backed securities, and other financial derivatives caused some big banks to become insolvent, including the ill-fated Lehman Brothers.
What happened next was catastrophic. The stock market plummeted after the rule went into effect, but rebounded after a proposal to relax the rule’s guidelines. Coincidence? Maybe. Maybe not.
Now, don’t get me wrong. A recession was bound to happen at some point and these risky lending schemes were going to catch up with big banks eventually. But many economists believe that by letting Lehman Brothers go belly-up, a typical run-of-the-mill recession turned into the ”Great Recession.”
The days leading up to Lehman’s bankruptcy found regulators frantically trying to arrange a rescue for the bank which, at that time, was the 4th largest lending institution in the U.S. But their efforts, including a potential sale to Barclays and Bank of America, turned to smoke - forcing Lehman to file for Chapter 11. Regulators bailed out AIG the next day and Congress passed the Troubled Asset Relief Program (TARP) a few weeks after that. TARP injected $700 billion into the financial system.
One big question that remains debated to this day: Would the financial crisis have been so severe if regulators had bailed out Lehman Brothers? But that brings an underlying question: do you remember Bear Stearns?
Bear Stearns was a small bank by comparison. Regulators bailed out Bear Stearns by facilitating a distressed sale to J.P. Morgan Chase in March 2008. They also provided $29 billion to assist, ensuring that sale go through. This bailout gave Bear Stearns the necessary resources to avoid default, while setting an expectation to the banking community that banks will be rescued. The problem for Lehman was the assumption they would be saved and never considered the possibility of bankruptcy until the day before they were forced to file.
Why am I writing about this? To show that sometimes it doesn’t take anything more than a regulation change to trigger an unfortunate series of events. Here we are, ten years later, still debating what should have and could have been done. Can it happen again? Of course. After all, the biggest lie on Wall Street is….“this time, it’s different.”
I am tempted to end this commentary here. However, I want to impress that we don’t see the avalanche as much as we see more snow falling on the mountainside. A trigger might bring that snow crashing down one of these days. But we don’t see that happening in 2018. 2019 might be another story and we’ll evaluate it when we get there.**