The financial crisis following the Lehman bankruptcy was the most challenging, terrifying time in my 30 years in the investment business. Financial markets practically froze, the banking system nearly collapsed, and the global economy — not just the United States’ — contracted sharply, leading to the deepest recession since the Great Depression.
Now, five years after Lehman’s collapse, what have we learned? Have we fixed the problems that precipitated the financial crisis? We have identified many of the root causes of the crisis and reduced the risks of another one. But we have by no means eliminated the risk.
Major financial reforms have been enacted, such as the Dodd-Frank Law passed in 2010, but scores of rules still need to be written, illustrating the complexity of both the law and the financial services industry. I remain hopeful, but also skeptical that new tools and new rules will allow regulators to spot future financial bubbles — and stop them before they burst. I’m also skeptical that financial reforms have adequately addressed the problem of “too big to fail” and the need for future bailouts. We won’t know if these measures will work until the next crisis hits.
Housing was at the epicenter of the last crisis. While there’s a natural human tendency to identify the villains (“greedy bankers”), the reality is that there was plenty of blame to go around. Certainly lending standards were lax — encouraged in part by well-intentioned policy makers trying to promote home ownership — but homeowners taking on mortgages they couldn’t afford, using home equity like a piggy back, or trying to get rich by flipping properties also share responsibility.
What many people learned — bankers and policy makers included — was that home prices can go down as well as up. As a result, it’s more difficult to get a mortgage today, making for a safer financial system, but also a tougher time for people wanting to buy a home. This tension between prudent lending and public policy (owning a home as “The American Dream”) remains unresolved.
One area of the financial system that still poses significant risks is the bond market, where corporations and governments go to borrow money for operations, projects, and expansions. Unlike stocks, which trade on exchanges such as the New York Stock Exchange, bonds are still primarily traded through Wall Street firms. These firms buy and sell bonds as needed to keep the market functioning, a process known as market making.
While companies that invest heavily in bonds, including mine, have generally grown since the financial crisis, Wall Street firms have shrunk and reduced the market-making they do in bonds. The reduced market liquidity — the ability to easily buy and sell bonds — could become very problematic if we have another financial panic and investors rush to sell their bonds or shares of bond mutual funds at the same time. A worst-case “vicious cycle” of selling could be analogous to the runs that banks experienced in the 1930s, and money markets experienced in 2008, before the government came to the rescue.
We have learned a number of valuable lessons since Lehman’s collapse. Lawmakers have passed legislation and regulators have implemented rules to reduce the probability — and perhaps severity — of another financial crisis. However, we have not eliminated the risk of future crises, nor have we changed human nature, which is still motivated by both fear and greed, two of the key ingredients for financial bubbles and crises.