Much to do to prevent another Lehman Brothers
Financial firms are still too complex, concentrated
We’ve learned a great deal from the failure of Lehman and the financial crisis that followed — including that without substantial financial reform our whole economy is at risk. The question is what has been done in response to those lessons. Unfortunately the answer is too little.
Lehman’s failure was a case study in many of the core causes of the financial crisis. By 2007, Lehman was borrowing more than $30 for $1 of equity capital invested by its owners. That left no cushion to absorb the losses it faced from underwriting complex investments tied to subprime mortgages.
Lehman financed about one-third of its over $600 billion in assets with overnight borrowing, meaning that it had to turn over some $200 billion in loans on a daily basis. Lehman also misled both regulators and counterparties about the extent of its borrowing and its available funds.
Today, the largest banks probably couldn’t get away with behavior quite this outrageous. Regulators have forced them to raise an additional $400 billion in capital, creating a greater ability to absorb losses. They face regular stress tests that would probably raise red flags about a Lehman’s level of reliance on short-term funding, and would spot many of the techniques used by the Lehman to falsify its levels of borrowing and ready cash. And the new Consumer Financial Protection Bureau is taking action to eliminate the worst abuses in mortgage lending.
But these reforms still fall well short of what’s necessary to protect us against the next Lehman. About 60 percent of the rules necessary to implement the financial reforms of the Dodd-Frank Act are still incomplete, including numerous critical rules aimed at minimizing the kinds of risks that could bring down the financial system.
Regulators working to improve financial monitoring recently admitted that they still “do not have a clear view” of the risks in the system. Regulators plan to allow borrowing ratios of about 20-to-1 (compared to Lehman’s 30-to-1) at major banks, still too high for comfort.
Oversight of the ratings agencies that enabled the sales of toxic mortgage-backed securities by pronouncing them as safe is still seriously inadequate. There’s also been little progress on designating large nonbanks, such as hedge funds, for oversight or on writing rules governing such businesses. Lehman acted to a significant degree as an enormous hedge fund; the next Lehman might well be a hedge fund, not a bank.
The changes made so far also don’t do enough to address the combination of complexity and concentration at the heart of the 2008 crisis. The giant financial institutions at the center of the economy are larger than ever, and still combine economically critical payment functions with complex and murky trading and brokerage activities.
J.P. Morgan’s unforeseen $6 billion trading loss in the “London Whale” episode demonstrates that neither risk managers nor regulators are fully prepared to address these complexities. More fundamental changes in the rules of the game, like those proposed in Elizabeth Warren’s bipartisan 21st Century Glass-Steagall Act, are still needed.
Even after its behavior led to the loss of millions of jobs and trillions of dollars in wealth, Wall Street still has far too much ability to delay, dilute, or prevent reform. Addressing that problem might be the most important reform of all.
Marcus Stanley is policy director of Americans for Financial Reform, a coalition of more than 250 civil rights, consumer, labor, business, investor, and other groups working for a strong, stable, and ethical financial system.