On September 15, 2008, the $639-billion Wall Street investment bank, Lehman Brothers Holdings Inc., collapsed in a bankruptcy filing more devastating than any the world had ever seen. The aftershocks were swift and far-reaching. Stock markets plunged. Credit stopped flowing. In the United States, the Lehman debacle knocked an already stumbling economy to its knees. America lost almost 500,000 jobs in October, 2008, the month after the collapse. Before the hemorrhaging stopped, it would lose a total of 8.8 million. that’s equal to the population of Tokyo. Tokyo, for that matter, was not spared. Japan was rocked by the economic reverberations, as were China, Brazil, Russia, Germany, Britain, Canada and other major economic powers. The Lehman crash made a mockery of the notion of the great decoupling — the presumption that the global economy was no longer tied to the economic fate of the United States. Even in the varnished language of the International Monetary Fund, you can hear the alarm in their statement a month after the Lehman implosion: “The world economy is entering a major downturn in the face of the most dangerous financial shock in mature financial markets since the 1930s.”
Most observers call what followed the Great Recession. But why didn’t we end up in a Depression, as so many had feared when the stock market entered free fall and millions were laid off in the U.S., Canada and around the world. There is no shortage of memoirs, fly-on-the-wall reportage and academic analysis. And while the definitive account has yet to be written, consider this the first chapter on the lessons we learned — so far.
Maybe not everyone needs a home
Alberto and Rosa Ramirez, Mexican-American strawberry pickers in California, obtained a loan in 2005 to buy a $720,000 house. The couple made less than $15,000 a year, and they were not required to put any money down.
There’s no need to continue with this story, as recounted by Princeton University economist and former U.S. Federal Reserve vice-chairman Alan Blinder in his new history of the Great Recession, After the Music Stopped. We know how the story ends. The Ramirez family and thousands of others are the human face of the collapse. Yet before the crisis, Alberto and Rosa could just as easily have been the face of George W. Bush’s “ownership society.”
In 2005 and 2006, Bush and his Treasury secretary at the time, John Snow, thought they had orchestrated something special. The home ownership rate — the percentage of homes that are owner-occupied — was at record levels and pushing toward 70%. (U.S. house prices had increased by about 25% between 2003 and 2005.) It apparently occurred to no one in the Bush administration that maybe that was too good to be true. The home ownership rate was only about 64% a decade earlier, in line with historical norms. “These price increases largely reflect strong economic fundamentals,” Ben Bernanke observed in October, 2005, when he was the head of Bush’s Council of Economic Advisers.
There was nothing magical about the “ownership society.” Home buying and prices were being fuelled by the low interest rates the Fed had engineered, terrible underwriting standards and perverse incentives that drove real estate agents to sign up as many mortgage holders as they could. Mix in a little fraud that preyed on America’s obsession with property and its reckless relationship with credit and you have a recipe for the mother of all housing busts.
“In retrospect, the bipartisan consensus to promote housing went too far,’’ Snow said in written testimony to the House Committee on Oversight and Government Reform in October, 2008. “There was a push for too much of a good thing. Those excesses eventually came home to roost.’’
Too much home ownership only gets at part of the problem. Lehman’s collapse, and the crisis in just about every other major economy, can trace its origins to the arcane financial instruments banks employed to fuel the great real estate bubble of the early 2000s. For decades, governments had helped banks and other lenders to securitize mortgages — bundle them up into real estate securities that could then be sold off to investors. These allowed everyone from grandmothers in Norway to municipalities in Greece to own a piece of the American Dream. So complex were those securities that it was getting increasingly hard to see the dodgy loans at the bottom of them.
Get that dog back on its leash
“I’m being called Mr. Bailout,” U.S. Treasury Secretary Henry Paulson declared on a conference call in September, 2008, with Bernanke, now Federal Reserve Board chairman, and Timothy Geithner, president of the New York branch of the Fed. “I can’t do it again.” That call occurred a few days before Paulson, the former Goldman Sachs CEO, failed to persuade his fellow Wall Street Masters of the Universe to rescue Lehman. He had had greater success earlier, in March, when he arranged for JPMorgan Chase & Co. to buy troubled Bear Stearns Cos. Inc. But the Paulson-Geithner-Bernanke troika had provoked outrage in Congress by providing a $29-billion loan from the Fed to seal the deal (all currencies in U.S. dollars except where otherwise noted).
Lehman was to be the end of Paulson’s innocence. Without government help, no one would touch Lehman. He and the bank CEOs could see the obvious — Lehman’s structure was fundamentally and dangerously flawed, as was the rest of the U.S. banking system.
The 1990s had witnessed the loosening of a symbolic tether that Washington had placed on banks to rein in the excesses that had caused the Great Crash of 1929. The Glass-Steagall Act of 1933 had been passed to halt a wave of thousands of bank failures during the Depression. Among other things, it set up federal deposit insurance and created the Federal Reserve’s powerful Open Market Committee to oversee monetary policy. The act also split conventional commercial banking and investment banking. The business of taking in deposits and making loans was to be kept separate from trading stocks, bonds and other securities.
But in the 1990s, Washington was gripped by deregulation fever, and much of that barrier had eroded, so Congress eliminated it altogether. Banks went from big to massive, like New York-based Citigroup, which turned itself into the Walmart of financial institutions. Citi and its competitors started generating eye-popping profits by making high-stakes trades on their own accounts, much of them in elaborate and highly leveraged mortgage-backed securities and derivatives. Leverage meant that they could make bets many times greater than the value of the capital they risked, even though that capital could be wiped out almost instantly in a sharp market downturn.
Lehman’s fall brought inevitable recantations. Alan Greenspan, Fed chairman during the go-go 1990s and early 2000s, admitted that he had been wrong to believe that financial firms’ instinct for self-preservation would keep rogue elements in check. Sanford Weill, Citigroup chairman until 2006, now says the biggest banks should be shrunk. Arthur Levitt, chairman of the Securities and Exchange Commission from 1993 to 2001, says he was wrong to advocate for light supervision of derivatives trading. In Europe, governments and regulators also admitted that they had let their banks get out of hand.
There have been genuine reforms since 2008. Authorities the world over are telling their banks to hold more capital against their loan and securities portfolios, and to keep their exposure to risky bets under control. Governments also still appear to be determined to move derivatives trading onto public exchanges. In the U.S., the so-called Dodd-Frank Act, passed in 2010, didn’t re-erect barriers between deposit-taking and investment banking, but it included new measures to monitor institutions deemed “too big to fail” and to break them up if they get too large, or restructure or sell them off quickly if they get in trouble.
There are no ideologues in a foxhole
As the Group of Seven finance ministers arrived at the White House to meet with President Bush on Oct. 11, 2008, the signs of a potential global cataclysm were already clear. U.S. stocks had plunged by almost 30% since Lehman’s downfall on Sept. 15. Central banks were frantically injecting billions into crumbling economies. Bush had already rushed to expand government deposit insurance to forestall any Depression-style run on banks. “In my country, it is important for our citizens to have understood that that which affects Wall Street affects Main Street as well,” he said.
Although the regimes in power in the U.S., Germany, Britain, France, Italy and Canada were predominantly of a free-market bent, they quickly agreed that if governments didn’t create demand by running massive deficits, no one would. For Canadian Finance Minister Jim Flaherty, this was like swallowing Buckley’s Mixture: “It tastes awful. And it works.”
That was only the beginning. The fiscally conservative regimes in Washington and Ottawa soon found themselves meddling directly in the banking system, and in troubled companies. Both governments provided billions to General Motors and Chrysler to save the Detroit-based auto makers from certain bankruptcy. Treasury Secretary Paulson took equity stakes in the country’s biggest banks. After telling shareholders of Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corp.) that the government would not take over the agencies, the Bush administration assumed control of both and bailed them out — just as investors had always assumed that the government would.
Canada, for its part, stumbled out of the gate. Prime Minister Harper decided to play politics with his fiscal update in November, 2008, including provisions that would have forbidden federal public servants from striking and would have ended public subsidies for political parties. The opposition parties united to try to take down the minority Conservative government, which was saved only by Harper’s controversial decision to prorogue Parliament.
Flaherty backtracked — and backtracked fast. His next budget in January, 2009, was modelled on a classic Keynesian stimulus plan. He didn’t worry about fancy legacy projects such as high-speed rail and solar farms. He was content to fix up community colleges and build hockey rinks. If an infrastructure project was ready to go, Flaherty was ready to pay for it. He also instituted deadlines: No dilly-dallying; use it or lose it. That’s how emergency stimulus is supposed to work: timely, targeted and temporary. When asked by reporters in February, 2009, whether he was worried that the money would be misspent, he shrugged. “There will be some mistakes made,” he said. “Stimulus for next year is not what we want. We need it now, this year.”
Relative to the size of its output, Canada’s stimulus program was one of the larger ones among the world’s major economies. In total, Harper’s government spent about $47-billion (Canadian) directly on stimulus, spread over 2009 and 2010, which amounted to about 3% of gross domestic product each year.
The Auditor General of Canada concluded in the fall of 2011 that Flaherty’s “Economic Action Plan” got the job done. While stimulus laggards such as the U.S. suffered historic contractions, Canada’s downturn was relatively short and less severe than recessions in the 1980s and 1990s. “Our analysis clearly shows that the fiscal stimulus by the federal and provincial governments worked,” says Glen Hodgson, chief economist at the Conference Board of Canada, an economic research outfit based in Ottawa.
Flaherty had been inspired to get into politics by former prime minister Pierre Trudeau’s indifference to making the right side of the accounting ledger match the left. But Flaherty took the government deep into deficit and demonstrated that John Maynard Keynes’s Depression-era economic theories are still relevant.
Somewhere, Keynes is smiling. So is Trudeau, although for slightly different reasons.
Central bankers are gods — they have to be
In the 1990s and the early 2000s, then-Federal Reserve chairman Alan Greenspan appeared to have one of the sweetest jobs in the world. Central bankers were like commercial airline pilots: A lot of training was required to get to the top, but once there, modern economies basically fly themselves. Keep an eye on inflation and move the benchmark interest rate a little bit up or down — or just hint that you will. Easy.
There’s nothing easy about central banking now. Led by Bernanke, who succeeded Greenspan in 2006, central bankers took on a new persona: superhero. In the immediate aftermath of the Lehman collapse, the world’s central banks, most of which were born in crises, had to rise above the financial and political chaos quickly and dramatically.
Bernanke seemed especially well-placed. The Great Depression scholar, who, as happenstance would have it, wound up leading the U.S. Federal Reserve at the start of the next great global economic conflagration, reminded the world of the critical reason central banks were created: to put money into the economy when no one else will. From early October until December, 2008, Bernanke slashed the Fed’s benchmark federal funds rate from 2% to essentially zero. In November, he announced that the Fed would buy up to $600-billion worth of housing agency debt and mortgage-backed securities to inject cash into the economy. In March, 2009, he said he would expand those purchases, and buy government Treasury bonds, up to a total of $1.75-trillion — an amount almost double all Federal Reserve assets prior to the crisis.
Throughout the 2008 crisis and afterward, Bernanke acted with what veteran U.S. financial writer Roger Lowenstein describes as a “preternatural calm.” The day after Lehman failed, Bernanke immediately authorized the New York Fed to lend up to $85-billion to the giant life insurer American International Group (AIG), to prevent it from becoming the next massive financial domino to fall. When Congressman Barney Frank asked Bernanke if he had the money for the rescue, Bernanke coolly replied, “I have $800-billion.”
Later that month, as the skittish Paulson struggled to persuade legislators to give him $700 billion for his Troubled Asset Relief Program — needed, he said, to buy toxic mortgage-backed securities and other severely battered holdings off banks’ and insurance companies’ balance sheets — the lawmakers listened to the Fed chairman. After several of them said they saw little evidence of an economic downturn in their districts, Bernanke warned, “You will.”
For many U.S. politicians and commentators — the fiercely libertarian Ron and Rand Paul crowd in particular — the Fed’s powers now look frightening. Thirty senators voted against Bernanke’s renomination as chairman in 2010, the most ever. For mainstream economists, however, Bernanke’s willingness to use those powers to the full has come as a relief. “Counting the score from the days and weeks after Lehman until today, Bernanke’s performance as leader of the Fed has been superb,” says Alan Blinder, who was Greenspan’s top lieutenant from 1994 to 1996.
Bernanke wasn’t alone. The leaders of the world’s other major central banks morphed into the Avengers, the Marvel Comics band of champions that includes Captain America, Iron Man and Thor.
In Canada, near the depth of the downturn in April, 2009, Bank of Canada Governor Mark Carney dropped his central bank’s benchmark overnight rate to 0.25% — the lowest he could — and promised to keep it there for at least a year. In Britain, the Bank of England followed the Fed in essentially printing billions to buy troubled assets from banks. The Swiss National Bank bought euros with abandon, flooding currency markets with its francs to keep the value from soaring into the stratosphere.
When Carney went to London this past February for the mandatory parliamentary review that goes along with accepting the top post at the Bank of England, he said that he hoped his exit at the end of a five-year term would be “less newsworthy than my entrance.”
A man can dream, can’t he? It seems unlikely that the world’s central bankers are destined for the back pages any time soon.
The next big mistakes will not be the same as the last big mistakes
Jamie Dimon must be one of those dads who keeps work and home separate, because one of his daughters had to ask him one day after school, “What’s a financial crisis?” Dimon, the CEO of JPMorgan Chase and the undisputed Prince of Wall Street, responded, “Well, it’s something that happens every five to seven years.” Dimon recounted the exchange to the Financial Crisis Inquiry Commission in January, 2010, revealing a disconcerting level of fatalism.
Here’s a taste of what Fate has wrought. Four years after the U.S. economy officially stopped contracting and began a halting expansion, 136 million Americans now have jobs — 337,000 fewer than held jobs in September, 2008. So difficult has been the climb out of the crater left by the Lehman collapse that all the world’s major growth engines are now spent: The U.S., China, Japan and Europe are all sputtering below their potential output. Canada’s new central bank governor, Stephen Poloz, likens the uneasy state of the global economy to a period of “postwar reconstruction.”
The human toll can also be measured in an expanding gap between the richest and everyone else, and street violence in such cities as Athens, Madrid and Rio de Janeiro. In the U.S., the jobless rate peaked at 10% in October, 2009, and remains stubbornly high at 7.4%. (The Fed’s unofficial target is in the neighbourhood of 5.5%.) Canada’s unemployment rate ticked up in July to 7.2%. The political toll can be measured by tallying the number of leaders from 2008 who are still standing today. The count won’t take long.
Yet there’s a reason the downturn is called the Great Recession, not the Great Depression: The U.S. economy’s performance in 2008 and 2009 was stellar — relatively speaking. In the Depression, unemployment soared to almost 25% in 1933 (in Canada, the peak was almost 30%), and didn’t fall below 10% again until 1941. Compared to current unemployment rates in Europe, which average about 12%, and are more than 25% in intensive-care patients like Greece and Spain, the U.S. could have had it much, much worse.
Fortunately, some of the leaders in Washington who faced down the crisis don’t share Dimon’s fatalism. “I’m not a believer in the Old Testament theory of business cycles,” Bernanke said in November, 2011, during a visit to the Fort Bliss military base in El Paso, Tex. “I think that if we can help people, we need to help people.” Bernanke performed feats of monetary policy that few realized were possible. Some critics still think he did too little; others think he meddled too much. None of that matters. Bernanke will almost certainly retire next January a hero. He was the bulwark between recession and something worse.
Blinder begins the conclusion of his book with Ten Financial Commandments. The first is Thou Shalt Remember That People Forget. This is the reason Geithner gave for rushing to introduce new financial rules after he took office as Barack Obama’s Treasury secretary in January, 2009. Market gurus such as George Soros complained that officials were moving too fast, but the political window to do so is only as wide as voters’ memories.
Geithner and others were right to worry. The bank lobby in Washington not only fought to delay the enactment of Dodd-Frank in January, 2010, but continues to fight through the process of writing and implementing specific rules. A surprising number of Republican lawmakers would happily scrap it even now. The Obama administration’s ability to fight the crisis was also restrained by an already-bloated budget deficit. As surpluses under Bill Clinton turned to deficits under George W. Bush in the early 2000s, politicians forgot that one of the main reasons governments should run surpluses is so they are able to provide shelter when the rains come. Yet Democratic and Republican lawmakers still would rather score political points than balance the books.
In the post-crisis years, it’s become fashionable to reflect on the teachings of Hyman Minksy, an American economist who died in 1996. Minksy believed financial markets were prone to euphoria — and forgetfulness. Stability led to risk, which led to debt. And debt brought everything crashing down. This is the root of Dimon’s fatalism. There is something in the human condition that pulls us to the brink. There will be more crises and new lessons. But that’s not an excuse for allowing history to repeat itself. Bernanke, Carney and others have helped to improve the New Testament theory of business cycles. The challenge now is to commit its lessons to memory.
March 17, 2008
Shares of the 158-year-old investment bank Lehman Bros. fall by 48% after news that Bear Stearns has been bought by JPMorgan for $2 a share. Dick Fuld, who has been Lehman’s CEO since 1993, makes an appearance on the bank’s trading floor to boost morale — “the only time he did that in the last six months of the firm,” according to one Canadian trader. “It was like seeing Elvis or Madonna, because otherwise, you never saw the guy.” The shares bounce back the next day
Lehman investment bank posts a $3.9-billion loss in the third quarter, after writing down $5.6 billion in toxic mortgages. Fuld and CFO Erin Callan also announce that the brokerage firm has raised $6-billion in fresh capital. Its share price falls by 10%
Barclays announces it is considering buying Lehman, joining another potential bidder, Bank of America. Lehman’s shares fall by 13.5%
Moody’s warns it could downgrade Lehman’s credit rating if the bank doesn’t find a “stronger financial partner”
Over the weekend, 100 Wall Street bankers, regulators and Treasury officials meet at the New York Fed to discuss Lehman’s future. Treasury refuses to cough up more bailout money. Barclays withdraws its bid for Lehman; Bank of America follows suit within hours. Alan Greenspan warns that if Lehman goes, “we will see other major firms fail.”
Ten of the biggest investment banks put together a liquidity pool of $70 billion that any of them can tap
Sept. 15, 1 a.m.
Lehman files for Chapter 11 bankruptcy. With $639 billion in assets and $619 billion in debt, it is the largest corporate bankruptcy in U.S. history. Lehman’s 25,000 employees worldwide start packing their boxes
Sept. 15, 8 a.m.
Bank of America announces it will rescue Merrill Lynch in a $50-billion buyout
The S&P 500 falls 4.7%, its worst showing since the market reopened after the Sept. 11, 2001, attacks. Financial stocks have their worst day ever, down more than 10%
Barclays swoops in to buy Lehman’s U.S. business for $2-billion
The Fed announces an $85-billion rescue of AIG, giving taxpayers an 80% stake in the insurer
May 14, 2009
Fuld, whose compensation totalled roughly $500-million between 2000 and 2008, finally leaves the bank with no severance or bonus