Lehman Brothers and the Age of Stupidity

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Next Tuesday, Sept. 15, marks one year since Lehman Brothers filed for bankruptcy protection. The company's failure was the biggest bankruptcy in history, and it sparked one of the largest-ever financial panics -- large enough to nearly drag the entire economy down with it. As my colleague Alyce Lomax brilliantly put it, Lehman's demise was the onset of The Autumn of the Massive Collective Pants-Soiling. 

The key to Lehman's failure was, of course, leverage. At the end of 2007, leverage stood at more than 30-to-1, with $22 billion of equity supporting $691 billion in assets. The mechanics of such leverage is nauseating: A little more than a 3% decline in asset values, and it's game over. Anyone with a handle on fifth-grade arithmetic gets this, and the pre-Lehman leveraged failures of Long-Term Capital Management and Bear Stearns reiterated its cruelty. Name one bank that's flourished long-term on gross leverage, and you'll find thousands that met a quick death. It just doesn't work.

But leverage in itself wasn't the sole problem. What ultimately took Lehman Brothers (as well as Bear Stearns) down was how that leverage was financed.

Same industry, many types of stupid
Banks such as Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , and Wells Fargo (NYSE: WFC  ) finance their operations primarily through customer deposits. Thanks to FDIC insurance, this is a stable source of funding not prone to instantaneous evaporations.

Lehman was a different story. At the end of 2007, its balance sheet had $691 billion of total assets, financed largely by $28 billion in short-term debt, $123 billion in long-term debt, $150 billion in sold securities waiting to be purchased, and some $182 billion in various repurchase agreements.

Repurchase agreements -- called "repo" loans -- are collateralized financing instruments made in terms as short as 24 hours. Institutional investors with idle cash, such as mutual funds, pension funds, and hedge funds, lend banks like Lehman money in exchange for securities held as collateral. Once the term of the loan expires, the borrower promises to "repurchase" the collateral at a slight premium. The lender typically just rolls the loan from one day to the next, so the actual repurchasing of assets doesn't always occur.

In essence, repo loans are very, very short-term loans that investment banks use to cheaply finance their operations. Banks get a low cost of capital; investors invest cash at favorable rates. Everyone's happy.

Until things go BOOM
Everyone's happy, that is, as long as each party trusts each other. As lenders questioned the quality of the collateral being put up -- as was the case last fall -- they started backing away en masse. Then things hit the fan. Instantly.

Think of it this way: Imagine, rather than a 30-year mortgage, you bought your house with 24-hour repo financing. Every evening, you have to go to the bank and ask for an extension on your loan to the next day. Most of the time, especially when real estate prices are going up, the bank is more than happy to do so.  

Then one day, the bank gets worried about the value of your home and decides not to roll your over mortgage to the next day. You're suddenly forced to repurchase the house at its full price. If you don't have the cash to do it, the bank takes the house on the spot. You go from happy homeowner to homeless in the course of a few minutes. And with no more home, your other lenders might either back away, demand their money back, or ask for more collateral.

Similarly, banks reliant on the repo market could literally go from well-capitalized to bankrupt almost instantly if repo loans couldn't be rolled over to the next day.

This was a major concern among Wall Street CEOs last fall. After Morgan Stanley CEO John Mack suggested that letting Merrill Lynch fail was a sensible option, JPMorgan CEO Jamie Dimon said, "John, if we do that, how many hours do you think it would be before [mutual fund giant] Fidelity would call you up and tell you it was no longer willing to roll your paper?"

The viability of some of the largest banks in the world rested on the day-to-day confidence of a few counterparties. It was an incredibly dangerous, and incredibly stupid, way to conduct business.

Here's why that should bother you                         
In the days after Lehman's demise, Goldman Sachs (NYSE: GS  ) and Morgan Stanley (NYSE: MS  ) became bank holding companies, in what was seen as an exit from the short-term fickleness of short-term repo financing. The two investment banks, the thought went, would either form commercial banks or they'd buy something like SunTrust (NYSE: STI  ) or even Citigroup (NYSE: C  ) , as a way to gain a stable deposit base and end the era of short-term financing that proved so faulty.

A year later, that hasn't happened. While leverage has decreased and massive amounts of capital have been raised, a flurry of measures designed to prop up and guarantee lending markets has made it possible for the two banks to continue on as before, still heavily reliant on short-term funding. "Our model really never changed," said Goldman's CFO in July. "We've said very consistently that our business model remained the same."

As my colleague Matt Koppenheffer put it, nothing has changed in banking. Come the next financial panic -- which will happen -- we wonder what that means for the industry.  

Read more of our coverage, as we look back one year later.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.

Read/Post Comments (19) | Recommend This Article (85)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 11, 2009, at 11:40 AM, MKArch wrote:

    Over all good article but you forgot to include the role of shorts and financial terrorist in using this funding weakness to create a self fulfilling prophecy. Use the fear of the time to run the banks stock down effectively killing two birds with one stone. You take raising capital through stock sales off the table and plant the concern that there might be a run on the bank in the lenders minds causing them to pull their money to get ahead of the crowd creating the run on the bank. Banks dead mission accomplished on to the next bank.

  • Report this Comment On September 11, 2009, at 1:05 PM, TMFAleph1 wrote:


    Nice article. I just want to mention that Goldman's balance sheet is dramatically more liquid than it was prior to Lehman's bankruptcy, i.e. while their liabilities still include short-term financing, their assets include a much higher proportion of cash and equivalents.

    Alex Dumortier

  • Report this Comment On September 11, 2009, at 5:09 PM, pbielagus wrote:

    right on. I wrote about this in my blog a couple weeks ago. This nonsense has been going on for 30 years. I'm surprised it lasted that long.

  • Report this Comment On September 11, 2009, at 5:17 PM, 60srad wrote:

    Another thing you neglected to mention was the stupidity of deregulation, especially the lifting of Glass-Steagall. This is precisely the kind of failure to learn from history that brought us close to repeating the Great Depression. My favorite synonym for stupidity is conservatism. Bipartisan conservatism is the reason the country was able to lower its collective intelligence for such an uninterrupted period.

  • Report this Comment On September 11, 2009, at 5:31 PM, plange01 wrote:

    the age of stupidity is back and stronger than ever.companys like goldman sacks that were on the edge of failing once they recieved government aid and knew they had a back up went right back to their old ways and even to more risky investments....

  • Report this Comment On September 11, 2009, at 8:20 PM, spokeanwheel wrote:

    stupidity never get old people do and people forget,but stupiditynever forget s or gets old

  • Report this Comment On September 11, 2009, at 9:23 PM, mpg57 wrote:

    Dear 60's rad,

    Remember the Who? We won't get fooled again? Guess what! Lib or conserve doesn't matter. The same old stuff is still happening. There is no intelligence in politics, so let it go. Reagan was trickle down, BO is pee away! How about a lottery? that would shake it up!

    Seriously, government can't control anything, they just think they can.

  • Report this Comment On September 12, 2009, at 7:28 AM, wuff3t wrote:

    Short-sellers certainly took advantage of Lehman's troubles, but no company with Lehman's size and status and a sound financial footing would be as susceptible to a short attack as Lehman Brothers was. Blaming the short-sellers was just Dick Fuld's pathetic attempt to distract attention from his own failings.

  • Report this Comment On September 12, 2009, at 8:50 AM, jesse2159 wrote:

    In less than a week last year, Dick Fuld went from being a billionaire to merely having a few million. Not chump change, but a staggering correction to someone grossly overpaid to do something grossly stupid. We will all pay dearly for saving the other losers with government money. The shift of risk merely went from Citi and BoA to the taxpayer. Just like credit default swaps, except the risk is ours alone to shoulder. And politicians are at a loss to understand our anger. I'm at a loss to understand that they don't understand.

  • Report this Comment On September 12, 2009, at 11:48 AM, JoeDeanPhipps wrote:

    thank you jesse2159...well said. and I would add...they don't understand because they "have no ears to hear"...they don't listen...they don't care. it's an overstatement because there are SOME who are not in this category...but we common taxpayers, to them, are just a mass, opaque, absorbent sponge...a pool to absorb whatever they want to pour out on it. All they really do care about is getting reelected and maintaining their little cushy place of power and ego. one day...I predict...all of the pent up anger to which you refer will coalesce/come together or become organized in some way and come down like an avalanch on them...just like the financial crisis did...suddenly and without warning. see Ramo's book The Age of the Unthinkable and his metaphor of the pile of sand, and...just ONE MORE grain being added to the pile.

  • Report this Comment On September 12, 2009, at 6:14 PM, artbros wrote:

    The real problem is not regulation or deregulation, it is a plague of individual moral degeneracy that raises greed and other social sickness from vice to virtue. The sickness that causes CEOs to believe that they deserve millions or even billions in pay, a board to support short-term thinking that encourages leveraging everything in order to look good in this year's 10k filing, the utter contempt with which they treat shareholders and, by extension, their employees... this is the root of the problem.

    Until this changes, until we, collectively and individually, change our hearts and minds, the body of the United States will continue to decline and

    changes in the economy will happen regionally.

    When a gangerous wound rots, flies lay eggs and maggots hatch. The dead flesh begins to spread. If the necrotic process is not stopped, you are likely to die or lose a limb.

    Our wound, our infection is our greed, glutony and selfishness. There in lies the true source of the problem.

  • Report this Comment On September 13, 2009, at 12:06 PM, Poly1 wrote:

    Artbros...You are correct. But so many do not beleive.

  • Report this Comment On September 14, 2009, at 9:01 AM, howboutme wrote:

    When did the Motley Fool switch from writing articles that offer investing advice to writing newspaper articles, were you bought out? This article doesn't do anything for investing ideas.

  • Report this Comment On September 14, 2009, at 1:18 PM, rabbitt0 wrote:

    Artbros is right on. When you all get your greed under control and stop needing more and more of _____ (fill in the blank), the entire system will function with less turmoil.

  • Report this Comment On September 14, 2009, at 6:34 PM, thomdd1959 wrote:

    Who Are The Current Owners of “The Fed Scam”?

    While there may still be some smaller shareholders in the “The Fed Scam”, it is believed that the Federal Reserve is owned and controlled primarily by the following Central banks:

    1. Rothschild Bank of London

    2. Warburg Bank of Hamburg

    3. Chase Manhattan Bank of New York

    4. Warburg Bank of Amsterdam

    5. Rothschild Bank of Berlin

    6. Lehman Brothers of New York

    7. Lazard Brothers of Paris

    8. Kuhn Loeb Bank of New York

    9. Goldman Sachs of New York

    10. Israel Moses Seif Banks of Italy


  • Report this Comment On September 18, 2009, at 2:30 PM, dc46and2 wrote:

    If you have Washington in your pocket and the taxpayers to bail you out, you would be stupid NOT to take these kinds of risks.

    @60rad, could you provide more detail on which regulations (that were removed) would have prevented the behavior described in this article?

    @thomdd1959, I don't think making nonsensical comments to apparently unrelated articles is going to accomplish your goals.

  • Report this Comment On September 18, 2009, at 11:20 PM, Retirefunds wrote:

    Most of what you have to say is bang on.

    You failed to note however, that as we speak, the "Gluttons of Wall Street" are morphing into vultures as they circle over the life insurance policies of what remains of the middle class.

    The lions will feed, then the cubs will feed, then the hyenas and finally the vultures will pick to bones, until the middle class is a foot note of history in the U.S. and the economy resembles much of South America.

    This is the subject of one of my recent blog entries:

    Maybe it is time for average people to deny the gluttons by keeping our money out of the cesspool, and investing it in community businesses that actually create jobs and security.

  • Report this Comment On September 20, 2009, at 5:50 PM, DoctorDum1 wrote:

    If an entity is "TO BIG TO FAIL", then it must be "TO BIG TO EXIST"!

    As someone once said: "There ought to be a law".

    (Something like Anti-Trust measures could apply.)

    It seems obvious that the Stupid are not astute enough to control their stupid actions. That may leave the job to the Politicians.(?) If We The People could convince our Representatives in Government to do the right things for at least Most of The People, Most of the Time, then maybe our sick society could be cured of the leveraged selfishness and greed which harm us all.

  • Report this Comment On September 21, 2009, at 1:20 PM, prospectr1 wrote:

    Since all the players in the bubbles, Dot-com, Housing, and Derivatives aren't stupid, Is there a possibility that some clever players, knowing that baby-boomers were accumulating money for their retirement in 401Ks etc.did not bother to warn or to deflate the bubbles before they burst in order to profit from the baby-boomers losses? Since the baby-boomers were handed the losses, someone must have got the winnings.Please comment.

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