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We Haven't Learned Lehman's Lesson Yet

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Lehman Brothers was the linchpin, according to Simon Johnson. "When you let Lehman Brothers fail, it brought down a lot of other pieces of the financial system, including most prominently AIG (NYSE: AIG  ) ," the economist said during a recent visit to Fool HQ.

Johnson is an authority on financial crises like this one. He's the former chief economist of the International Monetary Fund, a professor at MIT's Sloan School of Management, a senior fellow at the Peterson Institute for International Economics, and co-founder of The Baseline Scenario.

It's been one year since the collapse of Lehman Brothers, arguably the biggest financial shock to rock the globe in nearly 80 years. Yet not much has changed about our financial system. The big banks that were "too big to fail" have only gotten bigger, and they're just as risky as ever.

Goldman Sachs (NYSE: GS  ) clocked its most profitable quarter in history mere months after Lehman's demise. U.S. banks as a whole racked up a stunning $5.2 billion in profit from trading derivatives in the second quarter, while JPMorgan Chase (NYSE: JPM  ) , Goldman Sachs, Bank of America (NYSE: BAC  ) , Citigroup (NYSE: C  ) , and Wells Fargo (NYSE: WFC  ) accounted for 97% of the total derivatives outstanding. The FDIC's reserve fund is in the red, and banks are still playing dangerous games, like repackaging real-estate mortgage conduits.

Lessons from Lehman: Size matters
According to Johnson, there are many lessons we can learn from Lehman. "The key lesson in my mind is, we've got to make our biggest banks smaller to really make our financial system safe again," he said. Johnson defines big banks as having $600 billion to $800 billion in assets. That club includes Lehman, Bear, and Morgan Stanley (NYSE: MS  ) -- the same "too big to fail" banks that were in the line of fire last fall.

However, policymakers are not applying the lessons learned from Lehman, according to Johnson. Profits from the financial sector comprise an even larger percentage of our GDP since the crisis erupted. Johnson thinks their share of corporate profits, which was an astonishing 40% in 2003, may actually be higher now, given that the rest of the economy is in bad shape. Banks have doubled their share of GDP to 8% from 4%, he said.

As a percentage of GDP, a huge banking sector can be problematic. Take Iceland, a small country that had a dangerously large financial sector. Banks' assets stood at 11 or 13 times GDP, pre-crisis, in Iceland. When the sector collapsed, the country's banks required a massive taxpayer bailout. "Yet they could not bail it out," Johnson said. "You were looking at a vulnerable place."

Johnson pointed to Western Europe as another example of the perils of large banking systems in smaller countries -- notably the U.K., where banks peaked at six or seven times GDP. "They have banks that are bigger than the economy," he said. "The Royal Bank of Scotland is 1.3 times the U.K. economy. Switzerland has an even bigger banking system, relative to the size of its economy. Now, I'm not saying they're going to collapse, but it's a vulnerability."

Defang the financial sector
Luckily for the U.S., our biggest banks are considerably smaller, according to Johnson.

"Finance is not so big relative to our economy that we're at that level of danger, but we should disengage from where we are," he said. "These banks have become too big. The question is, how do you ramp that down without destabilizing the economy?"

"The financial sector has captured the government, and it hasn't been defanged," Johnson said. If decision-makers in Washington believe that finance is good, and more finance is better, then big banks will count on a bailout if they take on a lot of risk and fail. "So that mindset behind too big to fail is very dangerous."

Crisis aftermath
We haven't rectified the financial system, Johnson said. We haven't removed financial advocates from the halls of government, and now we face a mountain of debt as a nation.

"As a result of this crisis and the measures taken to counteract it, we're going to end up doubling our debt-to-GDP from 40% of GDP to 80% of GDP," he said. Though that's definitely bad, Johnson noted that it's not a cataclysm. However, it could mean higher taxes, and a period where we don't even tackle the underlying problem.

"We're looking at more of the same in the future, eating into [the] debt capacity of the government," he said. "This is not good."

Related Foolishness:

Are the threats Johnson discussed overblown, or largely ignored? Let us know your thoughts in the comments section below.

Fool contributor Jennifer Schonberger owns shares of Bank of America, but does not own shares of any of the other companies mentioned in this article. The Motley Fool has a disclosure policy.

Read/Post Comments (7) | Recommend This Article (16)

Comments from our Foolish Readers

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  • Report this Comment On October 08, 2009, at 3:22 PM, dcrednek wrote:

    One year after the financial assassination of Lehman Brothers by then-Treasury Secretary and former Goldman Sachs executive Henry Paulson the US economy is no more stable ---and may be even less stable---than it was in the fall of 2008. Banks and large investors still speculate in derivatives without regard to consequence BECAUSE THERE IS NONE to speak of. This new government of "Hope and Change" is no more immune to cronyism than the last, and for some reason all the "smart guys" in government seem to think that the way to repair an economy broken by overconsumption and overleverage is, in fact, to maintain the trend of debt-fueled consumption by replacing private spending and borrowing with public spending and borrowing. Hmmmm, wonder who came up with that idea?

    There are plenty of sane investors out there. There are plenty of sane people out there. It's just that none of them seem to be in a position of authority, nor do they have the power to put the brakes on this runaway train. Like it or not, that runaway train will one day run out of track...and it won't be pretty.

    The Obama administration and Congress are woefully short of solving the regulatory issues surrounding the US finance and banking troubles. I think the result of allowing this level of banking consolidation to occur, the reluctance and refusal to allow big businesses to fail, and the delay in developing and regulating derivative instruments will be a second financial meltdown that will have us begging for the good 'ole days of March 2009.

  • Report this Comment On October 08, 2009, at 8:02 PM, xetn wrote:

    It is also possible that the reason that Lehman was not bailed out is to give a nice boost to Paulson's former employer GS and maybe a reason for bailing out AIG was to aid in paying out over 15 billion to GS for insurance coverage on some of its "products".

  • Report this Comment On October 09, 2009, at 1:37 PM, thisislabor wrote:

    So why don't they apply the Sherman Anti-trust laws to the banking systems then?

    besides the fact that the banks can afford better lawyers?

    the laws were designed to protect the general welfare of the population - not to keep competition high for the fun of it.

  • Report this Comment On October 09, 2009, at 1:45 PM, maccdw wrote:

    The Feds needed to prevent banks "that are too big to fail" from doing so. Bear Sterns was only 1/3 the size of Lehman, but they let Lehman die instead, while saving BS. Paulson had no personal interest in Lehman like he did in Goldman Sachs.

    AIG sold CDSs by the billions, assuming that Lehman could never default. Oops.

    Geithner blames Lehman's collapse on Fuld.

    The Feds (taxpayers including you and me) bailed out AIG, and we'll never be told how much of our tax money went straight through AIG to European banks, because AIG could not honor their debt to those banks without our tax money.

    And, remind me, exactly what has been accomplished to systemically fix our US banking systems?

  • Report this Comment On October 11, 2009, at 5:43 PM, thisislabor wrote:

    I'm so bad in social situations, hard for me to keep all the players and names strait. reminds me of RWK all over again.

    thank you for the explanation mccdw.

  • Report this Comment On October 11, 2009, at 5:50 PM, thisislabor wrote:

    I guess if it's ethically not right to pick one person over the other, but IF you had to I could see why he would save one bank and not the others.

    definately is a mental note in my head on paulson.

  • Report this Comment On October 26, 2009, at 6:21 PM, neldon1 wrote:

    What is the story on life insurance derivative?

    Betting on when a person will die

    From what I hear people who need cash sell their life insurance policies for a discount on the dollar. They are bundled up, sliced and sold as a derivative, with the hope that they die before the premium eat up the profit. Through in some Obama health and it sound like a pretty sure bet.

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