How to Avoid the Next Lehman Brothers

By the time Lehman Brothers collapsed on Sept. 15, 2008, it was the largest bankruptcy in U.S. history. The company had borrowed to the hilt against shaky capital. Its leverage ratio -- a measure of risk -- had exploded beyond 30-to-1, way beyond what sane people would consider safe.

What went wrong?
Part of the reason blowups are less common since the Great Depression is that regulators require banks to keep their leverage under control by holding a certain amount of capital as a cushion in case their investments lose money. These capital requirements also reduce a single bank's footprint on the financial system, helping to limit collateral damage on the rest of the economy should a bank fail.

Banks usually don't like strict capital requirements because it limits their ability to take more risk and earn higher short-term profits -- and bonuses. Really clever banks like Lehman are always trying to find ways to get around these requirements.

Cue terrible mistake
By late 2007, leverage at the big five investment banks had risen to pretty dramatic levels:

Company

Leverage Ratio (Assets-to-Equity), 2007

Bear Stearns

34:1

Morgan Stanley (NYSE: MS  )

33:1

Merrill Lynch

32:1

Lehman Brothers

31:1

Goldman Sachs (NYSE: GS  )

26:1

Data from Capital IQ, a division of Standard & Poor's.

These numbers are absurd, particularly considering the garbage banks were buying. Keep in mind that to be considered well capitalized, deposit banks need to keep their leverage well below these levels. So the big investment banks were making riskier investments on higher leverage.

And even these figures considerably understate leverage because they don't take into account these banks' massive off-balance sheet derivative exposure.

From 2008 to 2009, all five banks failed or were bailed out. Bear Stearns was failed out by JPMorgan Chase (NYSE: JPM  ) after taxpayers guaranteed they'd cover much of Bear's potential losses. Lehman Brothers was allowed to go bankrupt, triggering a global financial panic. Bank of America (NYSE: BAC  ) rescued Merrill Lynch. Goldman Sachs borrowed $5 billion from Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) at near-punitive rates. Both Goldman and Morgan Stanley were handed TARP money and granted bank holding company status so that the Federal Reserve could offer them 0% loans should they need them.

Since then, leverage has come down somewhat, but it's only a matter of time before investment bankers decide that they can produce higher profits and bonuses if they once again juice their leverage.

How to avoid the next Lehman Brothers
If you're an investor in financial companies, it's simple: Stay away from names that look like the last Lehman Brothers: those with assets-to-equity ratios in excess of 15, that are funded largely with short-term borrowings, and whose arcane business models no human could possibly hope to understand.

For everyone else, avoiding the next Lehman Brothers is less simple, because decisions taken at systemically risky banks affect everyone. As Lehman Brothers showed us, anyone who invests in companies that would be hurt by another financial meltdown, or who have jobs and would prefer not to see a return to 20% underemployment, needs reasonable leverage limits for our financial system.

Two provisions in the financial-reform bill are critical to avoiding the next Lehman Brothers.

The first is the Speier Amendment, which would require systemically dangerous financial companies to keep their leverage below 15-to-1. Hopefully the House can clarify that it means assets-to-shareholder-equity instead of debt-to-equity, because that would be a stricter metric.

Of course, sneaky banks will try their best to load up their balance sheets with garbage assets to get around the spirit of the requirements. So the second important provision is the Collins Amendment, which would effectively require banks to hold good-quality capital. The amendment passed unanimously in the Senate -- bank lobbyists admit they completely blew it -- and FDIC Chairwoman Sheila Bair is also a major supporter.

Harvard Business School Prof. David Moss, an expert on the Speier and Collins amendments, recently put it to me this way:

Authorizing regulators to limit leverage isn't enough, because many regulators fell down on the job last time around. As a result, it's essential that Congress also create a hard cap on leverage that no regulator could weaken. The Collins amendment in the Senate bill sets such a cap for a broad set of financial institutions, including banks, bank holding companies, and systemically significant non-bank institutions. The Speier amendment in the House bill sets a potentially tougher 15-to-1 leverage cap exclusively for systemically significant firms.

I believe these two provisions would work extremely well in combination. I also believe the Speier amendment, which currently defines leverage as 'debt to equity,' should be strengthened by using the definition 'total assets to shareholders' equity' instead. This would ensure greater clarity as well as an appropriately tougher standard for the largest -- and potentially most dangerous -- financial institutions. In combination, Collins and Speier could mark a major step forward and could prove absolutely essential in helping to prevent another crisis from striking in the future.

Banks obviously hate these proposed rules that would improve the long-term stability of our financial system, because they would also limit bankers' ability to generate outsized short-term profits and huge bonuses.

But despite opposition from The Wise on Wall Street, these measures are critical to avoiding the next Lehman Brothers. If you'd like to weigh in with your opinion, simply call one of the numbers below. Just tell whoever answers the phone that you'd like to comment on the financial-reform bill, and tell them how you feel about the Speier and Collins amendments to cap risky leverage.

Sen. Chris Dodd, (202) 224-2823
Rep. Barney Frank, (202) 225-5931
Sen. Jack Reed, (202) 224-4642
Sen. Tim Johnson, (202) 224-5842
Sen. Chuck Schumer, (202) 224-6542

Fool editor Ilan Moscovitz owns shares of Berkshire Hathaway, which is a Motley Fool Inside Value and Motley Fool Stock Advisor pick, as well as a Motley Fool holding. The Motley Fool is investors writing for investors.


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