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