Tuesday, September 16, 2008
Every financial crisis is different from the one that preceded it, and every crisis is a little bit the same. The panic of 1907 caused a run on the major trust companies of New York. The Great Depression took out thousands of small deposit-taking institutions. The savings-and-loan fiasco of the 1980s engulfed hundreds of retail lenders.
Speculative mania leads to panic, which leads to a run on the bank. The story is as old as modern capitalism. Eventually, these crises blow over – sometimes in a matter of weeks or months, as in 1907, and sometimes after many difficult years. This one will, too. But even if it were to end tomorrow, we’d remember it not only for its length (15 months and counting) and severity (worst since the Great Depression, senior bankers say), but for the way it has toppled the strong, rather than the obviously weak. It’s one for the history books.
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Through all the financial catastrophes of the past 160 years, Lehman Brothers survived and thrived. Resilient? Its traders were flipping bonds two days after the 9/11 attacks destroyed the company’s headquarters. Respected? Last year, Barron’s named Lehman chief executive Richard Fuld one of the 30 best CEOs in the world, right alongside Steve Jobs and Warren Buffett. Fortune hailed Mr. Fuld’s “magic” and called the firm “a booming investment banking operation that is now competing head-on with Goldman Sachs, Morgan Stanley, and Merrill Lynch for mega-deals.”
Magic, indeed – just like that, they’ve disappeared! And so will Merrill as an independent firm if Bank of America’s play for it comes to pass (and probably even if it doesn’t). Merrill made it through two world wars and every previous crash, correction, contraction and contagion since 1914, and even managed to get some of them right. Charles Merrill advised his customers to “take advantage of present high prices and put your financial house in order” – in 1928.
For several years before the subprime mortgage losses began to hit, Merrill economists were making gutsy and prescient points about the depth of the stupidity of U.S. real estate lending. Everyone who read their work or listened to their advice profited from it, a group that apparently does not include Merrill’s executives and traders, judging by the tens of billions of dollars in mortgage securities of dubious quality that are attached to the firm’s balance sheet like a concrete anchor.
The destruction of Merrill – and that’s what it is, even if it’s being dressed up as a takeover – has to be seen as a major financial event. Look at it this way: when Continental Illinois National Bank collapsed in the mid-1980s, it was a huge story because it had been the seventh-largest U.S. bank. In today’s dollars, Continental had less than $100-billion (U.S.) in assets. Merrill has nearly $1-trillion. It’s fully 40 per cent larger than Lehman and its solvency is more important because of the reach of its vast retail brokerage operation. If Bank of America’s rescue falls apart and Merrill wobbles, the crisis could reverberate back to Main Street in a hurry. For now, the epicentre is Manhattan rather than Nebraska. That’s one thing that separates this from earlier banking crises. Another is the presence of collateralized debt obligations (CDOs), derivatives and other financial exotica that were just a minor part of the financial market 20 years ago.
But scratch a little deeper, and there are just as many similarities with the crises of the past. Borrowing short term and lending long. Too many assets, accumulated too quickly, by people with too much confidence. Hubris. Too much debt. It’s like the savings-and-loan crisis but with red suspenders. It’s easy to blame greed as the root cause, but it’s also human nature. For bankers, the tendency to veer toward excessive behaviour and easy lending standards during boom times is as natural as college students having sex. It’s just what they do. And the actions that in hindsight seem risky or stupid didn’t look so foolish at the time.
Consider Lehman – or, more specifically, consider its barely controlled growth of the past half decade. Its assets more than doubled in size, to $691-billion (as of the end of ’07), while revenues and profits grew even more quickly. It was a trading house and investment bank on steroids. The juice was borrowed money, most of it short term, which allowed Lehman to accumulate $31 in assets for every buck the shareholders had in the enterprise by the end of 2007, up from $23 per dollar of equity in 2003. At Merrill, the story was exactly the same – a doubling of the balance sheet in just five years, leverage piled on top of leverage, ever more assets heaped on a thin reed of equity.
As long as they could keep it going, it was a virtuous circle – their returns on equity went higher, their stock prices followed. For a time, it was like magic. But the credit expansion game is now operating in reverse, and if Lehman and Merrill and Bear Stearns are the biggest casualties, they’re not the final ones. The crisis will likely now spread from New York to Charlotte and San Francisco and other places where you can find regional banks that got too heavily into mortgages or real estate construction loans. The biggest financial convulsion since the 1930s is far from over. With Lehman’s demise, it has entered a new phase.
This article was posted: Tuesday, September 16, 2008 at 11:08 am