Not Too Big To Fail: Why Lehman Had to Go Bankrupt

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Former Lehman Brothers chief risk officer Madelyn Antoncic and Jyoti Thottam, opinion editor for business and economics at The New York Times, discuss the downfall of Lehman Brothers.

Ten years after the financial crisis, a nagging question that has persisted is this: Why did the U.S. government allow Lehman Brothers to fail while it bailed out AIG? Both of the financial services companies were large and traced their financial woes to excesses in subprime housing mortgage financing. To add insult to Lehman’s injury, AIG’s $182 billion bailout began the same week when the former folded, and a week prior the government had taken over the financially embattled mortgage guarantee companies Fannie Mae and Freddie Mac. And in March of that year, the Federal Reserve had helped bail out Bear Stearns, another struggling Wall Street firm, by loaning $30 billion to its buyer, JPMorgan Chase.

Lehman’s wounds “were self-inflicted,” whereas AIG’s collapse would have caused a worldwide “systemic macro event” with cataclysmic repercussions, according to Madelyn Antoncic, who was chief risk officer at Lehman Brothers between 2002 and 2007, among other roles during a decade at the company. An economist, Antoncic later worked at the World Bank as vice president and treasurer, and is currently on the board of governors at Weill Cornell Medicine.

Antoncic traced Lehman’s bankruptcy on September 15, 2008, to top management’s “hubris” and its brushing aside of risk management principles, in an interview with Knowledge@Wharton and Jyoti Thottam, opinion editor for business and economics at The New York Times. Antoncic originally had resisted airing her insights into the events that led to Lehman’s collapse. But she decided to break her silence when a recent Wall Street Journal article suggested that AIG was bailed out and Lehman was left to die because of politics and personality issues, not hard-nosed business and economic wisdom. She attempted to set the record straight in a New York Times op-ed article published a week later, titled “Lehman Failed for Good Reasons.”

Why Lehman?

“It’s pretty clear in my mind why AIG had to be saved and why Lehman should have been let go, because they (Lehman) could have helped themselves, but they failed,” said Antoncic. “Lehman basically put the nail in [its own] coffin.”

At its peak, AIG had a market capitalization four times the size of Lehman at the latter’s highest. However, AIG was bailed out not purely because of its size, according to Antoncic. “It’s not just the size that matters; it is the interconnectedness,” she said. If AIG failed, it would trigger a domino effect globally as the insurance giant had provided protections worth more than half a trillion dollars, including $300 billion to banks in the U.S. and in Europe. “Imagine if AIG went away. All of these banks would have had enormous regulatory capital problems. It would have been an extremely systemic macro event.”

“Imagine if AIG went away. All of these banks would have had enormous regulatory capital problems. It would have been an extremely systemic macro event.” –Madelyn Antoncic

Changing Tones on Risk

Lehman was no stranger to financial troubles. According to Antoncic, in 1998, it had “a near-death experience” in the wake of the Russian debt default and the imploding of Long-Term Capital Management, a hedge fund. “[Lehman Brothers] almost went bankrupt back then,” she recalled, although she was not at the firm at the time. The company wriggled out of that mess after persuading investors to provide some relief. But the red flag was clearly there: “At that time, they didn’t have much of a risk management function at all.”

Antoncic saw that situation persisting when she joined Lehman in 1999. “I found myself in an institution that didn’t have much of an appetite whatsoever for risk management, which is why they got into that spot to begin with [in 1998], and they were also having liquidity problems,” she said. But the company wanted to fix those problems, which became her responsibility.

Soon thereafter, Antoncic created a comprehensive risk framework with a risk equity model, and hired people to staff the function. “[I] got everybody on board internally to the point where everybody really did live risk management.”

That risk management rigor did not last too long. At a big meeting in 2006, Lehman’s managing directors and senior executives decided “to start putting the pedal to the metal,” Antoncic recalled. The prevailing mood that drove their confidence was, “We’ve gotten our acts together; we’re making a lot of money. So let’s take more risk.”

Sidelined and Overruled

By late 2006 and early 2007, Antoncic could read the proverbial writing on the wall. “I was just sidelined,” she said. The court-appointed examiner’s report of 2,200 pages that investigated the causes of Lehman’s problems also noted that “risk management was repeatedly overruled,” she added. “It was a shame because back in 1998 they were in trouble, and there was no need for them to have gotten themselves back into that spot by 2008.”

Antoncic pointed to market signals that Lehman perhaps did not take seriously enough — HSBC writing down large amounts of its exposure to housing finance. “The market was in a shaky condition for certainly a year.”

While Lehman watchers tended to focus on its real estate exposure, she said, they paid less attention to its other parts. “They also had enormous credit exposure to, for example, high-yield assets, and the leverage lending business was getting out of control,” she noted. Those loans were “covenant-light,” which is industry parlance for loans that do not have sufficient covenants, or protections, for lenders. As it happens, that practice “is now rearing its head again,” she warned.

“Unfortunately, part of the hubris among the management was they knew better than anybody else.” –Madelyn Antoncic

Another millstone for Lehman in the buildup to its bankruptcy was its exposure to “bridge equity,” or money that investors put up towards an acquisition as a token of commitment before the actual purchase. At one point in 2007, Lehman had $50 billion of bridge equity. The problem with bridge equity is that it is “extremely illiquid stuff,” she explained.

Antoncic had tried unsuccessfully to hedge against the risks of those illiquid assets in Lehman’s portfolio. “They didn’t want it because obviously there’s a cost to hedge, but of course it’s an advantage when the market goes down.” But problems like those had been building up for “a very long time” and reduced Lehman’s flexibility to respond to a crisis, she added. “In the spring of 2007, they had a $750 billion balance sheet — outsized risk but also very illiquid positions” so it wouldn’t be easy to sell off assets to straighten the ship.

Even during its final days in August 2008, Lehman’s management seemed to be in a state of denial. The Korean Development Bank had offered to invest in the company for a 50% equity stake, but Lehman’s management disagreed on the price for the deal. Meanwhile, the market environment deteriorated, which forced Korean Development Bank to keep reducing its offer price. The Korean bank made its last offer of $5.3 billion for a 25% stake just three or four days before Lehman wound up, and they still could not agree on a price. “Unfortunately, part of the hubris among the management was they knew better than anybody else,” Antoncic said. She did not think hubris was a cultural phenomenon among Wall Street firms at the time, but was more of a characteristic in certain individuals.

Why No Criminal Prosecutions?

Another issue that has arisen since the crisis is the lack of criminal prosecutions. In the case of Lehman, “it was poor judgment; [they were] not very smart,” Antoncic said. “But there’s no law against not being smart.” She recalled the court examiner asking her why she did not blow the whistle on Lehman’s practices. “Blowing the whistle means that there’s something illegal going on, and in my view this was not illegal,” she had told the examiner at the time. “There was no whistle to blow. … It was just exceedingly poor judgment, poor decisions being made, certainly poor governance, and certainly poor leadership and management. But that doesn’t stand up to criminality.”

One unhelpful practice that was widely prevalent at the time was company chairs acting as CEOs. “It has always bothered me that there is no separation of the CEO’s role and the chairman’s role,” Antoncic said. She said such a separation could bring in “checks and balances.” Dick Fuld, Jr., Lehman’s chairman between 1994 and 2008, was also president until 2004, she pointed out.

“Leadership is about doing the right thing, and no one should go unchallenged when they are about to make a questionable decision,” she wrote in her Times op-ed. “This culture of checks and balances is still lacking in many organizations.”

The separation of the roles of the chairman and CEO is important also to allow for a free airing of views among a company’s management, according to Antoncic. “There are chairmen who are also CEOs who are willing to listen, to ask questions, and to take on board other people’s views. [But] there is a bully mentality when people don’t want to stand up and speak what’s really on their minds. And that’s always a dangerous thing.”

“A lot of these loans are being made by private equity firms as opposed to banks, which means now there’s less transparency to the regulator….” –Madelyn Antoncic

Newer Risks Loom

Today, with tighter regulations after the financial crisis, banks are “in much better shape” with more capital, more liquidity and reduced leverage, Antoncic said. However, the so-called “living wills” that banks now have to put in place to ensure an orderly unwinding in the event of a crisis are “not all that effective” in cases where an institution has subsidiaries across the globe. “You need to have harmonized bankruptcy legislation, and that does not exist even in the European Union, which is trying to harmonize many things,” she said. “So it’s a little bit of a false sense of security.”

What kind of fallout might the next financial crisis bring? “While I do not think we will have a large credit-induced financial crisis in the near term, there is always the possibility that, in the next big financial crisis, taxpayers again will be forced to pay the bill — if not directly through a bailout, then most certainly indirectly, through lost jobs and an economic downturn,” Antoncic wrote in her Times article.

Antoncic also pointed to other areas of concern. Banks today have more capital than they did before the last crisis, and are more cautious in lending. “That has caused an unintended consequence … it has led to the growth of shadow banking…. A lot of these loans are being made by private equity firms as opposed to banks, which means now there’s less transparency to the regulator, and these loans are being made by unregulated entities.”

On the other hand, “the good news” is that U.S. households are “in good shape,” Antoncic noted. They have a combined net worth of more than $100 trillion; the value of their homes is $25 trillion, while their mortgages total $10 trillion, she noted.

Antoncic, however, is concerned about the state of U.S. corporate debt, which has doubled in size from a little more than $3 trillion before the crisis to more than $6 trillion today. Another potential red flag is that shadow banking is behind much of the leveraged lending these days. Such lending is typically covenant light. Covenants are helpful as early warning indicators if a company gets into trouble, she noted.

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