Lessons to Be Learned One Year After Lehman Brothers Collapse Roiled the World

Worst recession since the Great Depression followed Lehman's collapse.

September 13, 2009, 7:33 PM

Sept. 14, 2009 — -- On the morning of Saturday, Sept. 13, 2008, Treasury Department official Tony Fratto was talking to a friend at a major New York City investment firm. The offices at every big bank in the city, Fratto's friend told him, were packed with staffers trying to figure out their firms' counterparty risk to Lehman Brothers.

"To me, that was just jaw-dropping," Fratto said.

The legendary investment bank had been teetering on the brink of collapse for months. To think that banks were only now scrambling to assess their vulnerabilities to Lehman was, Fratto felt, "staggering."

Two days later, on Sept. 15, Lehman went bankrupt. Just like that, the world had changed.

Lehman's failure rocked the financial system to its core, sending shockwaves around the world and sparking a global crisis that can still be felt today.

In his address to Congress last week, President Obama said confidently, "We have pulled this economy back from the brink."

On the eve of the one-year anniversary of Lehman's bankruptcy, a look at the past year provides insight into the current economic environment and hints at what lies ahead.

After Lehman Brothers collapsed, the financial system fell into a state of fear and panic.

"Over the course of 20 years, the financial system had become bigger and much more risk-loving in a way," said Simon Johnson, a professor at MIT and senior fellow at the Peterson Institute. "Sept. 15 is when we woke up to the dangers."

With the system in shambles, the economy started its descent into the deepest recession since the Great Depression.

"It was an intense environment," Fratto recalled. "We were dealing with a whole series of crises ... investment banks collapsing, the takeover of [mortgage giants] Fannie Mae and Freddie Mac, money markets freezing up, auto companies collapsing, the AIG problem.

"The world had in fact changed," he said. "There were things happening that no one could anticipate and no one knew what the next unintended consequence was going to be."

The Bush administration was faced with a choice between letting major firms like Lehman collapse or rescuing the financial system.

If the situation in mid-September had continued to deteriorate, "You would have seen a collapse of the global financial system," Fratto recalled. "That would have been absolutely catastrophic."

The government chose to bail out the financial system, a move made more difficult in the midst of last year's presidential elections -- "the perfect storm," Fratto called it.

Weeks after Lehman failed, Congress passed the $700 billion Troubled Asset Relief Program to rescue the financial system.

"I think it's one of the great achievements of all time that we were able to get Congress to understand the problem and to agree to pass that legislation because in my opinion, there has never been a more reviled piece of legislation to make it through the Congress than the financial rescue legislation. Nothing has ever been less popular and more urgently needed, and in retrospect, it worked."

But some analysts, such as Jim Paulsen, chief investment strategist for Wells Capital Management, contend that the government's sounding the alarm bells only made matters worse.

"This crisis was made far worse than it needed to be because our leadership fostered the environment of fear rather than trying to extinguish it," Paulsen said.

"Everyone understands that if you yell fire in a crowded theater, even if there is no fire just saying that will create fundamental damage," Paulsen said. "But for some reason if we yell fire in the midst of an economic panic, we seem to think that it won't have any detrimental impact."

Since last fall, the $700 billion TARP has now morphed into a much larger bailout. The government has now spent trillions of dollars to bail out a slew of other companies on the brink of collapse, from automakers such as General Motors and Chrysler to insurance behemoth AIG.


Say the word "banks" today and the word "bailout" springs to mind. Since last October, the $700 billion bailout has become a lightning rod for criticism from lawmakers, economists and the general public.

Even the banks have sought to distance themselves. JPMorgan Chase CEO Jamie Dimon famously called participation in the $700 billion program "a scarlet letter" for banks.

However, almost 12 months after its inception, the bailout is now starting to pay off. At its peak, the Treasury and the Federal Reserve had invested more than $4 trillion in 28 government programs to stem the financial crisis, with an enormous amount of taxpayer dollars at stake. But now, not only has the financial system been stabilized, but taxpayers are seeing a return on their investment. From eight of the biggest banks that have fully repaid government loans, taxpayers have raked in a $4.1 billion profit, according to Linus Wilson, a professor at the University of Louisiana at Lafayette. The Fed's programs have recorded a $16 billion profit from loan programs to various financial firms.

But the profits come amid continued public outrage about big Wall Street firms receiving massive taxpayer bailouts yet still dishing out enormous bonuses.

In March, insurance giant AIG -- the recipient of around $180 billion in government aid -- incited a national furor by paying out $165 million in bonuses. The insurance company had company. Nine of the biggest banks -- receiving a total of $175 billion in taxpayer money -- paid out almost $33 billion in bonuses in 2008, according to a recent report by New York Attorney General Andrew Cuomo. It's a "heads I win, tails you lose" culture.

"How can it make sense that during the greatest crisis since the Great Depression these guys make so much money?" Johnson asked. "The answer is, it doesn't make sense. We have a perverse system of incentives in the financial system, the financial system has gotten too big and too dangerous, and it threatens our future prosperity even today.

"The lesson Wall Street has learned," he continued, "is they can sell their stock to the government at some relatively high price the next time there's a problem. This is going to encourage more crazy irresponsible risk-taking. A big chunk of the financial system has become a giant casino that you really don't need for a productive, functioning economy."

Talbott refuted the charge, stating, "The motivation of the number of companies that have failed and the number of CEOs that have lost their jobs and the number of Americans who have suffered is motivation enough to alter practices."

The Obama administration has taken measures to clamp down on executive compensation. In June, the President appointed pay czar Kenneth Feinberg to oversee executive compensation at seven firms receiving what they called "exceptional assistance," firms such as AIG, Bank of America, Citigroup, General Motors and Chrysler.

While the big banks appear to be bouncing bank, some of their smaller counterparts have not been so fortunate. Many banks of all sizes have seen their balance sheets -- and therefore their lending -- weighed down by soured real estate loans, but bigger banks have an easier time raising capital to overcome the bad loans. Smaller banks, meanwhile, collapse. Ninety-one banks have been shut down by federal regulators so far this year. In all of 2008, there were only 25 bank failures.

There may have been no more damaging effect of the current recession than the fact that nearly 6 million Americans lost their jobs in the past year. Job losses, though, are expected to slow down in the coming months.

At the same time, the unemployment front is expected to worsen. Over the course of the last year, the nation's unemployment rate skyrocketed from 6.2 percent one year ago to 9.7 percent today, the highest rate in the last quarter of a century. Nearly 15 million people in this country are currently looking for jobs, but can't find any jobs.

Since unemployment is a lagging indicator, traditionally the last area to turn around after a recession, both government officials and economists expect the unemployment rate to climb into double digits in the coming months.

"Unemployment is high and could stay high for some period of time," Treasury Secretary Tim Geithner warned a congressional oversight hearing Thursday.

"The unemployment factor is the X factor in the recovery effort," said Scott Talbott, senior vice president for government affairs at the Financial Services Roundtable. "It is impossible for the economy to recover without bringing the jobless rate down. Everything flows from the unemployment factor -- that includes mortgages, credit cards, auto loans. It is almost impossible to pay any of your debts if you don't have a job."

Millions of Americans invest their money in the stock market, but this past year those investments took a beating. Look no further than the country's most famous investor, Warren Buffett, the great Oracle of Omaha: On paper, Buffett lost an estimated $25 billion during 2008, and with it, his title of the world's richest man.

Overall, the Dow Jones average has fallen nearly 20 percent from last September. The index is more than 30 percent off its peak. But things are looking up. Since the spring, the bulls have been back in control on Wall Street. Stocks are up 47 percent since their lows of March 9.

"The stock market," Talbott said, "is reflecting the strengthening and improving economic conditions in the country."

Some more bearish analysts warn that the country's recession will not take a V shape, but rather a W shape, reflecting more ups and downs.

"The stock market has obviously realized correctly that the risk of a total collapse or a second Great Depression has gone away, but it doesn't mean that everything's going to go smoothly," Johnson cautioned. "We're building up vulnerabilities the way we did in 2004 or 2005."

One of the root causes of the current recession was the housing crisis. Banks dished out subprime loans to borrowers ill-equipped to take on the burden of homeownership. Everything was predicated on housing values continuing to climb. But in the past year, home values have dropped more than 15 percent. Many homeowners found themselves "underwater," owing more money on their houses than the houses were worth. Foreclosures have soared to record levels. In July, the nation saw a record 360,149 foreclosure filings as the first wave of foreclosures, subprime borrowers, ended and a second wave, newly unemployed homeowners, began. Credit Suisse recently forecast that more than 8 million mortgages will go into foreclosure in the next four years.

To make matters worse, the Obama administration's mortgage modification has struggled to gain traction. As of the end of August, banks had modified loans for only 12 percent of the nearly 3 million eligible homeowners. The Senate's second-most-powerful Democrat, Dick Durbin, called the program "a waste of time" and said its approach had "failed miserably."

However, on the positive side, the fall in home prices has waned, while home sales have increased. In July, there were 571,000 total home sales.

"We're definitely at the end of the beginning and we're somewhere toward the beginning of the end," said Talbott. "There are a number of areas in the country where real estate prices continue to drop: California, Arizona, Las Vegas. In the rest of the country, we're seeing prices stabilize or even start to uptick."

The broadest measure of the country's economy is gross domestic product. The nation's GDP plunged after last fall's near collapse of the financial system. But in recent months, the economic outlook has shown signs of improving, and government officials and economists believe we will see signs of positive growth in the months ahead. The nation's economy shrank by 2.7 percent during the third quarter of 2008, by 5.4 percent during the fourth quarter of 2008 and by 6.4 percent during the first quarter of 2009.

However, during the second quarter of this year, it shrank by only 1 percent. And 11 of the 12 Federal Reserve regions reported in the latest Fed Beige Book that economic conditions had improved or stabilized in recent weeks.

Still, there is cause for concern. Consumer spending accounts for more than two-thirds of all economic activity. The economy will not grow if consumers do not spend. Consumers will not spend if they do not have money. And consumers will not have money if they don't have jobs. During the current recession, consumers have tightened their purse strings, spending less money and saving more.

But, said Paulsen, as the fear and panic of last year disappears, consumers, just like investors and businesses, will become more optimistic and aggressive.

"The thing's that causing a recovery today is a reversal of the fear," Paulsen said. "People sold too many stocks; they've got to buy them back. People threw too many people out and purged too much inventory; they've got to rebuild that. People didn't buy cars for a year; now they have to buy them. In some regard the thing that made the crisis worse than it had to be -- fear -- is now the thing that's causing a recovery faster than people thought."

Despite recent improvements, the consensus forecast is that the country's economic recovery will take time. Numerous stumbling blocks stand in the way. Small businesses are the biggest creator of new jobs, but they are struggling to get loans from banks that have tightened up credit. Residential real estate might be showing some signs of improvement, but commercial real estate is seen by many as a huge problem in the near future.

Another issue is the soaring federal deficit. In August, the deficit hit a record $1.38 trillion with one month still to go in the fiscal year. Increased government spending to stop the recession and financial crisis combined with lower government tax revenues have taken a toll on federal coffers. The rising debt has drawn the ire of fiscal conservatives, who caution that future generations could be saddled with unmanageable burdens. It has also increased concerns among key foreign holders of U.S. government debt, such as China.

Johnson stated that the country will face another crisis in the next decade or so because the administration has not done enough to institute sweeping financial regulatory reform measures.

"There are no steps being taken to really solve the fundamental problems of the financial system," he said. "Because of that, I think we'll have another big crisis sometime soon. I don't know if soon is three years, five years or eight years, but it's going to be soon."

The administration, noting that a crisis is a terrible thing to waste, has unveiled an array of proposals currently making their way through Congress. The proposals include a regulator to oversee systemic risks to the economy, a resolution authority to wind down massive, failing companies and a consumer protection agency. But these measures have taken a back seat to health care reform in recent months, prompting skeptics to voice concerns.

"The proposals that they're considering are very weak," blasted Johnson.

Even while touting the progress made since last year's meltdown, including financial reform measures, administration officials such as Geithner have voiced caution about the country's future prospects.

At a CNBC town hall event last week, Geithner said,"If you look at any measure of basic health of the financial system, things are dramatically better today than they were, but we're not there yet."

Some things will never go back to the way they were before. One year ago this month, General Motors celebrated its 100th birthday. Today, that company has gone bust.

Now, in a sign of the times of the past year, a new government-owned General Motors has taken its place.

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