Uncontrolled Risk: the Lessons of Lehman Brothers and How Systemic Risk Can Still Bring Down the World Financial Systemby Mark T Williams; McGraw Hill; £19.99 (€24), reviewed by FRANK DILLON
AS A former trading floor executive and Fed examiner Mark T Williams provides an insider perspective on the events that caused the crisis in financial markets in 2008.
While the book covers other financial institutions and provides a good primer on the development and structure of the investment banking industry, the narrative never strays far from the story of Lehman.
Williams charts its meteoric rise from a humble retailer and cotton trader in the Deep South in to its key role in unleashing a tsunami on the markets.
The three Lehman Brothers, Henry, Emanuel and Mayer, emigrated from Germany in the 1840s to Montgomery, Alabama. Jewish immigrants, they had a simple goal of opening up a dry goods store. The brothers showed early business acumen in the shop. Montgomery was one of the key cotton markets and owning cotton was the equivalent of having cash. Soon they started accepting cotton bales as payment and learnt how to profit from trading a rising commodity. The seeds of a more ambitious enterprise were sown and within a few years, the eldest brother Emanuel, moved to New York to establish an office in the growing financial district of Wall Street.
Initially the subject of anti-Semitism from other financial houses, Lehman began tapping European banks and developing a close web of family connections. The second generation transformed the firm to an investment bank that managed to steer its way through the 1929 Wall St Crash and continued its upward trajectory through the 20th century.
Lehman’s move into real estate via subsidiaries from the late 1990s on proved to be the start of its undoing. At first it provided Alt-A mortgages – somewhere between prime and subprime on multi-million dollar properties. Many of the borrowers were Californian-based high-tech executives who received most of their compensation in stock options rather than salary. In 2000 it extended its risk profile into subprime, becoming the third largest player with an $18 billion exposure in just three years.
With profits booming, its appetite for risk extended into lending to developers and it started to place billion-dollar bets around the globe, playing out a real live game of Monopoly. By 2007, its real estate positions were four times greater than its capital.
As late as the first quarter of 2008 with the real estate market collapsing, subprime unravelling and Bear Stearns on the point of implosion, Lehman was still reporting profits. By now, however, the market was spooked and the stock began to slide, going into freefall from late summer.
The definitive move came on September 11th when JP Morgan, the firm’s clearing bank, cut off its line of credit.
Williams provides a detailed and colourful account of the last days of Lehman, charting the ebbs and flows of the final weekend when treasury secretary Hank Paulson assembled Wall Street’s top bankers to launch an ill-fated last-minute rescue bid.
As a last resort, Lehman’s chairman and chief executive Dick Fuld believed a government bailout would be organised, if only because of family connections. Paulson’s brother Richard worked at Lehman, the president’s brother Jeb was a paid adviser at the firm and one of Bush’s cousins was global head of Lehman’s investment management division.
Fuld has taken the rap for the sins of the industry. Since September 2008, he has been dragged in front of congress, allegedly punched by an irate employee, slapped with countless lawsuits and has lost his family fortune. The popular view was that Fuld was a master puppeteer, controlling his followers – over 200 partners and 28,000 employees – like marionettes.
However, Fuld’s leadership closely resembled that of nearly every Wall Street chief at the time.
The 10-member board of directors at Lehman – whose function should have been to provide a counterbalance to management’s risk-taking practices – is at least equally culpable. Nine were retired, four were over 75 years of age and only two had financial industry expertise. Clearly most had little or no understanding of the potential risks associated with the cocktail of illiquid derivatives, high leverage and inadequate capital.
Tellingly, multimillion dollar error and omission insurance policies were provided to insulate directors against lawsuits and in the case of nine of them, two thirds of their compensation were received in stock.
The environment in which Lehman and others were allowed to take such monumental risks also begs the question of the role of the financial supervisory authorities. The rolling back of the Glass-Steagall Act, which was designed to separate commercial and investment bank activities, is identified as a major mistake.
The decision to let Lehman fail was unquestionably wrong but we need to learn lessons from it. In an all too short epilogue, Williams suggests we must acknowledge systemic risk and co-ordinate regulation across boundaries, create an uber systemic risk regulator, raise capital requirements and impose greater leverage constraints while compensation packages should be adjusted to promote longer term profitability, with claw-back provisions for profits that later turn to losses.
In addition, he suggests boards need to exercise greater independence and that a firm policy stance on moral hazard needs to be taken. The Lehman fiasco proved sending mixed messages can be hazardous to the market’s health, he concludes.
Frank Dillon is a freelance journalist and media lecturer
