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Sun 23 Sep 2018 08:08 AM

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Lehman's legacy: Ten years on, have the lessons been learned?

A decade after the cataclysmic collapse of Lehman Brothers sparked the global financial crisis, have the lessons been learned?

Lehman's legacy: Ten years on, have the lessons been learned?
The filing for Chapter 11 bankruptcy protection by financial services firm Lehman Brothers on September 15, 2008 remains the biggest bankruptcy filing in US history

“Wall Street’s worse day since 9/11. The Dow plunging more than 500 points. The S&P down almost five percent. The wreckage unprecedented. Lehman bankrupt. AIG on the brink. Merrell under new ownership… the bedrock of America’s financial underpinning rocked to the very core.”

Those were the words that greeted viewers to CBNC’s closing bell report on the evening of September 15, 2008, as b-roll footage showed panicking traders, ski-slope stock charts and facades of the august institutions, complete with Romanesque pillars and shimmering logos, that were suddenly facing ruin.

The caption that concluded the montage asked a question that would begin to percolate through the global economy over the subsequent weeks and months: “Is your money safe?”

The implosion of Lehman Brothers, the fourth-largest investment bank in the US, with debts of $619bn was, of course, just the start. A staggering $10tr was wiped from global equity markets by the end of October as the full impact of the crisis swept through the financial world and, as a result, the wider economy.

As we now know, it was all sparked by the “sub-prime” mortgage industry in the US. In the early 2000s, banks and mortgage providers, buoyed by the removal of regulations on derivatives and credit default swaps, and brokers motivated by healthy commissions, had been serving up home loans for people who didn’t have to prove they had the means to repay them – people who had previously been prohibited from accessing the booming housing market.

These mortgages were then bundled into mortgage-backed securities, given an A-plus rating by the likes of Moody’s and sold to investors – which then enabled the banks to lend more money against the new funds.

It’s not necessarily the firms that are making the errors in many cases, but the system of corporate governance that needs to be updated

It proved to be a huge house of cards. When a number of mortgages defaulted as interest rates climbed, these over-leveraged, under-capitalised financial institutions realised they were holding billions of dollars of bad debt on assets – houses – that were rapidly declining in value as foreclosures started to spiral. That also impacted insurance firms such as AIG, who had been offering coverage for the failure of such products not believing back in 2005 or 2006 that there was any chance of anyone making a claim.

The scale of the catastrophe was such that it required a series of government interventions – including the forced sale of Bear Stearns to JP Morgan Chase and the merger that created Bank of American Merrill Lynch – that culminated in a $700bn banking bailout from the US Treasury on September 2008. Chairman of the Federal Reserve Ben Bernanke prefaced the decision with a warning that if they failed to act, “we may not have an economy on Monday”.

In time, it also prompted legislation to prevent a repeat. The Dodd-Frank Wall Street Reform and Consumer Protection Act – or just Dodd-Frank – became law in July 2010. Among its many provisions were an increase in regulation of the ratings agencies, greater transparency to retail investors, the establishment of a Bureau of Consumer Financial Protection, the prohibition of those who securitise assets from hedging or transferring their risk and a requirement for any institution to retain no less than five percent of the value of any securitised product on the balance sheet.

Desert storm

The GCC didn’t have any direct exposure to the subprime mortgage catastrophe, but that didn’t prevent it from being caught off-guard by what had turned into a liquidity crunch cascading across global financial hubs. The effects were felt most prominently in Dubai 14 months later after Lehman Brothers collapsed, eight months after the US bear market had reversed course.

On November 25, Dubai’s investment vehicle, Dubai World, which held nearly three quarters of its $80bn debt at the time, asked all financiers to “standstill” for six months on bonds due to mature. The world’s markets panicked – a day after the announcement, the Dow Jones Industrial Average fell 1.5 percent, European stock indices by double that, and safe haven currencies, the dollar and yen, spiked sharply. It wasn’t until  a comprehensive restructure took place that Dubai World  was able to pay off its most immediate obligations, renegotiate the rest with its lenders, and calm investors around the world. By that time, asset prices across the UAE had plunged as much as 60 percent, with Dubai World’s own portfolio declining in value by 35 percent to $12bn.

“Dubai is an important part of the global financial system connected to others,” says Francesco Pavoni, head of MENA at PA Consulting. “What happened here was a delayed reaction to a set of defaults triggering a systemic collapse across markets and financial hubs that affected its liquidity position… the regulators and control architecture were not ready to cope with a problem of the magnitude of the imported crisis.”

For nearly half a decade after the crash, the UAE’s economy, much like the world’s, would languished – in stark contrast to the breakneck pace of growth it had experienced at the turn of the century. Between 2008 and 2012, real average GDP growth was 1.6 percent, roughly a third of the growth rate between 2002 and 2008.

The only way we could have saved Lehman would have been by breaking the law, and I’m not sure I’m willing to accept those consequences

Since then, the UAE has mandated a raft of reforms, including stronger capital adequacy ratios according to international regulatory accord Basel-III. Banks in the country will, by 2019, maintain capital assets up to 15.5 percent of their risky assets portfolio. In addition, real estate investments now involve funds being deposited in an escrow account and mortgages are capped.

“The mindset of the financial management architecture over the past few years [globally and regionally] has been to minimse short term profitability [in favour of long-term stability],” according to Pavoni, and it has come at an expense. “As banks have improved compliance, like their global counterparts, profitability has been low.”

Local trouble

Recent developments haven’t helped build confidence in the system, however. As reports of the conflicts of interest at the upper echelons of Abraaj’s leadership gain clarity, a need continues to grow for stricter practices relating to whom and how financial institutions hire to manage their businesses, especially locally.

For instance, auditor mismanagement stemming from advisory firm Arthur Anderson’s involvement with Enron, the firm that triggered the bursting of the dot-com bubble in 2001, led to calls for accounting reform in the form of the Sarbanes-Oxley Act and the eventual establishment of the Public Company Accounting Oversight Board (PCOAB). The latter effectively acts as a regulator for audit firms, the stewards of financial statements that investors rely on to make buying and selling decisions. Yet, even after the collapse of Lehman Brothers, and Abraaj Group’s current problems, no such organisation exists in the UAE.

“It’s not necessarily the firms that are making the errors in many cases, but the system of corporate governance that needs to be updated,” says Pavoni. “This is not to say that the world hasn’t made great strides in improving the framework of financial management architecture, but that while we’ve worked hard, we haven’t worked hard enough to use the steps taken as a direction toward a stable future.”

Lessons learned?

Ten years on, though, what has really changed? In March 2018, the Republican-led Congress rolled back some of the Dodd-Frank provisions, including the size of the banks that have to undergo annual stress tests – a move that the Congressional Budget Office said would increase the probability of a big bank failure.

The banking sector has become better capitalised, and the largest players are much less dependent on one another for funding

In recent days, as the tenth anniversary of Lehman’s collapse rolled around, the latter has come into sharper relief. Writing for CNBC, Victor Li, professor of economics at the Villanova School of Business, suggests that the financial crisis can not only “happen again” but that “the current direction in federal policy suggests it even may be likely”. Among the factors he cites are the all-too-cosy relationship between Wall Street and Washington DC and the subsequent rolling back of regulation.

“It was precisely the pre-2008 deregulatory agenda, including the elimination of barriers between investment and commercial banking, that led to the development of complex financial instruments, such as credit default swaps and derivative markets, that led to banks taking excessive risk,” he says. “By rolling back these regulations and dismantling portions of the Dodd-Frank Act, the Trump administration is removing the safety net and creating a perfect storm that could lead to a crisis even worse than 2008.”

Across the Atlantic in London, Nicky Morgan, chair of the Commons Treasury committee, sees similar warning signs. “Since the financial crisis ten years ago, the banking sector has become significantly better capitalised, and the largest players are much less dependent on one another for funding,” she wrote in The Guardian. “Yet in many ways, this still-concentrated sector looks remarkably similar to the one that threatened to bring the global economy to its knees… until the public is confident that the sector’s cultural flaws have been rectified, trust in banking will remain low.”

It’s clear that being weaned off easy liquidity will prove to be the first stress test the financial system will face. Many will argue that the reforms already enacted are enough, but considering Lehman Brothers still serves as an object lesson in undue risk, everyone ought to  hope they are.



A way forward

Given the interconnected nature of global financial systems, stricter capital control requirements inevitably cushion against domino effects that threaten to topple global markets – as they did in 2008. Monitoring those controls in global financial management is a task given to a network of professionals that, by definition, have to be averse to numerical wizardry: accountants.

The accounting industry has been the subject of wide-scale reform and regulation since the turn of the century. In 2001, audit firm Arthur Andersen’s faced charges for being complicit in the $100m accounting fraud perpetrated by US firm Enron.

Telecom’s giant Worldcom was found guilty on similar charges relating to fraud in 2002. The revelations not only derailed the US economy, but resulted in the US Senate passing the Sarbanes-Oxley Act in 2002. This mandated the disclosure, among other things, of audit partners associated with an account as well as detailing off-balance sheet transactions that could affect a company’s financial position. It also led to the establishment of the Public Company Accounting Oversight Board (PCOAB), effectively a regulator for audit firms which oversees the audits of public companies.

The fact that financial statements, unless audited, are not considered reliable is an expression of the space accountants occupy in the world. “Unfortunately there are going to be failures in every learned profession that we need to fix and address,” says Jeff Thomson, CEO of the Institute of Management Accountants (IMA). “But the big picture of the accounting profession is that it is trusted.”

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