Up until then, you would have struggled to find many market participants who thought such an outcome was possible. One of the most important and most storied investment banks, founded in 1847, was defaulting on its obligations and collapsing into the hands of the administrators. Lehman Brothers was bankrupt.
That was when everything changed. Investors, commentators, observers and policy makers were all forced to face a new reality – previously held assumptions were no longer sacrosanct.
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The news sent financial markets into a tailspin and caused shockwaves around the world. Fifteen years on, we are still contending with the aftermaths of those shocks.
The conditions leading to the demise of Lehman Brothers were a long time in the making. Under former chair Alan Greenspan, the Fed had become increasingly adept at using monetary policy in response to challenges to US economic stability. Whenever there was concern, the Fed would cut rates and make everyone feel better.
Easy money would lead to the Nasdaq bubble. When that bubble burst, yet more easing created a housing boom across the United States, which quickly became a bubble.
That bubble was packaged into securities of increasingly dubious quality and sold to financial institutions across the world using cheap money thanks to the Fed’s largesse.
Following the housing bust, no-one was surprised when the Fed came to the rescue. Each time the process was repeated, the magnitude of the crisis seemed to get larger.
What became known as the Global Financial Crisis took monetary policy into a whole new realm. The white-knuckle shock of the Lehman bankruptcy announcement caused credit markets to seize almost instantaneously.
Seismic changes
The term ‘too big to fail’ really was not in common use at the time. It was more of an unspoken implication. For some time, analysis had suggested that some of the largest institutions in the financial world were able to access financing that was cheaper than implied by their standalone credit rating.
The reason ascribed to this was that there was an implicit government guarantee. In essence, these firms were too large and too integral to the entire system to be allowed to default.
This assumption disappeared in a puff of Wall Street smoke, but somewhat ironically was to reappear in an even stronger form just days later when the scope of what was unfolding became truly known.
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In Washington, the government was “forced” to bailout the behemoth insurer AIG, as well as the pseudo-government entities of Fannie Mae and Freddie Mac.
So how had it come to this? That question has received more column inches than most in the years following this apocalyptic financial event. The short answer is bad assets and too much leverage.
Banks across the world had gorged on increasingly speculative mortgage- and asset-backed securities, using excess leverage and based on a highly fallacious assumption that house prices could not fall significantly across the US. Of course, that assumption was wrong, and the leverage involved hugely magnified the negative impact.
As to the longer answer: well, the ultimate causes divide opinion even today.
How complicit were central banks? Was this a failure of regulation? And what about the involvement of the ratings agencies which had garlanded many of these assets with the coveted AAA rating, thus placing it alongside the US and UK governments in its likelihood of default?
Lessons learned
The truth is that all these factors, and more, played a role in creating the conditions that led to the financial crisis of a century.
The important question is: have lessons been learned? The impact was severe and still reverberates through the system today. The use of unconventional monetary policy tools has become, for better or worse, completely conventional. We live in a world where bailouts – either by governments or central banks or both – are swift and aggressive and almost universally cheered.
We still seem incapable of stopping to ask whether these bailouts create incentives perverse enough to bring about the very outcomes they seek to address – moral hazard is now an accepted feature of the system.
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Now, 15 years later in 2023, the banking system is far more heavily regulated than ever before and yet is still fragile enough to generate bank defaults on a historically enormous scale. Financial markets too appear less liquid and more fragile than in the pre-crisis era. There is every chance that the lessons learned by our leaders and decision-makers in the years after this most historic of crises were not the right ones.
In 2020 when the pandemic hit, we knew what was coming. Central bank response was Pavlovian: see problem, print money. Nobody stopped to ask if this situation might be different.
The problem at hand was the shuttering of the global economy. Goods production worldwide ground to a halt.
For years, global manufacturing had shifted offshore to low-cost producers, driving down prices and keeping inflation low. Now, we faced the opposite – impeded supply with demand boosted by free money.
The result was inevitable, and those institutions tasked with maintaining a low rate of inflation created the most damaging inflation episode in 40 years. Their complicity in creating the foundations for a once-in-a-century crisis had taught them badly.
Now, their over-aggressive response to this major inflation episode has every chance of plunging economies into recession, as policymakers once again overcompensate for one error with the opposite error.
James Athey is investment director at abrdn
