Lehman, the crisis and the politicians

I have been listening carefully to the TV, radio and blogging media about the first anniversary of the Lehman Brothers collapse. I don’t know about anyone else but I have found vagueness, confusion and wordiness as a substitute for knowledge to an extent almost unprecedented.

I should like to mention first, in passing, that if you had asked anyone in the financial markets before the crash which firm they would like to go bust ignominiously, they would have said Lehman. It had an arrogance, a class-based superiority which is less uncommon in East Coast America than most people think but which was out of place on Wall Street. At the time I and others were warning about the moral hazard of giving banks a bailout and Lehman was a perfect answer of ‘pour encourager les autres’.

The questions people seem to be asking a year on are ‘Can it happen again?’, and ‘Why didn’t we have regulation to make sure the banks had enough capital?’. The answer to the first question is yes, and it will, but not for maybe a generation. The second is more difficult, and more interesting.

Regulation is done, either at first hand or second, by politicians. Someone has wisely said that come the next collapse we will be rushing around imposing the regulation we should have had for the previous ones, as they say of generals always preparing for the previous war. Some of it is bad. The Clinton administration wanted everyone to have a house. So it told the two state bank/reinsurance companies, Freddie Mac and Fannie Mae, to do most of their business with high risk poor people. It wasn’t all Lehman’s fault.

But there was some regulation on capital and in retrospect it is fairly easy to see why we were all wasting our time. Let us say a bank has £10 of capital, and, looking solid, it borrows £90 and lends a total of £100. That is a leverage of ten times: its loans are ten times its capital, so it only takes ten percent of them (£10) to go bad and they have wiped out their capital and can’t repay their borrowings. Many of the banks were leveraged 30 times, which means it only takes around 3% to go bad and they are in trouble. Given that in the States, thanks to Mr Clinton, they were lending to insolvent Mississippi farmhands to buy a property and you can see there will have been problems.

Some years ago, in the early 1980s if I recall, the chaps from the Bank for International Settlements in Basel, Switzerland, came up with a formula for regulation. Naturally not all loans were the same. Lending money to the farmhand unsecured was highly risky, whereas secured against a property meant you were likely to get something back. So they made a table of different types of exposure, secured, unsecured etc, requiring different amounts of capital. Then what to do about guarantees? If the bank guarantees A’s loan to B there was the chance that B would pay it back, or part of it, so it should need less capital put by. Then suppose Barclays Bank asked Natwest to lend money to a company called Barclays Bank (Dodgy Lending) Ltd. Natwest didn’t get a guarantee but look at the name! A guarantee in itself! Then suppose BB (DL) L floats on the stock exchange, sells shares and we start selling options on their share price? Wow! Or make a market in the future price of those options? Or give the options futures away to enhance the risk on even dodgier stuff, like toys in the packet of cornflakes? Wow Wow Wow!

So as soon as the regulations appeared, banks started to devise ways to get around them, to take more profit-generating risks without having to provide more capital.

And if you put more regulations in place there will be more people paid million dollar bonuses to get round them. The solution is what we had before Gordon Brown became Chancellor. The Bank of England had its nose in every banking pie and could understand what was going on and occasionally warn that it was too much. Brown’s socialist mentality couldn’t cope with this so he split this responsibility between the Bank, the Government and the Financial Services Authority. Three times the people doing the same work but no one was responsible and no one knew what was happening. Northern Rock, which should have gone under for imcompetence, was rescued for the simple reason its base was in Labour heartlands and it had been a donator to the Labour Party. If it had been Cheltenham and Gloucester (Tory), Labour would have laughed its head off and we would have been saved billions.

That’s the problem with regulation. It’s done by politicians.