Lessons From Lehman, 10 Years Later

10 years ago, on September 15, 2008, Lehman Brothers filed for bankruptcy, sparking the worst financial panic since the 1930s. It was a defining moment in the seminal market event of most investors’ lives. Financial media are full of retrospectives, from interviews with former employees to analyses of what has—and hasn’t—changed since. In our view, Lehman’s failure serves as a reminder of crises’ silver linings: They offer learning opportunities for investors.

The popular narrative of what happened then hasn’t much changed since we were all in the thick of it 10 years ago. Many experts continue blaming the same characters: “too big to fail” financial institutions; a housing bubble; subprime loans; banks that were houses of cards built on sand. Very little coverage has dwelled on what we (and others) believe were the true culprits. The first: a widely overlooked accounting rule change that decimated financial institutions’ balance sheets. The second: the government’s haphazard response to the resulting crisis.   

While our view is in the minority, evidence supports it. In November 2007—weeks after the last bull market’s peak—the Financial Accounting Standards Board (FASB) started enforcing FAS 157, the mark-to-market accounting rule. This required banks to mark assets on their balance sheet to their current market value. This makes sense for liquid, widely traded assets whose market value is up-to-the-minute—like stocks. But not for everything. Financial institutions also hold illiquid assets like mortgage-backed securities (MBS) and collateralized debt obligations (CDO) with no intention of selling. Rather, they hold these assets to maturity and collect the interest. Their market value is more difficult to determine since they trade rarely and aren’t trackable on a daily basis. The only reference point is the last sale price of something comparable. Booking these assets at face value seems more sensible, lest one institution’s hasty sale force healthier banks to book a loss—or lest one institution’s ability to sell these assets far above face value forces other banks to inflate the assets on their own balance sheets, artificially juicing capital. Yet FAS 157 forced financial institutions to treat all assets on their balance sheets as if they would have to sell on a day’s notice. This created a destructive feedback loop that destroyed trillions of dollars of bank capital.

With home prices falling, subprime mortgage worries spiked in 2007, driving investor fears about hedge funds with leveraged exposure to subprime MBS. To meet redemption requests and margin calls, the hedge funds eventually sold these securities on the cheap. FAS 157 forced all financial institutions holding similar assets to write them down to matching prices. These paper losses started hitting banks’ earnings and capital, which prompted more firesales, which prompted more writedowns, lather, rinse, repeat. With fear dominating the marketplace, major financial institutions couldn’t get overnight funding. Bear Stearns was the first big domino to fall in March 2008 after questions about its balance sheet and collateral quality. Bear wasn’t technically insolvent, but it was illiquid—leaving it functionally bankrupt despite its wealth of long-term assets. The Fed arranged for JPMorganChase to buy it out and took over its more troubled assets.

This calmed markets for a spell, but FAS 157’s destructive feedback loop continued. The kicker was private equity firm Lone Star Capital buying nearly all of Merrill Lynch’s “troubled” assets in July 2008 for a mere 22 cents on the dollar. That fire sale set a new reference price, forcing banks to write down comparable assets again. This event led to Lehman’s profit warnings later that summer—and made creditors gun shy about extending funding to the bank.

The turmoil continued as Freddie Mac and Fannie Mae fell in September and the government nationalized them. But one week later, the feds defied investors’ expectations that major firms would get assistance. Lehman faced a crunch similar to Bear Stearns, but the Fed forced Lehman to fail. (AIG, one of Lehman’s main counterparties, was nationalized one day later.) At the time, the Fed and Treasury said Lehman lacked collateral to get a loan. Later on, some decision makers argued they couldn’t find a buyer to step in. However, Fed transcripts and other information show this to be false: The Fed and Treasury deliberately denied funding for Lehman’s suitors. The Treasury apparently didn’t want more political backlash while the Fed seemed to want to make an example out of Lehman.

This rocked markets as investors saw the government arbitrarily picking winners and losers. It turned the financial crisis into a full-fledged panic, and market liquidity evaporated as nobody knew what the government would do next. Investment banks quickly reorganized to shore up their defenses and be able to tap the Fed’s discount window. BofA bought Merrill Lynch; Citigroup merged with Smith Barney; Goldman Sachs and Morgan Stanley reorganized as bank holding companies. Wall Street as investors knew it was over. And it all started with FAS 157. We don’t think it is a fluke that the bear market’s end in March 2009 coincided with Fed chair Ben Bernanke’s suggesting the rule be revised to be more flexible with illiquid, held-to-maturity assets and a congressional hearing putting pressure on the FASB to act.

We have been able to piece this story together over the years with the benefit of hindsight and research. But as our commentary archives show, in the moment, we had as hard a time as anyone connecting the dots. We did notice mark-to-market accounting’s distorting effects—see our 7/24/2008 commentary “Mark It to Market?”—but we didn’t foresee its full fallout. Rather, we saw it as an arbitrary rule that could easily be suspended or bring write-ups that would repair bank balance sheets. We thought markets would likely see through the temporary paper losses and realize the underlying assets were in better shape than most thought. And we certainly didn’t know the government would act haphazardly as judge, jury and executioner. Even when Lehman failed, we had no inkling of the rumblings to come as the government’s arbitrariness became more readily apparent. You can see that in our commentary from Lehman’s bankruptcy day, “Weekend at Lehman’s.” It was only with hindsight that we put the pieces together later in the autumn and in the months that followed.

This highlights the key for investors: Every market event is a learning opportunity. We learned bear markets can start with secondary regulation outside of the stock market—you can thank that for our seemingly bizarre obsession with banking regulations and accounting rules over the last 10 years. We hope the Fed and Treasury learned consistency is key. We also hope the Fed learned dropping the discount rate (at which banks borrow from the Fed) below the fed-funds rate (at which banks borrow from each other) is an easy way to keep banks liquid in a crisis, as we suspect banks would have been more apt to lend to Lehman if they could have simply arbitraged funds they first borrowed from the Fed.

As awful as the last bear market was, it imparted valuable lessons. Chief among them: Bull markets always follow bear markets. The bull that began in March 2009 continues today. (We think.) Investors who learn and apply lessons from bad times can make more informed investment decisions in the future.