09.16.08
Early Conclusions from the Lehman Bankruptcy
It is dangerous to draw conclusions before the dust has settled from an event. In fact, it may be dangerous to draw conclusions before the dust has settled for many years upon an event. However, since Investment Initiatives is more useful to its clients if it can help them in the foreseeable future rather than in the distant past, I will hazard that the destruction of Lehman Brothers Holdings has underscored the following eternal verities, and that investors may draw upon them to try to avoid getting trapped in a re-run at some future date. Boards and other interested parties (do you hear this Federal Government? No?) may do likewise.
1. The man or woman who has built up a great organization is rarely the one to save it in a real crisis. It is too difficult to perform surgery on one’s own ‘baby.’ Boards must take note, and be prepared to act accordingly when the proper steps do not seem to be taken, and before the situation is a matter of life or death.
2. Traders (and ex-traders) are dangerous to have as key decision-makers in a real emergency. They will always remember the time they saved their own skins and those of their employers by doubling down in a crisis. They survived then because otherwise they wouldn’t be where they are now. But if they do the same thing again, the odds may catch up with them.
3. Large, bureaucratic institutions, like giant ships, will always find it more difficult to change course. It takes more time, requires more maneuvering space, more specialized teams must be consulted, there must be ‘buy-in’ from many more individuals, the whole maneuver must be coordinated, there is more chance that some subgroup will refuse to respond, or respond more slowly, etc. Making the group more flexible by decentralizing management may make the vessel more flexible in skirting small obstacles, and making it larger might make it more seaworthy in a heavy storm. But none of these will save it from sinking if it runs onto the rocks. Lehman’s risk managers had decided that the bank was over-committed to mortgage-backed securities in early 2007. But the mortgage traders and underwriters kept piling it on—that was their job, and they didn’t want to forgo any profits that were there for the taking, no matter what the guys up on the bridge were screaming. Short of military discipline (and even then there are problems) there is no easy way to make a large organization adequately responsive to a change in direction in an emergency.
4. Businesses, like biological individuals, have a life cycle. It may be lengthened, and sometimes the business may transform itself enough that what amounts to a new being may gain a new lease on life and another cycle. But sooner or later, the environment which spawned the business will change too radically, and the business begin to die. Worse, before that time, the business may contract a fatal illness. For this reason alone, it is a poor strategy to encourage businesses to become so large that their death would endanger the whole economy. If a business is ‘too big to fail,’ an economy is irrevocably committed to spend its resources upon life-support operations. “Small” may not only be “beautiful” as Schumpeter wrote, it may be necessary for the long-term health of an economy.
5. On the other hand, a business which has not reached the terminal phase may survive even if its conglomerated parent dies. According to early news releases, Barclays Bank is interested in the historic core of Lehman—stock broking, equity trading, and corporate finance—and buy it to get an instant access to U.S. markets. It would be ironic if the ‘old’ Lehman Brothers outlives all the jazzy new businesses they diversified into as a result of the breakdown of the barriers between Wall Street and commercial banking, and all of the exciting new products which have been invented in the last 25 years. Lehman had diversified into many new lines of business which all required more capital than its historic business did. Ultimately, it could not weather a crisis brought on by its being more extended than it could afford to be, given its size.
6. The effect of leverage is symmetrical. Creditworthiness isn’t. Lehman wasn’t making record profits in 2004, 2005, and 2006 because they had created a form of transaction no one else had thought of or could imitate; they were getting a higher return because they were running higher risks. When the mortgage market started to go down rather than up, their profits on hugely levered inventory turned into losses. Unfortunately for them, they couldn’t claim back the profits from past years in order to cover their losses in the current one, or to satisfy the banks that they were no worse off than before they started.
7. Things are better if you are making money at what you naturally do best than they are if your source of profits is what somebody else naturally does better. In the latter situation, you are squeezing more stable and secure competitors, either because your own historic business is no longer profitable enough, or because a restless management is looking for new worlds to conquer. This is an unstable situation: either a more inherently stable competitor will eventually come back to crush you, or the exogenous risks you are running will do the job for him. In any case, a board should decline the invitation to commit more resources to the new business than it can afford to lose, no matter how profitable the activity may be in the short term. They are playing on someone else’s turf, and eventually will have to retreat.
8. Market interventionists love universal banks, because they are so much easier to regulate and control, and because they can get their hands on so much more capital. Given the effects of #3 and #4 above, this impulse should be resisted in the regulatory backlash which will inevitably follow the high-profile events of the past weekend. Risk is still risk, oversized organizations are even more oversized if they get larger, and a market mechanism is not better served by requiring participants to be groups which are better equipped to introduce political forces to attempt to tilt the odds more in their own favor. This is what got Fannie Mae and Freddie Mac into the mess that they are now in.