Lehman Lessons (Part 2)

Why did Lehman fail?

Lehman’s went bankrupt five years ago because they had too little capital and too many risky assets. But how did they get there? Don’t we regulate our banks and financial intermediaries?

The short answer is yes. Banks and brokerages are some of the most highly regulated institutions in the economy, and for good reason. When if a bank failure is considered part of a wider problem, depositors pull their money out of other banks, leading to a credit crunch and broad economic contraction. That’s financial contagion. Regulation and examination are supposed to limit this.

But regulators have a problem: they’re people with their own interests, like everyone else. When an examiner who makes $100 thousand / year sits across from an executive who makes $ 1 million / year–who he’d like to work for some day–it’s unlikely the agency will be hard on the bank. This is regulatory capture, where the inmates are running the asylum.

It’s one reason the Dodd-Frank financial reform bill created oversight agencies insulated from Congressional and even Federal Reserve review, but that creates other problems–a virtual fourth branch of government with no constitutional mandate.

Capture allowed Lehman to be over-levered with the wrong assets at the wrong time. Shareholders were wiped out, but the rest of us were hurt pretty badly as well.

Douglas R. Tengdin, CFA

Chief Investment Officer

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