Numerous articles have been written about what has changed since the time Lehman Brothers collapsed until now. The tone of most headlines is pessimistic. A couple of examples: “How Financial Reform Became a Fiasco” (Research Magazine, August 2013) and “Five Years Later, The Plumbing is Still Broken” (New York Times, Gretchen Morgenson, September 15, 2013). Below we will take a brief look at the major issues that led to the collapse of Lehman and subsequently the financial system.
- Leverage: In 2008, one of the biggest problems was the depth of bank borrowing. In 2008, it was up to 50 times what they were worth in net capital. While net capital has increased, there is still no restriction on leverage.
- The Volker Rule: The rule limited bank activities to earning money by making loans and taking companies public. It was removed from Dodd-Frank. Investment banks can use our money in the stock market, derivatives, etc. The JP Morgan Chase Trader – “London’s Whale” is the most recent example of the lack of risk management. He lost $7 billion of the shareholders and company’s capital.
- Complex Derivatives: This is the activity that guaranteed payment if derivatives defaulted (think AIG). There is some progress on this front. Interest-rate-swaps must now go through a central clearing house which tracks who owes what to whom. The Wall Street Lobby carved out significant loopholes. Banks and hedge funds continue to actively trade in derivatives without oversight and are unregulated.
- Rating Agencies: They gave AAA ratings to the toxic mortgages. The companies issuing the products paid the rating agencies (conflict of interest). No change.
- Wall Street Incentive System: The toxic products were sold by brokers, traders, etc. and the compensation was based on the sale. The more you sold, the higher the bonus. When these products fell apart, there was no penalty. The money was kept. Nothing has changed.
- Too big to fail: Nothing has changed. Risky bets can be made with the expectation the government will bail them out again.
Intense lobbying by Wall Street has succeeded in blocking most of the changes to the financial system. This does not mean the financial crisis is going to occur again, but it isn’t very encouraging that Congress is bullied by the lobbyists into inaction.