The Independent Market Observer

9/13/13 – Five Years Later

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Sep 13, 2013 10:16:01 AM

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Today is Friday the 13th, an apt day, perhaps, to consider the five-year anniversary of the collapse of Lehman Brothers, the event that touched off the most recent financial crisis.

There will be a great deal written and said on this topic, including right here (by me) and on Monday at 5:30 a.m. ET on CNBC (also by me). I’m excited to be on the program, so if you’re awake, check it out.

In case you choose to sleep in, one of the important points is contained in the first sentence—specifically, “the most recent financial crisis.” I’m not that old (no comments, please), and I can remember the oil embargoes and bear markets of the 1970s. I lived through the stock market crash of 1987, the real estate crash of the early 1990s, the Asian financial crisis, the dot-com boom and crash, and the financial crisis of 2008. I know I left some things out, such as Long-Term Capital Management, but that’s the point—there have been lots of crashes and crises.

What made this one different was the real possibility that the whole system could come apart in the West. (Again, the qualifier, as the Asian financial crisis did result in the system coming apart in Asia.) When I honeymooned in Bangkok in 2003, there were half-finished skyscrapers rotting on the skyline, a reminder of what had been. The West hadn’t faced the prospect of systemic collapse since the 1930s, and it came as a shock on multiple levels.

Viewing the collapse of Lehman and the onset of the financial crisis five years on, we shouldn’t be asking, How are things better now?, but rather, Are things better? Do we face the same set of systemic risks, or did we actually learn and make changes to reduce the chance of a systemic collapse?

As usual, the answer is mixed. In the U.S., the banking system is much better capitalized—that is, the banks have more solid financial foundations—so the risk to the system as a whole is less. Many of the riskiest trading strategies and levels of leverage used by institutional investors have also been dialed back. In Europe, though, the banking system remains significantly undercapitalized, and much of that capital is tied up in government bonds. Other risks have actually increased since the crisis, as measures taken by the European Central Bank to bail out banks have heightened many healthy economies’ exposure to weak banking systems in other countries.

In terms of regulations here in the U.S., a great deal has been said but relatively little done. Much of the Dodd-Frank Act hasn’t been turned into regulations yet, and other regulatory changes have been fought more or less to a standstill by financial industry lobbyists. Progress has been made, but in many cases, it’s been due to banks voluntarily making changes based on pressure—changes that could be reversed in the future. In Europe, again, changes have been incremental, and many of the risks that existed in 2008 remain.

The big question, for both Europe and the U.S., is whether the banking system could collapse and take the economy down with it. In the U.S., overall, the answer appears to be no. The system is stronger, the risks are more contained, and the government has legal and operational tools now that it didn’t have then, enabling us to better manage a crisis. As a case in point, while officials still insist they didn’t have the tools to either save or take over Lehman, those tools are now more readily available. It would still be messy, but we have learned from some of our mistakes.

In Europe, the news is not as good. Regulations and oversight are still fragmented, and rescues still the province of slow intergovernmental negotiations.

Looking back, we’re better off in the U.S. today than we were five years ago. Not as much as we should or could be, but meaningfully so. Against the reduction in systemic risk, though, we have to place the smaller toolkit now available to the Federal Reserve and the accumulating debt, which limits possible fiscal support. With rates coming back up, and fiscal support unlikely, the regulators have to be the first line of defense. It’s good that we have made progress on this.

The other lesson I take from the Lehman debacle is that, while the U.S. has made some progress, other financial systems remain at risk. Many of the imbalances from the late 2000s still haven’t been purged from many markets, and banking systems remain opaque around the world. The developing situation with emerging markets may be the first test case of how stable financial systems in the rest of the world are.

So, on the whole, Friday the 13th doesn’t look too bad in the U.S., but it could look a lot worse elsewhere. As I’ve said on many issues, we certainly have our problems here, but in context, we’re doing quite well. Let’s hope we keep working on doing better.

One additional note: Today is my dad’s birthday. He was born 73 years ago, also on a Friday the 13th, so at least something good happened that day! Happy birthday, dad. You and mom made me who I am today.

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