5 Lessons From Lehman and AIG

by Marc Bastow | September 13, 2012 12:17 pm

It’s hard to believe just short four years ago we experienced two events that, while they played out quite differently, helped shape what’s now part of the American business lexicon: “Too Big to Fail.”

On September 15, 2008, venerable Wall Street institution Lehman Brothers (PINK:LEHMQ[1]) failed catastrophically by declaring bankruptcy. Lehman, which was founded by brothers Henry, Emanuel, and Mayer Lehman, was at the time the fourth-largest investment house in the U.S., with 25,000 employees. In February 2007, its market cap peaked at nearly $60 billion.

Only 17 months later, with $639 billion in assets and $619 billion in debt, and the subprime/housing market crisis crashing in all around it, Lehman filed Chapter 11, making it the biggest bankruptcy filing in U.S. history to that date.

Having just let Lehman go under on Sept. 15, only one day later the U.S. government did an about-face. It seized control of AIG (NYSE:AIG[2]), one of the world’s biggest insurance companies, as the collateralized debt obligation (CDO) markets collapsed under the weight of that same housing debacle, putting a death squeeze on AIG.

That’s because it had issued scads of credit default swaps (CDS) that effectively served as insurance against those CDOs going bust. The sudden, massive payout liability AIG ran into led to a credit downgrade that required AIG to post cash collateral it didn’t have.

Up to that point, the Federal Reserve had resisted every effort by AIG to come to its rescue. But the Fed knew that if not paid out, the debt insurance sold by AIG to both hedge funds and banks like Citigroup (NYSE:C[3]), JP Morgan (NYSE:JPM[4]) and Goldman Sachs (NYSE:GS[5]), just to name a few, could take down the entire financial market, including the U.S. banking system.

An outstanding recap[6] of the efforts by all parties in The Wall Street Journal provides great detail on the true urgency of the day and is well worth re-reading.

The price of the bailout was the Fed lending AIG up to $85 billion, with the U.S. obtaining a 79.9% equity stake in the insurer in the form of warrants called equity participation notes. The government has been slowly unwinding its position[7], and by the end of 2012 will own a minority stake in the company. The debate[8] on whether the Treasury (and U.S. taxpayers) has benefited financially from the transaction will rage on for some time to come.

In the four years since the market shook, regulations put into place appear to have stabilized the banking industry — at least that’s the hope. And with those regulations come people who no longer believe “Too Big to Fail” can happen again.

I tend to sort of half-agree: I think we can do better. Here are 5 takeaways from those dark days:

1) Markets need more sunlight, as in transparency. Trading in derivatives and esoteric products that appear to sprout like weeds must be, if not completely regulated, at least tightly controlled.

Get over worries about “overregulation” and “the heavy hand of government.” Yes, investors are adults and should employ “caveat emptor” logic to financial decisions. But the country — indeed the world — is still trying to get past the over-exuberance of the last bubble, a bubble that was accelerated by, among many other things, unimaginably complex “financial weapons of mass destruction,”[9] as Warren Buffett described them.

You should be able to read a prospectus without a forensic accountant and a lawyer at your side.

2) Regulators and politicians should be pushing back every day to make sure real capital requirements (Tier 1) are strengthened and standardized.

Capital is the cushion that banks and companies live and die by. While it’s impossible to make the case that none of this would’ve occurred with more capital, the reality is more capital might’ve made a big difference. Will higher capital requirements cost financial institutions more and perhaps cost consumers in the short run? Of course. But what was the cost of the financial crisis? Avoiding the next one is worth the price today.

3) Not every new product created on Wall Street is a benefit to Main Street. I have no problem with Wall Streeters cranking out product for the sake of product, and making a buck or a million on their expertise and mathematical acumen. Hell, that’s why they went to MIT, Princeton or Yale.

However, what we’re producing are simply winners and losers in moving money — not actual goods and services — around. The country is losing its manufacturing edge at the expense of ever-more-clever financial software, and some of our best and brightest future engineers and doctors are instead taking up quantitative analysis.

Out-of-control loan products supposedly helped people get into homes during the housing bubble. But what they really did was put people who shouldn’t have been in homes into debtor hell instead. The end result was a collapse.

4) Government may not be the answer to all things, but it can help in lots of them. I’m sure the hand-wringing over the AIG and subsequent banking industry bailouts was heartfelt. And sure, government legislators and cronies had their hands in the meltdown that was Fannie Mae (OTC:FNMA[10]).

But only the government had the ability to step in and provide at least enough money to keep the doors open and avoid what might’ve been the greatest run on the banks in history.

5) Market are resilient, and so are investors. We’ve been high, we’ve been low, and now look where we are: The Dow is at its highest level since 2007, and bank stocks are making a big comeback in a big way.

The Lehman bankruptcy and AIG bailout should be remembered for the lessons learned and as an opportunity to look forward. So, happy 4th birthday to both.

Marc Bastow is an Assistant Editor at InvestorPlace.com. As of this writing he did not hold a position in any of the aforementioned securities.

  1. LEHMQ: http://studio-5.financialcontent.com/investplace/quote?Symbol=LEHMQ
  2. AIG: http://studio-5.financialcontent.com/investplace/quote?Symbol=AIG
  3. C: http://studio-5.financialcontent.com/investplace/quote?Symbol=C
  4. JPM: http://studio-5.financialcontent.com/investplace/quote?Symbol=JPM
  5. GS: http://studio-5.financialcontent.com/investplace/quote?Symbol=GS
  6. outstanding recap: http://online.wsj.com/article/SB122156561931242905.html
  7. slowly unwinding its position: https://investorplace.com/2012/09/treasury-to-sell-even-more-of-its-aig-shares/
  8. The debate: https://investorplace.com/2012/09/should-you-buy-aig-as-uncle-sam-sells/
  9. “financial weapons of mass destruction,”: http://www.fintools.com/docs/Warren%20Buffet%20on%20Derivatives.pdf
  10. FNMA: http://studio-5.financialcontent.com/investplace/quote?Symbol=FNMA

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