From the October 01, 2011 issue of Futures Magazine • Subscribe!

McDonald: Inside the fall of Lehman


FM: How is it that you were able to earn significant profits for Lehman Brothers by realizing the extent of the housing and subprime bubble yet the firm was so tied to it?

LM: By no means was it me, I was just part of a wonderful group of people and our group made a lot of money in '07 and a lot of money in '08. We were short a lot of things like Countrywide, like New Century, a lot of these mortgage brokers. The problem with some banks is they become like silos; one part of the firm is not communicating with another and you have very serious franchises around the firm that are just immense powerful franchises that are not very easily challenged. If you picture a massive bank like Lehman [as] a 767 with 16 engines, we were just one engine. For every dollar we were making some of the guys upstairs were losing five.

FM: What has been the feedback by former colleagues?

LM: When the Valukas report came back — a wonderfully done examiners' report written by Anton Valukas — many of my findings were consistent with his report. The feedback has been incredibly supportive over the years.

FM: Did you hear from any of the people who resisted your warnings?

LM: I have not. Not in any meaningful way. People just want to move on. It is just a bad trade.

FM: You blame the credit crisis directly on the repeal of Glass-Steagall. How is it responsible? Have we gone far enough in restoring those protections?

LM: I don't think [the repeal] of Glass-Steagall was 100% responsible. In a perfect world we could make a matrix of responsibility for the financial crisis and give a certain weighting to each part of the matrix and the Glass-Steagall dismantling by the Gramm-Leach-Bliley Act would have a substantial weighting in that matrix. I would say that the problem with Gramm-Leach-Bliley is that it put banks like Lehman and Bear into the ring with giant colossal opponents. It is like taking a middle-weight fighter and all of a sudden he is fighting a heavy-weight for the first time. The deposits that the big banks have and had in this country [are huge]. It made firms like Lehman [use] leverage to compete against the colossal giants.

FM: Glass-Steagall wasn't completed reinstated by the Volker Rule and many experts believe it was watered down. What would you like to see?

LM: The best thing that I see in financial reform is what is being done by the banks themselves. The invisible hand of Adam Smith is actually working through the system as we speak. Even without a Glass-Steagall, many banks are reducing leverage, they are reducing proprietary trading. Now banks know that Glass-Steagall and Basel III are out there in the future and they know the blades are coming. There has been an amazing job by a lot of U.S. banks. What they have done is remarkable in terms of deleveraging, in terms of selling off proprietary trading units, in terms of downsizing. The U.S. banking system is in a [very] healthy spot. Where we are being challenged is in Europe.

FM: But has the problem of too big to fail been alleviated?

LM: The banks are definitely deleveraging but some of [them] have merged and too big to fail has not been solved yet, but there are mechanisms in the wings — this living will, this resolution authority that is part of Dodd-Frank that would allow the FDIC to come in and take over an institution — we are not done with that yet. We are getting closer to ending too big to fail but we are not there yet.

FM: To what extent did all the major investment banks know — or think they knew — that they were too big to fail? That they made decisions knowing the government would bail them out?

LM: I will leave that up to the book.

FM: Did Lehman believe this?

LM: Just look at the credit default swap levels on banks then vs. now. Credit default swaps on banks in '06-'07; the big banks were trading 30-65 basis points above Libor and today the big banks are trading at hundreds and hundreds of basis points wider. So there is no question that the market, not just the banks, everybody viewed them as too big to fail. It was an entire all-encompassing market belief. I can't begin to stress the importance of this. If you looked at the biggest banks, their credit spreads over Libor, their bond yields were so low, everybody was swept up in this too big to fail.

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