How did Lehman et al survive the Great Depression?

Jeremy Stein, Wharton Univ Professor has given excellent insights on the crisis:

What was the true cause of the worst financial crisis the world has seen since the Great Depression? Was it excessive greed on Wall Street? Was it mark-to-market accounting? The answer is none of the above, says Jeremy Siegel , a professor of finance at Wharton. While these factors contributed to the crisis, they do not represent its most significant cause.

Here is the real reason, according to Siegel: Financial firms bought, held and insured large quantities of risky, mortgage-related assets on borrowed money. The irony is that these financial giants had little need to hold these securities; they were already making enormous profits simply from creating, bundling and selling them. “During dot-com IPOs of the early 1990s, the firms that underwrote the stock offerings did not hold on to those stocks,” Siegel says. “They flipped them. But in the case of mortgage-backed securities, the financial firms decided these were good assets to hold. That was their fatal flaw.”

This is quite neat. Though, I still think greed was the main reason. Why would they do it otherwise? It is all about incentives. Another thing is, I don’t think  it matters whether you flip and sell the securities to someone else or keep it on your books. After all whenever the crisis breaks, it is going to hurt you as financial system is highly interconnected. Someone else could have held the mortgages but he/it would be liable to someone else and it all falls down. Siegel adds:

 Siegel pointed out that many troubled banks and insurers continued to prosper in almost every other aspect of their businesses right up to the 2008 meltdown. The exception was the billions of dollars in mortgage-backed securities that they bought and held on to or insured even after U.S. home prices went into a free-fall more than two years ago. American International Group (AIG), the insurer that received an $85 billion federal rescue package last September, is a prime example. Some 95% of its business units were profitable when the company collapsed. “AIG has 125,000 employees,” Siegel noted. “Basically, 80 of them tanked the firm. It was the New Products Division, which had an office in London and a small branch office in Connecticut. They came up with the idea of insuring mortgage-backed assets, and nobody at the top decided it wasn’t a good idea. So they bet the house — and the company went under.”

Excellent. Come to think of it, Great Depression led to collapse of many banks and fin firms. Why did Lehman et al survive? Stein gives you the reason (though more reasons would be welcome).  

This is precisely what I said – it is all too interconnected. A bad strategy is bound to impact you. He then asks and answers a question which I find very interesting:

 He said he and others have wondered why firms like Lehman Brothers, Bear Stearns and Morgan Stanley — which survived the much more severe Great Depression of the 1930s — collapsed during 2008. One reason, he suggested, might be that, back then, these firms were organized as partnerships. In such an organizational structure, the partners would have to risk their own capital. When the partnerships were reorganized as widely held public companies, however, they no longer had such constraints. “Back when it was a partnership, you had your life invested in that company,” said Siegel, noting that banks also began making higher-return but higher-risk investments in recent years as public ownership increased.

He also takes on Greenspan and Great Moderation:

One other key player that Siegel criticized for not heading off the collapse of the mortgage-backed securities is former Federal Reserve chairman Alan Greenspan, who oversaw the government’s central bank until 2006. Greenspan was so influential while he oversaw the Fed that he could have easily blown the whistle on the over-accumulation of mortgage-backed  assets by the U.S.-based financial giants. He, however, failed to discover that firms were taking such large, risky individual stakes without protecting themselves against a housing market collapse. “[Greenspan was] the greatest central banker in history — he had access to every piece of data,” Siegel said. “He could have looked at the balance sheets of Morgan Stanley or Citigroup and said, ‘Oh my God — they didn’t neutralize their risk.

Greenspan bashers are increasing. I agree he was at fault, but there were other important policymakers (if not as powerful) who could have raised flags but chose to join Greenspan instead.

 Another reason why federal officials and economists failed to detect the perilous economic risks of  the 2000s, Siegel said, is the so-called “Great Moderation.” This term refers to the fact that since the 1980s, the volatility of the business cycle has declined, thanks to more aggressive fiscal policy and the rise of a service-based economy, among other factors. Siegel noted that a similar flattening of the economic cycles had occurred during the 1920s after the 1913 establishment of the Federal Reserve Bank, a factor that caused stock investors to ignore risks, which eventually led to the stock market crash of 1929 and the Great Depression.

This is also very interesting. Remember this for next time…whenewver there is moderation, chances of crisis are quite high. More the moderation..more the severity of the crisis…

He then says Keynesian expenditure is the only way out now

 According to Siegel, monetary policy has failed to stimulate the U.S. economy. The U.S. faces a situation similar to what happened in Japan during the 1990s when interest rates of zero could not revive the country’s moribund financial markets. The only viable solution now open to American policy makers is Keynesian fiscal policy, a stimulus program that lowers taxes or increases government spending or both. Indeed, this is exactly the type of program — costing at least $825 billion — that the Obama administration and Senate Democrats are considering. Siegel said that policymakers should not worry about the impact on deficits; it is large, he added, but not dangerously so.

Finally an idea for budding entrepreneurs:

 Towards the end of his 90-minute talk, Siegel offered some tongue-in-cheek advice to would-beentrepreneurs. “Start a new bank,” he said. “You won’t have the problems of existing banks, and the federal loans interest rate is near zero. Demand for loans is high, and you will face no competition from the private market. You could become very profitable.”

This is a great idea as all Treasury/Fed support is available in case there are any bad loans. Though, I doubt demand for loans (from good borrowers) is high. This is what Akerlof’s information asymmetry theory taught us – in times of high information asymmetry (which always is in case of crisis, you neither know the quality of the borrower nor lender), the chances of adverse selection are higher (loan going to the most risk seeking borrower). Moreover, at zero percent rates, why would banks lend?