Learning from Lehman

“Is this more serious than Lehman? Yes. Is this more systemic than Lehman? Yes.” So says Larry McDonald, who was vice president of distressed debt and convertible securities at Lehman Brothers Holdings during the collapse of the firm.


Just three years ago Lawrence McDonald found himself at the epicenter of a global financial crisis. As vice president of distressed debt and convertible securities at Lehman Brothers Holdings, he was on hand during the collapse of the firm, its markets and the global economy. McDonald — out of work and reeling from the loss of much personal wealth tied to the firm — turned to writing. The result was A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers. He’s now president of asset manager LGM Group and senior director of corporate credit sales at Newedge, the brokerage formed by Société Générale and Crédit Agricole. He’s also a blogger, with the Twitter handle @Convertbond.

McDonald, 46, sees more than a few similarities between the summer of ’08, just before the collapse of Lehman, and the current economic and financial environment. He spoke with Institutional Investor Contributing Writer Steve Rosenbush about those similarities — and why this time the situation is even more serious. Here are highlights of their conversations.

Institutional Investor: Why do today’s financial markets remind you of the situation in the summer of 2008?

McDonald: The situation that we now face is very similar to the summer of ’08, very similar to the early stages of the credit crisis, before Lehman. Banks are just not lending to one another. There are many disturbing indicators. The Euribor-OIS spread, a measure of banks’ willingness to lend to one another, was just a few basis points from 2003 to 2007. Now it has widened to levels last seen during the credit crisis — 80 or more basis points. That is just crazy. That is huge.

The TED spread, a measure of what banks charge to lend to one another, is the highest it has been in more than a year. The same is true for the dollar LIBOR-OIS spread, a sign that banks are unwilling to lend. The CDX index that measures corporate credit risk is rising. And CDS on five-year Italian debt is blowing out. I think that is very, very important.

Here are other distressing signs. IPOs such as Facebook are getting delayed or pulled. High-yield debt issuance is very low. It’s also troubling that the credit markets have not been able to keep up with the equity markets. Since August 1 stocks have made huge moves of 6 or 7 percent or more, from peak to trough and back up. But the credit markets have not bounced back from waves of selling to the same extent. That is because the credit markets are so much bigger. It’s like turning an aircraft carrier. You don’t buy unless the conviction is really there. And it’s not.

Just how great is the threat to the global financial markets and the global economy?

Is this more serious than Lehman? Yes. Is this more systemic than Lehman? Yes. Can it be fixed? That will depend on how the IMF, the ECB and other policymakers and governments around the world react.

Remember, Lehman was brought down by a relatively small amount of toxic debt. Lehman had a balance sheet of $660 billion. It was carrying about $35 billion in toxic debt, which wasn’t written down to market value. The problem was that the toxic debt was levered about 40 to 1. Now the sovereign debt that banks are holding isn’t as bad as Lehman’s. The sovereign debt isn’t even toxic, really. Iceland defaulted, Russia defaulted, and they were soon back in the capital markets raising money.

The problem is that sovereign debt was supposed to be risk-free, so banks held lots and lots of it. Now that conventional wisdom about sovereign risk is being reassessed. Even if that sovereign debt is worth just a little less than the banks thought it was worth, it can wipe out their capital.

Don’t European banks supposedly have more than enough capital to withstand a default by Greece and maybe even more countries?

Greece is just a small country. Banks have enough capital to absorb its default. But if Greece defaults, then the value of other sovereign debt may need to be written down. That is why some banks have stopped lending to one another. Now all of this is taking place against a backdrop of a slowing economy in Europe, the U.S. and China. That is why this situation is even more dangerous than Lehman.

In the United States, the Federal Reserve has tried two rounds of quantitative easing, and last month it announced Operation Twist, a plan to sell short-term Treasury notes on its balance sheet and buy an equal amount of debt with longer maturities, to push down longer-term rates and hopefully stimulate the economy. Yet such plans haven’t solved the problem, and Twist led to a global sell-off in many markets. What is the problem?

A few years ago banks were like a heart pumping money into the economy. Now central banks in the U.S. and Europe are trying to take on the role of that heart, pumping blood into the economy. It is government action on a massive, massive scale. What has changed? A few years ago the securitization process in mortgage-backed securities was like a vascular system, transmitting that lifeblood through the economy. Now that securitization process — the vascular system — isn’t working. It once seemed like there was a mortgage broker on every corner, distributing funds. They are mostly gone, over 330 of them. That is why quantitative easing isn’t working.

The ECB has been spending about $12 billion a week to support the sovereign debt markets in Europe. That works out to about $520 billion a year. They need about a trillion, though, and they don’t have the political or financial capacity to do that. The people of Germany have had enough of bailouts to Greece. They feel like they are sending money into a black hole. Imagine how they would feel if China helped, along with the G-7. The German people might not feel so alone; it might reduce the growing political pressure. It would be good to see concerned support for Europe by the G-7 and maybe one or two emerging economies. Italy has $350 billion of government debt maturing over the next 15 months; that’s $23 billion a month that has to be financed. Bond buyers in the capital markets are balking, and the ECB does not have that kind of bandwidth to buy the rest.

Just how feasible is that sort of bailout given the various needs and agendas of so many countries? Signals from China and Brazil suggest a cautious approach. There’s apprehension in Europe and resistance within Greece to austerity.

I hope — I hope to God — they figure this out.