Financial Times September 11 2009
http://www.ft.com/intl/cms/s/0/6a0627a4-9ec2-11de-8013-00144feabdc0.html#axzz1WV4KM3Sy
Twelve months on from the collapse of Lehman Brothers and much about the event remains mysterious. It was the trigger that caused a deep recession, which began in the US but steadily crept across Europe and Asia, morphing into a global catastrophe worthy of a potboiler novel.
Within weeks of Lehman’s failure, banks throughout the world were teetering, trade finance had dried up, and big Asian exporters were suffering declines in output on a 1930s scale. When journalists and pundits talked about the “end of globalisation”, the “end of market fundamentalism” or indeed the “end of capitalism itself”, people nodded their heads. It certainly felt like the end of something.
EDITOR’S CHOICE
Lex: Distressed debt – Sep-17.Bank runs left repo sector exposed – Sep-10.Industry unites to cut systemic risks in CDS – Sep-10.How the buck finally broke – Sep-10.The legacy of Lehman – Sep-10.Markets one year on – Sep-09..The human mind has a need for grand narratives of this sort. They give structure to events that are otherwise chaotic and disorienting. It is comforting to think that an event of such magnitude has a similarly large-scale explanation. But what if there was nothing inevitable about the Lehman’s shock? What if the real cause was something as mundane as stupidity?
Behavioural finance has challenged the efficient markets hypothesis by casting doubt on its premise — the rationality of market participants. Historians have always had a more sceptical view of the decision-making capabilities of human beings, especially leaders and governments. The classic work on the subject is Barbara Tuchman’s “The March of Folly,” which chronicles profound miscalculations such as the Trojans’ decision to accept a gift from the Greeks, the Japanese attack on Pearl Harbor and American policy during the Vietnam war.
Ms Tuchman defines folly as “the pursuit of policy contrary to the self-interest of the constituency or the state involved”. Her key criteria are that the policy must have been perceived as counter-productive in its own time, and that a feasible alternative course of action must have been available. The fall of Lehman ticks both boxes. The risks of allowing a systemically important financial institution to go bust were well known; six months earlier, the US authorities had backstopped JPMorgan’s takeover of the failing Bear Stearns in order to avoid exactly such an outcome. And as for the feasible alternative – they could have simply repeated the Bear Stearns formula, as they were soon to do with Merrill Lynch.
It is still unclear what was going through the minds of the key decision-makers at the time. Were they running scared of anti-bail-out public sentiment, just a few weeks ahead of the presidential election? Did they believe they needed a sacrificial victim to justify other bail-outs? Whatever the motivation, the result was folly. Like the Japanese leaders who believed that attacking Pearl Harbor was the “safe” option, they ended up destroying what they though they were protecting – the credibility of the administration, the prestige of Wall Street, the global standing of the US. Backstopping a takeover of Lehman would have been a trivial outlay compared with the eye-popping sums that governments would soon be pouring into financial institutions.
According to Ms Tuchman, folly is rooted in self-delusion, the source of which is “wooden-headedness”— the habit of “assessing a situation in terms of preconceived fixed notions, while ignoring or rejecting any contrary signs”. Self-delusion was not restricted to the policymakers. Think of Lehman chief executive Richard Fuld rejecting a last-minute Korean takeover bid because the price was too low. Within a week, the Lehman’s stock – in which he and many of his colleagues were heavily invested – was worthless.
Think of the politicians and commentators who cheer-led the folly with solemn talk of moral hazard and the need for creditors to take their lumps – without understanding the effect on the money markets. Think of the media and the public who delighted in the spectacle of Lehman staff exiting their offices with their possessions in plastic bags – without considering that the biggest victims of a financial meltdown are always the weakest members of society.
So what would have happened if the authorities had arranged a Bear Stearns-type deal for Lehman? The interbank market would not have gone into toxic shock; panic-stricken consumers would not have suddenly stopped buying cars and other goods; tens of millions of Asian workers would not have been sacked; government deficits would not have soared to once-unimaginable levels.
To be sure, the US economy would still be in rocky shape, with serious debt problems in the household sector and a broken financial industry, much of it surviving on direct or indirect government support. The world would still be in recession – for most countries, a bad but “normal” one.
As the Japanese proverb says, there is no medicine for stupidity. It is an underappreciated force in human affairs, from ancient times to modern. Financial regulation needs to assume its existence – in the behaviour of investors, financial professionals and, most important, the policymakers and regulators themselves.