– The “Lehman moment”… could it happen again? – The finance industry is infested with moral hazard – Even more moral hazard today sowing seeds of next crisis – “Next crisis will not look the same as the 2008 crisis”
Protestors hold signs behind Richard Fuld, Chairman and Chief Executive of Lehman Brothers Holdings after its collapse led to the last global financial crisis. REUTERS/Jonathan Ernst/File Photo
A decade ago this week, in the US, the government had just nationalised government-sponsored mortgage lenders Fannie Mae and Freddie Mac.
In the UK, the then-chancellor, Alistair Darling, had, at the tail-end of August, given The Guardian one of the most honest interviews ever given by a serving Cabinet minister, in which he warned that we were facing the worst financial crisis in 60 years.
In short, we all knew things were turning bad.
But the full-on tipping point came with the demise of Lehman Brothers, which was barrelling towards the end of its existence.
This week, ahead of the tenth anniversary of the “Lehman moment”, we’re going to be looking at what happened, what’s changed, and whether it could happen again.
Today I want to start with one of the most important concepts you have to understand in order to grasp what went on.
That’s a phenomenon with the rather curmudgeonly name of “moral hazard”. The finance industry is infested with moral hazard The notion of moral hazard originated in the insurance industry. It’s a very simple concept. It refers to the danger that if someone is insured against a loss, then they won’t take the necessary steps to prevent that loss from happening in the first place.
So, used more widely, moral hazard is what you get when an individual’s actions are divorced from their consequences. Or as Paul Krugman (loosely paraphrased) puts it, it’s when you take the risk, but someone else bears the cost.
This one notion explains why the entire financial crisis happened.
Human beings respond to incentives. If you pay them to take risk and shield them from the lion’s share of the consequences, then you will get a system that skews towards careless risk-taking.
Let’s start with the finance industry. The finance industry runs almost entirely on Other People’s Money (OPM). That creates an immediate problem. The finance industry likes to present itself as a steward of OPM, from institutional investors to individuals. Instead, it more often cares about getting as big a chunk of that OPM as it can. The more it has, the more fees it can extract from it.
That incentivises the creation of complicated, fee-heavy products. It incentivises the expansion of balance sheets. It incentivises short-term behaviour.
And it incentivises careless expansionism, because caution is penalised if you are trying to win business in a “race to the bottom” environment – note that financial industry whistleblowers were fired or victimised in most cases ahead of the financial crisis.
“Career risk” – whereby falling behind your peers in a booming market means getting fired – militates against a more balanced approach. And a lack of genuine “skin in the game” – investing with your own money – means that the finance industry gets the upside with very little of the downside.
If you get paid a life-changing sum on an annual basis then does it matter if you get fired and the value of your shares collapses? Not really.
As Jimmy Cayne, the bridge-playing, dope-smoking ex-CEO of Bear Stearns, put it to finance writer William D Cohan, on the consequences for him of the financial crisis: “The only people [who] are going to suffer are my heirs, not me… Because when you have a billion six and you lose a billion, you’re not exactly, like, crippled, right?”
You can dismiss some of that as the macho bravado of a wounded Wall Street ego. But the basic point is true.
Ex-Lehman Brothers CEO Dick Fuld might cry himself to sleep every night, mourning his lost reputation (I don’t think he does, by the way, although it clearly still rankles with the man), but he’s crying himself to sleep on a big golden pillow.
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