Learning from Lehman Brothers

It takes more than one screwup to trash an icon like Lehman Brothers, the venerable investment bank that sank in 2008 and took down the global financial system with it. Mark Williams, executive-in-residence and master lecturer in finance at the School of Management, sifts through the debris and lessons of Lehman’s demise in his first book, Uncontrolled Risk, released as the U.S. Congress debates financial reform.

The Lehman Brothers discussion has also raised questions about possible conflicts of interest between investment banks and their clients who hold investments promoted by the banks, but that the banks themselves might consider junk. In the midst of busy book promotions, Williams (SMG’93) chatted with BU Today about what made Lehman a lemon, and where we go from here.

BU Today: Many of Wall Street’s marquee names figured in the financial meltdown. Why a book about Lehman?
Williams: I started my career working in financial markets, which gravitated to working with Joe Kennedy’s company, Citizens Energy. At one point, Citizens was owned in part by Lehman Brothers. I was impressed with their risk management department. I revered the firm. So I was shocked that this historic firm failed. Why did they fail? Initially, I thought it was one executive being greedy.

CEO Dick Fuld?
That’s correct. What I realized was that it was more complicated. There were many Wall Street firms and banks that ended up doing excessive risk-taking. If this was a play, there were many villains. Clearly some were Wall Street executives, driven for high bonuses, but there were other folks. Those include the boards of banks. There’s a lack of independence at the board level. We also saw a lack of oversight. Banks overdosed on risk over time, not overnight. They did it under the nose of the Federal Reserve, under the nose of the SEC.

Was Lehman a microcosm?
Yes. They engaged in excessive risk-taking, but that was being done across Wall Street. If we had a traffic intersection with lots of accidents, you can imagine how quickly that intersection’s going to be fixed. At that financial intersection, Wall Street, we had a lot of accidents. Yet we’re at 20 months now, and it hasn’t been fixed.

Is it possible that investment banking is fundamentally a conflict of interest, with firms both marketing and hedging the same securities?
Historically, investment banks provided an important function. Without banks willing to lend, consumers can’t spend. The Goldman Sachs model is a different model. Not only is a client a client, but a client can also be an adversary. They can sell a product and bet against a client. Historically, investment banks would not put their own capital at risk. Increasingly, investment banks are using their own capital to take risks. They became, potentially, a conflict with their customers. That speaks to the need for better legislation to control the activities and make sure they’re not counter to the banks’ customers.

What is the single most important reform?
Canada withstood the financial hit. There wasn’t one bank in Canada that filed bankruptcy. There was no government rescue. We can learn from Canada. It has one uber-regulator. As a bank, you need to respect what they say. Canada requires higher capital standards for banks. The Canadian system also had a view on leverage, created by taking on debt to buy more assets. That leverage ratio in Canada averaged 18 to 1. In the United States by 2007, at investment banks like Lehman Brothers, the ratios were over 30 to 1. Every congressman should have a bumper sticker that says, “Leverage Kills.”

What are the odds we’ll get real reform?
I’m very much a pessimist, because I’ve seen how powerful lobbyists are. Financial reform means reduced profit for banks.

What’s your answer to people who say increasing regulation decreases the availability of capital for investment and new breakthroughs?
I would tell those people to look at the credit crisis of 2008. How many trillions of dollars were destroyed because banks misallocated capital? We have to protect banks from themselves.

Rich Barlow can be reached at barlowr@bu.edu.