Column  International Exchange  2012.03.05

-The Ongoing Economic Crisis- Series 2: What went wrong? Why did the world economic crisis occur after the Lehman Shock?

Newsletter from Daisuke KOTEGAWA

1.  Why did the world economic crisis occur after the Lehman Shock? Little has been discussed on this point in detail, probably reflecting Western media's bias towards Wall Street. The complete abolishment of the Glass-Steagall Act in February 1999 was the main structural cause of the financial bubble in the United States and Europe from 2002 to 2007. It was abolished under the leadership of Treasury Secretary Lawrence Summers during the process of liberalizing financial markets in the late 20th century. The act was enacted in 1933 in order to divide the business of banking and securities in light of the tragic experiences of the Great Depression. Surplus liquidity created by an extended period of lax monetary policy in the first decade of the 21st century under the auspices of the Federal Reserve and Chairman Greenspan fueled a so-called money game by investment banks, which was inconsistent with the laws of real demand. Such policy and administration by the Fed and Treasury were the main causes of the bubble. However, I would like to leave a more detailed discussion of this point for another occasion and focus instead on the problems related to the failure of Leman Brothers in September 2008, which is what triggered the world economic crisis. I would now like to discuss two major mistakes made by U.S. and European financial authorities with regard to (i) how Lehman Brothers was liquidated and (ii) how the bailout of financial institutions was worked out. I will start with the liquidation of Lehman Brothers.

2.  Financial institutions in the United States have been suffering from non-performing subprime loans since the fall of Bear Sterns in March 2008. According to IMF staff who were seconded to the Federal Reserve Board for six months in March 2008, all staff at the Fed were so busy as to give up all weekend holidays. Under this backdrop, the memoir of Mr. Paulson ("On The Brink") published in 2010 gives a detailed explanation of what happened on the eve of the liquidation of Lehman Brothers on September 15, 2008. Initially, Lehman was negotiating with Bank of America about a possible buyout of Lehman by BOA. On Friday, September 12th negotiations fell apart and BOA decided to buy Merrill Lynch. Then the Barclays Group, which was the largest shareholder of Lehman and would suffer the largest loss if Lehman were to fail, joined the negotiation table. Barclays too had prepared for this by entrusting due diligence of the Lehman Group to a neutral third-party. Accordingly, when the issue was brought to the table, the parties concerned had expected that the buyout would be agreed to and made public on the weekend. That weekend Barclays branch office executives stood by at their offices around the world. However, they received no word from London headquarters until late Sunday. Finally, on the night of Sunday, September 14 they were informed by the Financial Supervisory Authority of the British Government that the FSA would not allow Barclays an exception from the rule by allowing them to waive the listing requirement for a shareholder vote. As such, Barclays had to get the approval of shareholders by holding an extraordinary shareholders' meeting within twenty-four hours. Considering the fact that it was physically impossible to convene such a meeting, this was in effect disapproval of the deal by British authorities. As this information was delivered to the United States government, Treasury Secretary Paulson and president of the Federal Reserve Bank of New York Timothy Geithner went pale and phoned the British FSA to ask them to waive the listing requirements for a shareholder vote so that Barclays could go ahead and buy Lehman. They received only a dry answer to the effect that only the Chancellor of the Exchequer had the authority to do that. Paulson writes in his book that when he talked over the phone with Alistair Darling, then Chancellor of the Exchequer, he made it clear without a hint of apology in his voice that there was no way Barclays would buy Lehman. (「Henry M. Paulson, Jr. On the Brink」 Page 272, Nikkei Publishing Inc. Translated by Yuko Aruga )

3.  The expression of "without a hint of apology" reveals well how Mr. Paulson felt. The basic position of the British authorities is understandable, however, taking into account the possibility that British taxpayers might have had to bear the burden of Lehman's loss if Barclays, which is much smaller than Lehman, failed after acquiring Lehman. I do not mean to say that disapproving the deal was a problem. The real problem lied in the following. When Yamaichi Securities closed in November 1997, which I was in charge of as the director of the Ministry of Finance, the Japanese government allowed the liquidation of Yamaichi only after all cross-border transactions had been unwound over the weekend of November 22-24. The main purpose of this was to not let the closure of Yamaichi affect overseas financial institutions and drag Japan into the epicenter of a world depression. The workload to do this was extraordinarily huge, but it was accomplished through cooperation between the Bank of Japan, Ministry of Finance, private financial institutions and foreign governments. This worked to contain the shock from the closure of Yamaichi within Japan and, as the world economy continued to grow, the Japanese economy has also recovered since 2003. On the other hand, this was not the case for the liquidation of Lehman Brothers. Lehman went bankrupt on Monday, September 15 without unwinding its huge volume of cross-border transactions. This had an extraordinarily contagious effect on the world financial system, starting with the London branch of AIG, and triggered a world depression comparable to the Great Depression before the Second World War. What U.S. and British authorities (Treasury Secretary Paulson and the president of the Federal Reserve Bank of New York Tim Geithner on the U.S. side and Chancellor of the Exchequer Alistair Darling and Prime Minister Gordon Brown on the British side) could have done was cooperate and, by suggesting to the market that negotiations between Lehman and Barclays were still ongoing, to save another week of time which would have enabled authorities to unwind all cross-border transactions. Liquidating Lehman only after all foreign transactions had been unwound could have averted a worldwide crisis.

4.  Understandably enough, if Lehman Brothers had been liquidated only after all cross-border transactions had been unwound, the United States government would have had to spend a huge amount of taxpayer money in order to bail out Lehman Brothers, protect the U.S. financial system, and put a halt to any contagious effects on other financial institutions. If this had happened, the government would have needed to offer a comprehensive explanation to persuade taxpayers why such a colossal amount of public and tax money had to be spent. It is highly likely that this would also have required an investigation into the responsibility of management and supervisory authorities. Such an investigation has never been conducted in the United States and the United Kingdom in the three and a half years since Lehman Brothers went under. In contrast, ten years ago in Japan, the responsibility of executives involved with failed financial institutions such as Yamaichi, LTCB and NCB was thoroughly investigated, while most of these executives were arrested and prosecuted. We have long pointed out the need for such investigations to our counterparties in the governments of the United States and the United Kingdom but our voice has yet to be heard. Taxpayers in both countries were deeply frustrated by the lack of an investigation. In addition, most executives of financial institutions on Wall Street and in London received tremendous bonuses and retirement compensation. The widespread woes of taxpayers were not properly reported in the media, which might have been overly biased towards Wall Street. Japansese correspondents, instead, reported many such woes from all over the United States when they visited local cities. The main reason why the Democrats lost in the mid-term election was not because of health care reform but due to the failure of the government to address complaints from taxpayers.

5.  It is my firm belief based on the above experiences that the most effective measure for protecting the financial system is to reach an international agreement to the effect that when the liquidation of a financial institution with a certain size of international transactions cannot be avoided, authorities must unwind all cross-border transactions before the liquidation takes effect. Such an agreement would allow the financial system to avoid a worldwide financial crisis whenever a financial institution is liquidated. This would naturally lead the country in which the financial institution is located to liquidate the institution at the cost of its taxpayers. Countries such as the United Kingdom and Switzerland, so-called financial nations that accommodate an excessively large financial sector compared to the size of their national economies, would no doubt dislike such an agreement. Any regulation of the financial sector, including the Basel Accords, tend only to create a vicious circle of regulatory loopholes and are not effective in avoiding financial crisis. To make money, bankers always try to find loopholes in existing laws. Accordingly, the most important and fundamental attitude of supervisory authorities should be to always maintain the utmost diligence in fulfilling its duties of daily administration based on the premise that there is no perfect form of regulation. The above-mentioned rule requiring authorities to unwind all cross-border transactions before the unavoidable liquidation of a financial institution with a certain volume of international transactions takes effect would likely encourage supervisory authorities to undertake day-to-day supervision with extreme diligence because any rule that would require the use of taxpayer money in one's own country would put enormous pressure on them to demand full accountability for the nation's taxpayers.