The Lex Column
Endless tenth anniversary articles are asking why Lehman Brothers failed. The more interesting question is why it took so long to fail when every dollar of assets on its balance sheet was funded with just 3 cents of equity.
Equally, pundits who wonder where the next threat to the system will come from are asking the wrong question. Knowable loss absorption capacity matters more than the nebulous origins of risk.
At the end of 2007, seven large banks — Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, Morgan Stanley, Citigroup and JPMorgan — had assets of $US8trn.
Against that, they held less than $US400b of shareholder’s equity, implying a leverage ratio of a whopping 25 times. In a go-go market of rising asset prices, such risk-taking was a huge boon to shareholders. They got used to returns on equity of 30 per cent.
JPMorgan had a leverage ratio of just 12 times at the end of 2007 and saw a measly return on equity of just 13 per cent. That explains why it weathered the crisis best.
At the end of 2017, five large banks — Bank of America, Goldman Sachs, Morgan Stanley, Citigroup and JPMorgan — have roughly the same total assets as those seven banks from 2007. They have nearly $US900b of equity capital. As a consequence, double-digit returns on equity have only become commonplace again this year in the tenth year of an economic expansion and after a large corporate tax cut.
The 2009 banking crisis was not just about solvency. Investment banks such as Bear, Lehman and Merrill relied on short-term funding that dried up as impairments loomed. Goldman Sachs and Morgan Stanley became bank holding companies, giving them access to Fed emergency funding. In 2018, the rollicking, risk-taking investment bank is essentially gone, driven to extinction both by regulation and market realities.
Worries about the next financial crisis now focus on trillion-dollar asset managers like BlackRock or consumer balance sheets swollen with student loan debt. Banks are far more boring than they were a decade ago. The world financial system is better for it.