In the aftermath of the
collapse of the Lehman Brothers investment bank 5 years ago yesterday, panic gripped Wall
Street and barometers of stress hit World War II levels.
We reproduce below our story
from September 18, 2008 and on that Thursday,
Patrick Neary, the then Irish financial regulator, reassured a fretful nation on national television that Irish
banks were "resilient" and had a "good shock absorption
There was of course nothing
reassuring in the well-honed mantra from Dublin's Dame Street, the location of
the Irish central bank. Even Irish politicians had years before dropped clichés
such as "the thin end of the wedge" or "paramount importance,"
when they realised they were making fools of themselves.
Before September was out,
Patrick Neary was in Government Buildings advising on how a feared collapse of
the Irish banking system, could be averted.
In New York, within a month
of the Lehman collapse, the Dow posted a record daily rise of 11%.
September 18, 2008:
Panic gripped Wall Street
on Wednesday; investors rushed to safety pushing the yield on three-month
Treasury bills to levels not seen since World War II; the two remaining
independent investment banks Goldman Sachs and Morgan Stanley came under siege;
corporate borrowing costs jumped and fears mounted about the unregulated
credit-default swaps market on more than $62 trillion in debt.
The Dow fell 449.36 points,
or 4.1%, to 10609.66, the index's lowest close since November 2005. The Vix -
Chicago Board Options Exchange Volatility Index - a measure of future movements
known as Wall Street’s index of fear, jumped 19.2% to 36.13 - - its highest
level since 2002.
Investment bank Morgan
Stanley fell 24% and its rival Goldman dropped almost 14%.
Gold for December delivery
rose as much as $90.40, or 11.6% to $870.90 an ounce in after-hours trading on
the New York Mercantile Exchange after rising $70 to close at $850.50 in the
regular session. That was the biggest one-day price jump ever; gold's previous
single-day record was a $64 gain on Jan. 29, 1980. In percentage terms, it was
gold's largest one-day rise since 1999.
A day after the Federal
government agreed to acquire 80% of insurance giant AIG in return for an $85
billion loan, at special government auction, demand was so high for Treasury
bills that the Treasury Department sold $40 billion, far in excess what it
required to cover the government's obligations.
Investors were eager to get
three-month Treasury bills with virtually no yield and as the price was bid up,
the yield fell - - it tumbled on three-month Treasury bills to 0.061% from
1.644% a week ago -- a level not seen since World War II.
US data firm CMA DataVision
reported that the cost of insuring $10 million of Morgan Stanley debt against
default for five years rose to $796,000 a year, up $40,000. Insurance policies
on the debt, known as credit default swaps, were trading as if the firm had a
"junk" status credit rating.
At the end of 2002, the
notional value (the value of the underlying assets of these contracts) of the
entire credit-default swaps market was just $2.19 trillion and about $144
billion a decade ago, but at the end of 2007, had rocketed to $62.17 trillion,
according to the International Swaps and Derivatives Association.
the chain linking a subprime mortgage issued to a resident of Reno, Nevada and a
municipality in northern Norway, the level of interconnectedness of CDS
contracts is now what could be termed a known unknown.
The Wall Street Journal
says that as of June 30, an AIG unit had written credit-default swaps on more
than $446 billion in credit assets, including mortgage securities, corporate
loans and complex structured products.
Lehman Brother was a big
player in the market, but it was both a buyer and a seller, so its net exposure
is relatively small as many contracts cancel one another out. AIG is primarily a
seller of credit default swaps, meaning there are many players who are depending
on AIG's ability to pay up on insurance policies.
Buffett - Financial Weapons of Mass Destruction
Investor Warren Buffett's
Berkshire Hathaway's principal business is insurance and in 2003 said: "In my view, derivatives
are financial weapons of mass destruction, carrying dangers that, while now
latent, are potentially lethal...there is no central bank assigned to the job of
preventing the dominoes toppling in insurance or derivatives.”
Buffett wrote in his
we began to liquidate Gen Re Securities in early 2002, it had 23,218 outstanding
tickets with 884 counterparties (some having names I couldn’t pronounce, much
less creditworthiness I could evaluate). Since then, the unit’s managers have
been skillful and diligent in unwinding positions. Yet, at yearend – nearly two
years later – we still had 7,580 tickets outstanding with 453 counterparties.
(As the country song laments, 'How can I miss you if you won’t go away?')
If our derivatives
experience – and the Freddie Mac shenanigans of mind-blowing size and audacity
that were revealed last year – makes you suspicious of accounting in this arena,
consider yourself wised up. No matter how financially sophisticated you are, you
can’t possibly learn from reading the disclosure documents of a
derivatives-intensive company what risks lurk in its positions. Indeed, the more
you know about derivatives, the less you will feel you can learn from the
disclosures normally proffered you. In Darwin’s words, 'Ignorance more
frequently begets confidence than does knowledge.'"
Following are edited excerpts
from the Berkshire Hathaway Annual Report for 2002.
I view derivatives as time bombs, both for the parties that deal
in them and the economic system.
Basically these instruments call for money to change hands at
some future date, with the amount to be determined by one or more reference
items, such as interest rates, stock prices, or currency values. For example, if
you are either long or short an S&P 500 futures contract, you are a party to a
very simple derivatives transaction, with your gain or loss derived from
movements in the index. Derivatives contracts are of varying duration, running
sometimes to 20 or more years, and their value is often tied to several
Unless derivatives contracts are collateralized or guaranteed,
their ultimate value also depends on the creditworthiness of the counter-parties
to them. But before a contract is settled, the counter-parties record profits
and losses – often huge in amount – in their current earnings statements without
so much as a penny changing hands. Reported earnings on derivatives are often
wildly overstated. That’s because today’s earnings are in a significant way
based on estimates whose inaccuracy may not be exposed for many years.
The errors usually reflect the human tendency to take an
optimistic view of one’s commitments. But the parties to derivatives also have
enormous incentives to cheat in accounting for them. Those who trade derivatives
are usually paid, in whole or part, on “earnings” calculated by mark-to-market
accounting. But often there is no real market, and “mark-to-model” is
utilized. This substitution can bring on large-scale mischief. As a general
rule, contracts involving multiple reference items and distant settlement dates
increase the opportunities for counter-parties to use fanciful assumptions. The
two parties to the contract might well use differing models allowing both to
show substantial profits for many years. In extreme cases, mark-to-model
degenerates into what I would call mark-to-myth.
I can assure you that the marking errors in the derivatives
business have not been symmetrical. Almost invariably, they have favored either
the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to
report impressive “earnings” (or both). The bonuses were paid, and the
CEO profited from his options. Only much later did shareholders learn that the
reported earnings were a sham.
Another problem about derivatives is that they can exacerbate
trouble that a corporation has run into for completely unrelated reasons. This
pile-on effect occurs because many derivatives contracts require that a company
suffering a credit downgrade immediately supply collateral to counter-parties.
Imagine then that a company is downgraded because of general adversity and that
its derivatives instantly kick in with their requirement, imposing an unexpected
and enormous demand for cash collateral on the company.
The need to meet this demand can then throw the company into a
liquidity crisis that may, in some cases, trigger still more downgrades. It all
becomes a spiral that can lead to a corporate meltdown.
Derivatives also create a daisy-chain risk that is akin to the
risk run by insurers or reinsurers that lay off much of their business with
others. In both cases, huge receivables from many counter-parties tend to build
up over time. A participant may see himself as prudent, believing his large
credit exposures to be diversified and therefore not dangerous. However under
certain circumstances, an exogenous event that causes the receivable from
Company A to go bad will also affect those from Companies B through Z.
In banking, the recognition of a “linkage” problem was one of
the reasons for the formation of the Federal Reserve System. Before the Fed was
established, the failure of weak banks would sometimes put sudden and
unanticipated liquidity demands on previously-strong banks, causing them to fail
in turn. The Fed now insulates the strong from the troubles of the weak. But
there is no central bank assigned to the job of preventing the dominoes toppling
in insurance or derivatives. In these industries, firms that are fundamentally
solid can become troubled simply because of the travails of other firms further
down the chain.
Many people argue that derivatives reduce systemic problems, in
that participants who can’t bear certain risks are able to transfer them to
stronger hands. These people believe that derivatives act to stabilize the
economy, facilitate trade, and eliminate bumps for individual participants.
On a micro level, what they say is often true. I believe,
however, that the macro picture is dangerous and getting more so. Large amounts
of risk, particularly credit risk, have become concentrated in the hands of
relatively few derivatives dealers, who in addition trade extensively with one
other. The troubles of one could quickly infect the others.
history of Lehman Brothers parallels the growth of the United
States. The firm began as a general store in the American South. Henry
Lehman, who came from Germany, opened a shop in Montgomery, Alabama in
1844. In 1850, he was joined by brothers Emanuel and Mayer, and they
named the business Lehman Brothers. Cotton was the cash crop of the day
and the Lehmans accepted it from farmers as currency to settle accounts.
The firm traded the cotton for cash or merchandise, becoming brokers of
the crop. In 1858, they opened an office in New York, which was the
commodity trading center of the country.
On top of that, these dealers are owed huge amounts by
non-dealer counter-parties. Some of these counter-parties, are linked in ways
that could cause them to run into a problem because of a single event, such as
the implosion of the telecom industry. Linkage, when it suddenly surfaces, can
trigger serious systemic problems.
Indeed, in 1998, the leveraged and derivatives-heavy activities
of a single hedge fund, Long-Term Capital Management, caused the Federal Reserve
anxieties so severe that it hastily orchestrated a rescue effort.
In later Congressional testimony, Fed officials acknowledged
that, had they not intervened, the outstanding trades of LTCM – a firm unknown
to the general public and employing only a few hundred people – could well have
posed a serious threat to the stability of American markets. In other words, the
Fed acted because its leaders were fearful of what might have happened to other
financial institutions had the LTCM domino toppled. And this affair, though it
paralyzed many parts of the fixed-income market for weeks, was far from a
One of the derivatives instruments that LTCM used was
total-return swaps, contracts that facilitate 100% leverage in various markets,
including stocks. For example, Party A to a contract, usually a bank, puts up
all of the money for the purchase of a stock while Party B, without putting up
any capital, agrees that at a future date it will receive any gain or pay any
loss that the bank realizes.
Total-return swaps of this type make a joke of margin
requirements. Beyond that, other types of derivatives severely curtail the
ability of regulators to curb leverage and generally get their arms around the
risk profiles of banks, insurers and other financial institutions. Similarly,
even experienced investors and analysts encounter major problems in analyzing
the financial condition of firms that are heavily involved with derivatives
The derivatives genie is now well out of the bottle, and these
instruments will almost certainly multiply in variety and number until some
event makes their toxicity clear. Central banks and governments have so far
found no effective way to control, or even monitor, the risks posed by these
contracts. In my view, derivatives are financial weapons of mass destruction,
carrying dangers that, while now latent, are potentially lethal.
Irish financial regulator;
October 02, 2008: