10 Bank Failure: Triggering Crisis—How Absent Management in Banks Triggered the 2008 Financial Crisis

Freddie Mac to fail. There may have been absent management in the two agencies. As they were not banks this is not the place to determine that. With their original remit of providing affordable financing of housing, their exclusive reliance on United States housing, their listing on the stock exchange requiring rewarding of shareholders and their phenomenal growth, perhaps these unique organisations were so complex that they were not possible to manage.

For the second half of 2007 the two agencies’ combined losses were close to $9 billion from credit losses on mortgages and reduced valuation on their investments. For the first half of 2008 losses were over $14 billion.

On Sunday, 7 September 2008, the United States government assumed majority ownership and control of Fannie Mae and Freddie Mac that together owned or guaranteed over $5 trillion of the United States mortgage debt (Pozen and Beresford 2010). This was done to stabilise the housing market. The two organisations continually financed their purchases of mortgages in the financial markets. Had the government not stepped in this, financing might not have been possible and the secondary market for mortgages would have dried up. This could have the most serious consequences for the prime mortgage market and house prices in the United States. In addition credit issues on mortgage-backed securities issued by the two agencies, which were backed by conforming and not subprime mortgages, would have made the crisis worse, possibly much worse.

An additional global aspect was the ownership of the two agencies’ mortgage-backed securities by foreign investors led by China with over $500 billion. Not explicitly guaranteeing this debt could raise questions about the financial standing of the United States. The government ultimately injected $188 billion into Fannie Mae and Freddie Mac (Frame et al. 2005).

RefeRences Brewster, Deborah, and Anuj Gangahar. 2008. Financial Times. 17 March 2008. https://www.ft.com/content/da8db5d2-f469-11dc-aaad-0000779fd2ac Calomiris, Charles W., and Gary Gorton. 1991. In The Origins of Banking Panics:

Models, Facts, and Bank Regulation in Financial Markets and Financial Crises, ed. R. Glenn Hubbard, 109–174. National Bureau of Economics. University of

Chicago Press. Demyanyk, Yuliya S., and Otto van Hemert. 2008. Understanding the Subprime

Mortgage Crisis. SSRN: https://ssrn.com/abstract=1020396 or https://doi. org/10.2139/ssrn.1020396

European Commission. http://europa.eu/rapid/press-release_IP-09-1235_ en.htm. 17 August 2009. FDIC. 1997. An Examination of the Banking Crises of the 1980s and Early 1990s.

Washington, DC: History of the Eighties – Lessons for the Future. Fotak, Veljko, Vikas Raman, and Pradeep K. Yadav. 2014. Fails-to-Deliver, Short

Selling, and Market Quality. Journal of Financial Economics (JFE) 114 (3): 493–516. (December 1, 2014). Frame, W. Scott, Andreas Fuster, Joseph Tracy, and James Vickery. 2005. The

Rescue of Fannie Mae and Freddie Mac. Federal Reserve Bank of New York.

Staff Reports. Staff Report No. 719. March 2015. Guillén, Mauro F. 2012. The Global Economic & Financial Crisis: A Timeline.

The Lauder Institute. Wharton. Harris, Randall D. 2014. Goldman Sachs and the Big Short: Time to Go Long?

Case Research Journal 34 (2): 133–162. Ho, Mary, and Yanling Guan. 2008. Merrill Lynch’s Asset Write-Down. Hong

Kong: The Asia Case Research Centre, The University of Hong Kong. Islam, M., N. Seitz, J. Millar, J. Fisher, and J. Gilsinan. 2013. Fannie Mae and Freddie

Mac: A Case Study in the Politics of Financial Reform. Journal of Financial

Crime 20 (2): 148–162. https://doi.org/10.1108/13590791311322346. Meagher, Evan, Rebecca Frezzano, and David Stowell. 2008. Investment Banking in 2008 (B): A Brave New World. Kellogg School of Management, Northwestern

University. Mikes, Anette, and Dominique Hamel. 2014. Capitalizing for the Future: HSBC in 2010. Boston: Harvard Business School. Milne, Alistair, and Geoffrey Wood. 2009. Shattered on the Rock? United Kingdom

Financial Stability from 1866 to 2007. Bank of Finland Research Discussion

Papers 2008. O’Connor, Anthony, Ingo Walter, and Seymour Milstein. 2013. HSBC Holdings

PLC Building a Global Wholesale Banking Capability. Fontainebleau: INSEAD. Pozen, Robert C., and Charles E. Beresford. 2010. Bank of America Acquires

Merrill Lynch (A). Boston: Harvard Business School. Reuters. 2008. https://www.reuters.com/article/us-usa-subprime-originationid$N0335941820070508 Reynolds, Vaughn K. 2004. The Citigroup and J.P. Morgan Chase Enron

Settlements: The Impact on the Financial Industry. Carolina Law Scholarship

Repository. North Carolina Banking Institute 247. Schiller Home Price Index. Trading Economics. https://tradingeconomics.com/ united-states/case-shiller-home-price-index SEC. 2008. https://www.sec.gov/news/press/2008/2008-211.htm SIFMA. 2009. https://www.sifma.org/wp-content/uploads/2017/05/us-researchquarterly-2009-q4.pdf

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August 2007. Stowell, David, and Evan Meagher. 2008. Investment Banking in 2008 (A): Rise and Fall of the Bear. Evanston: Kellogg School of Management, Northwestern

University. Wikipedia “IKB”. https://en.m.wikipedia.org/wiki/IKB_Deutsche_Industriebank Wikipedia “Northern Rock”. https://en.m.wikipedia.org/wiki/Northern_Rock

CHAPTER 10

Bank Failure: Triggering Crisis—How Absent Management in Banks Triggered the 2008 Financial Crisis

Growth is generally a result of production. And when growth is not controlled, it can be the result of absent management. In 2004 Bear Stearns was the leading underwriter of United States mortgage-backed securities. It had market share of over one-tenth. Second was the Swiss universal bank UBS and third was Lehman Brothers, both with around a tenth of the market. By 2006 and 2007 Lehman was top although with an unchanged market share. Bear Stearns was second also with close to the same market share.

Achieving leadership may have been successful management. Being the leader of the most talked about asset class at the time, United States housing and the securities related to it, came with a responsibility of leadership. The second largest underwriter, Bear Stearns, had been rescued by J.P. Morgan with the Federal Reserve of New York providing a $29 billion loan. There were concerns that Lehman Brothers would be next.

Lehman Brothers had been founded by German immigrants in Montgomery, Alabama, in 1847. Firstly Lehman Brothers was a grocery store that developed into cotton traders. It subsequently became a member of the New York Stock Exchange in 1887. The family ownership was diluted by outside partners as early as 1925, by which time investment banking had become Lehman Brothers’ primary activity. It survived the Great Depression, possibly due to its involvement in a range of diverse industries, where it operated as a high-level corporate finance advisor and underwriter of securities. On the passing of the Glass-Steagall Act in 1933,

© The Author(s) 2020 C. Dinesen, Absent Management in Banking, https://doi.org/10.1007/978-3-030-35824-2_10 177

Lehman Brothers ceased taking deposits and chose to become a pure investment bank. By 1967 it was one of the top four United States investment banks. Overseas expansion followed including to Paris, London and Tokyo by 1973. It merged with another United States investment bank with international operation, Kuhn, Loeb & Co., in 1979. Poor results in difficult economic conditions necessitated a merger with Shearson American Express in 1984. When credit card company American Express’ financial supermarket strategy did not work, Lehman Brothers Inc. was separately listed on the stock exchange, under the leadership of a former trader as the new chairman and chief executive officer (Nicholas and Chen 2011). The history of the family of the firm has recently been dramatised in a wonderful play called The Lehman Trilogy by Stefano Massini.

Lehman Brothers’ leadership of mortgage-backed securities was the result of a long-term strategy to be best-in-class for commercial and residential mortgages, in the whole chain from origination, to packaging and distribution to investors. In addition to its leadership in underwriting mortgage-backed securities, Lehman Brothers also had a mortgage origination business that sourced original mortgages. This meant that Lehman Brothers was also lending to people and companies that wanted to buy property. These mortgages could, in turn, be packaged and sold as mortgage-backed securities. Mortgage-related securities and loans was Lehman Brothers’ largest asset class with over a quarter of total assets (Rose and Ahuja 2011). So Lehman Brothers had significant exposure to the United States housing market on its balance sheet. In addition, the firm was earning large fees from originating mortgages and then packaging these loans and selling them on to investors. This leadership looked like successful management execution of strategy. However the same market share in 2004 and 2007 did not mean the same amount of business. There had been an explosion in banks issuing mortgage-backed securities in the United States. It had doubled from 2004 to 2007, from $400 billion to close to $800 billion.

All banks are leveraged, but there is an important difference between how this leverage is regulated. Commercial banks in the United States were ultimately regulated by the Federal Reserve with significant restrictions on their leverage. This meant that the amount they could lend above the deposits they had accepted was restricted by the amount of capital buffer they held. A bank with 10 per cent capital buffer would be considered well capitalised. In complete contrast investment banks were regulated by the Securities and Exchange Commission. Importantly,

there were no regulatory restrictions on their leverage (Stowell and Meagher 2008).

Leverage is regulated for a reason. The higher the leverage, the riskier the bank is. The more risky the bank, the more need for management and particularly risk management. The regulatory limit on leverage for commercial banks is aimed at securing depositors’ money. A certain amount of loans made by the bank can turn bad and may not be paid back, partly or fully. The restrictions on leverage with a required capital buffer aim to secure that the depositors’ money is still safe, even when some loans made by the bank turn bad at a time of stress or crisis.

There was a reason why there was an absence of regulation of leverage for investment banks. Most importantly they were not allowed to accept deposits, so regulators did not have to worry about the safety of deposits. Investment banks were therefore left to manage leverage themselves with no regulation. There was an assumption that investment banks would be restricted by market forces, by how much money the market would invest in them or lend to them. The credit rating agencies would take leverage into account when assigning their credit ratings of the investment banks. Financial analysts would consider leverage when making their buy and sell recommendations on the shares and bonds issued by investment banks. But in the end leverage was up to the management of investment banks. Or to absent management of some investment banks.

In 1478 the unregulated Medici Milan branch had a 7 per cent capital buffer with all other funds coming from depositors. The Milan branch was therefore not well capitalised, according to Federal Reserve approach, and was eventually liquidated. Its largest customers, the Duke and Duchess of Milan, accounted for one-third of all loans or five times the capital buffer.

Over 500 years later, in the years up to the 2008 crises, the leverage of investment banks grew rapidly. In 2002 Goldman Sachs and Merrill Lynch had leverage around 20 per cent while Morgan Stanley was at 25 per cent and Lehman Brothers at 33 per cent. By 2007 Lehman Brothers had grown to 35 per cent but had been overtaken by both Morgan Stanley at around 38 per cent and Merrill Lynch at close to 40 per cent. Goldman Sachs’ leverage had also grown but was below 30 per cent. By 2008 Lehman Brothers had approximately $700 billion of assets and corresponding liabilities on capital of just $25 billion (Maedler and van Etten 2013).

One effect of leverage is that it makes management more complicated. The more you borrow from others, the more dependent you are on them. And the more you borrow, the less the margin for error. This

is similar to the increased complexity a private person has managing a mortgage, a second mortgage, a car loan, credit cards and so on. For investment banks it can become very complicated. There is leverage from the issue of shares and bonds. You are not forced to pay a dividend on shares, but their value underpins your strength. If you do not pay a dividend the share price may fall. The bonds and loans issued by a bank, with fixed interest payments and maturities, are what are commonly considered as leverage. The ability to package and sell loans through securitisation was a new type of leverage. It created another complex dependency on investors in the packaged loans. And finally, investment banks are the masters of finance. The highly expert advice they gave to their largest clients could be used for their own business, increasingly innovative and increasingly leveraged.

There was a lot of management in Lehman Brothers by 2008, including a great deal of risk management. The organisation had made a virtue of managing risk. Risk management was mentioned as a strength by the senior management when presenting externally. Credit rating agencies, some of whom rated Lehman Brothers at the same level of credit strength as Goldman Sachs and Morgan Stanley in 2007, highlighted risk management as a particular strength of Lehman Brothers. Risk management was meant to be a sophisticated, comprehensive modelling of, in particular, the firm’s risk appetitive.

Financial risk modelling is the building of a representation of a financial situation, in this case the risks Lehman Brothers was exposed to. The modelling would aim to capture the amount of risk accepted, for example, when underwriting or investing in mortgage-backed securities. The model would also take account of any protections of these risks, for example by selling the risks on to other investors. Sophisticated models would also show the extent risks were diversified between several exposures, such as different types of lending or countries or both. It might also be possible to test or stress the model with such variables as a change in house prices, interest rates and so on. This would provide a theoretical indication of what would happen if, for example, house prices declined.

Risk appetite was expressed as an annual risk budget, taking account of the different types of risk faced by the firm, including market volatility, credit and event risks. The risk appetitive limit was $1.8 billion in 2004, being considered quarterly and rising rapidly, very rapidly, to $4 billion in 2008. During 2007 the estimated amount of risk taken by the firm was below its risk appetitive in the second quarter, above in the third and fourth

quarters and again below the, increased, limit in the first quarter of 2008. Risk management responsibilities were shared between the Executive and Risk Committees and the Global Risk Management and Finance Divisions. The Global Risk Management Division operated independently and employed 450 people in 2008 (Maedler and van Etten 2013). When the record 2007 year results of over $4 billion were announced, Lehman Brothers’ chief risk officer said the results fundamentally reflected Lehman’s strong risk management culture (Rose and Ahuja 2011).

With this level of risk management, it is perhaps surprising that it all went wrong and that Lehman Brothers failed. But it did all go wrong. If the complexity of Lehman Brothers was beyond the ability of the risk management effort to control it, there was a gap, an occurrence of absent risk management.

One reason was incentives. There was no absence of incentives at Lehman. The incentives were very considerable. The success in achieving leadership had allowed the firm to remunerate handsomely. But the incentives were focused on growth of revenue, although not exclusively. As part of the risk appetite, any division exceeding its limit could incur a charge including a charge on its executive compensation (Rose and Ahuja 2011). The intention was that there should be a link between what senior people were paid and the risk taken. However it was possible for traders at Lehman to get around the system because they could set the value of their risk positions themselves (Rose and Ahuja 2011). Over and undervaluing positions affected bonuses. Risk management linking incentives to risk was in place, but those in line for the bonuses had a way around this.

In 2004 expenses for compensation of $5.7 billion amounted to half the revenues of the firm. By 2007 the proportion was unchanged but compensation expense was now $9.5 billion, up one-third in only three years. One-third of the compensation was paid in cash, while the rest was paid in Lehman Brothers’ shares, which could be sold over two to five years. Net revenue was the primary decider for who got paid what bonus. Other factors could also influence bonuses, but importantly there were no written guidelines in place for determining this (Maedler and van Etten 2013). So the rewards for production and management respectively had not been documented.

Management could not possibly control this level of incentives. Half the revenue was paid to employees, a much greater proportion than anything else. Employees were enormously incentivised to grow revenues. And they were enormously successful at growing revenues and incentives.

Perhaps this is another type of leverage, the leverage of the firm on paying its employees and particularly its top producers. If revenue grew bonuses grew. Management and risk management would have to be strong and ever present to control growth that was incentivised like this.

Lehman Brothers grew much faster than its main peers in the years before its failure. Headcount almost doubled between 2002 and 2005 to 23,000 when Bear Sterns, Goldman Sachs, Morgan Stanley and Merrill Lynch were stable or reduced. Revenue grew by two and half times to $15 billion in this period. That was 1.7 times Goldman Sachs and over three times the other three. Lehman Brothers’ market capitalisation more than doubled to $38 billion, twice as fast as Bear Stearns and even faster than the other three (Gilson et al. 2017).

The failure of Bear Stearns in March 2008 affected Lehman Brothers negatively. In other industries the failure of a major competitor can be a commercial advantage but rarely in banking. That is evidenced by the Lehman Brothers’ chief financial officer who said that Lehman Brothers always knew they were the next name on the list (Rose and Ahuja 2011). When the credit rating agency Standard & Poor’s changed its outlook on Lehman Brothers’ credit rating to negative from stable, only indicating that a downgrade was becoming more likely than the credit rating remaining stable, Lehman Brothers’ share price almost halved.

It was then rumoured that the short sellers who had made significant amount of money on selling the Bear Stearns share short were now planning to take similar short positions on the Lehman Brothers’ share. The leadership by Bear Stearns and Lehman Brothers of underwriting United States securitised mortgages would have been one of the reasons for this. Once traders have been successful in selling one share short for a particular reason, their typical action is to seek other shares with similar characteristics and therefore profit opportunities. If one of the two leaders of this asset class had already failed, selling the other short would have seemed a good opportunity. And naked short selling was still allowed by regulation.

For the first quarter of 2008 Lehman Brothers reported net income of close to $500 million, even if this was a reduction of more than half compared to the first quarter of 2007. Lehman Brothers stated that it had $30 billion in cash and $64 billion in highly liquid assets, which meant that these assets could easily be sold. The firm then raised $4 billion of additional capital, which resulted in its share price going up by more than onetenth. Anyone having a short position on the Lehman Brothers’ share would have lost considerable amounts.

This capital raising was important, not just because of the equity capital market support shown for Lehman Brothers. Two weeks after the failure and the Federal Reserve supported rescue of Bear Stearns, the capital market was willing to support the second leader of the mortgage securities market. At least according to the investors providing this new capital, Lehman Brothers would survive and a failure was an unlikely outcome.

The failure of Lehman Brothers was, unsurprisingly, complicated. Lehman Brothers’ failure was not inevitable once Bears Stearns had failed. Four billion dollars of new capital said so. And inevitable is a very big word. Baring in 1890 was rescued to live another 90 years. The complexities of Lehman Brothers and the uncertainties of the markets it operated in made survival possible.

However Lehman Brothers was probably too much like Bear Stearns to survive. Like Bear Stearns, Lehman Brothers bailed out some of its debt investment funds taking over $1.8 billion worth of their assets in April 2008 (Meagher et al. 2008). Raising additional capital and laying off thousands of people did not stop the share price falling.

The second quarter of 2008 saw Lehman Brothers announce its first quarterly loss since it listed on the stock exchange in 1994 of close to $3 billion. The total cost of mortgage-related and other assets losses was $10 billion. Without hedging, the amount would have been $17 billion.

On 9 September 2008 the share price fell by a third closing at $3 per share. This followed an announced $4 billion loss in the third quarter of 2008. By this stage doubts about Lehman Brothers’ financial strength were so strong that the counterparties that Lehman Brothers relied on were becoming unwilling to continue financing. A final complication of Lehman Brothers was, like Bear Stearns, the reliance on financing from other investment banks and investment funds. Many of Lehman Brothers’ assets were long term, while its liabilities were largely short term. Lehman Brothers funded itself through the short-term Repo markets. Like many other investment banks, the firm borrowed short-term cash, from one day to several weeks, and pledged high-quality securities as collateral. The riskier the firm’s borrowing, the more collateral would be required by the lender. Lehman Brothers borrowed sometimes hundreds of billions of dollars in the Repo markets each day to carry on its business (Maedler and van Etten 2013).

As the perception of the strength of Lehman Brothers reduced, so the demands for additional collateral increased. Once borrowers, including J.P. Morgan, asked Lehman Brothers for additional security for this

financing, Lehman Brothers ran out of collateral on 12 September. Once Lehman Brothers was unable to refinance itself, its management, or lack thereof, was no longer the main issue. It was now up to the management of other banks and of the Federal Reserve.

Discussions had been held by Lehman Brothers in July 2008 about mergers with government-owned Korea Development Bank and China’s CITIC Securities. These came to nothing partly because Lehman Brothers could not agree to the price. Royal Bank of Canada considered Lehman Brothers but declined.

There was now a significant difference between Lehman Brothers’ situation and that of Bear Stearns. The Federal Reserve refused to provide protection for Lehman Brothers’ mortgage assets as had been done with the $29 billion loan to J.P. Morgan to save Bear Stearns. There had been a strong public reaction to this loan at a time when many people were being forced from their homes for not being able to pay their mortgages. The Federal Reserve, which like most central banks is ultimately backed by the taxpayer, did not want to make another commitment to an investment bank.

In addition, the loans made by the Federal Reserve to Bears Stearns had been fully secured on assets within these firms. Lehman Brothers did not have collateral left to provide security for a loan from the Federal Reserve that would be large enough to save Lehman Brothers from its creditors (Gilson et al. 2017).

Talks had already been held with other banks, including Bank of America in July and with Barclays. In the final weekend of 13–14 September 2008, Bank of America chose to take over another bank, which will be described later. Barclays declined taking over the business due to a lack of time to obtain shareholder approval, concerns by the British regulator, the Financial Services Authority and probably the lack of Federal Reserve support. On 15 September, Lehman Brothers announced the largest bankruptcy protection filing in U.S. history, listing assets of $639 billion and liabilities of $768 billion (Gilson et al. 2017).

The most important aspect about Lehman Brothers was the fact that it failed and the consequences of that failure for financial markets across the globe. Nobody manages a bank to fail. Banks can fail when management is absent in the face of great complexity and uncontrolled growth. But the big problem with Lehman Brothers was not its failure, but the consequences of its failure. The Board employed the management. If the management was not up to managing the bank and the bank failed, the Board

had failed. This was devastating for shareholders, employees and other shareholders. Those who had lent Lehman Brothers money might not be repaid. But failure was primarily a Lehman Brothers’ problem. However, the unusual thing about a bank failure is the effect it can have beyond the bank itself. And Lehman Brothers triggered a global financial crisis.

If it had not been Lehman Brothers, another bank might well have triggered the crisis. There was absent management in other systemically important banks. But once Lehman Brothers failed, the tide went out. And it was time to see who else had been swimming naked, where else there had been absent management.

One of the potential rescuers of Lehman Brothers was Bank of America. But during that fatal weekend of 13–14 September 2008, Bank of America decided to rescue another leading investment bank.

The largest attraction of Merrill Lynch was it large retail stockbroker franchise, the largest in the world. But it also had an enormous mortgage exposure. By July 2008, Merrill Lynch had made $52 billion of writedowns related to mortgage losses. It was one of these successive writedowns, $14 billion announced in early 2008 as part of the full 2007 year results, that gave me the idea that perhaps Merrill Lynch was not managed. Before joining Merrill Lynch in 2002, I had been a management consultant for ten years. I had made a living on advising companies on how to manage themselves better. But I was unable to understand what was wrong with the management in the bank where I worked that it could lose $14 billion in a quarter. Perhaps the reason was that the bank was not managed.

Merrill Lynch had been founded in 1914, was listed on the stock exchange in 1971 and had 56,200 employees and a presence in 37 countries by 2006. It was the largest stockbroker in the world with 16,000 brokers globally, known as the Thundering Herd. Merrill Lynch’s logo was, famously, a bull. A bull market is a market of financial securities where prices are rising or expected to rise. It was one of the five largest U.S. investment banks together with Goldman Sachs, Morgan Stanley, Lehman Brothers and Bear Stearns at the beginning of 2008. The firm underwrote and traded many types of securities and was a leading corporate and mergers and acquisitions advisor and asset manager. The sale of part of its asset management business in early 2006 left it holding just under half of Blackrock, one of the largest asset managers in the world.

Merrill Lynch had a turbulent period around the time the new chief executive officer took his seat in 2001, a turbulence that had already

started when he was President. Following the 11 September 2001 attacks, the chief executive officer instituted cost cuts of $2 billion. Fifteen thousand people were dismissed globally by the end of 2001, reducing the work force by one-fifth. When appointed chief executive officer, he replaced all but one of the direct reports to the former chief executive officer. This has become a typical approach of new chief executive officers in many large financial institutions. Their intention may be to have only direct reports that are known and trusted by themselves and that are also people who owe their new position to the new boss. This approach does not, however, ensure constructive challenge by the senior managers and has been criticised for producing yes men and women surrounding the chief executive officer.

The new chief executive officer had a range of challenges. Settlement was reached with 900 female employees claiming gender discrimination. Without admitting any charges, Merrill Lynch paid $280 million to settle charges related to the Enron energy giant’s fraudulent inflation of profits. In early 2003, the New York Attorney General produced evidence showing Merrill Lynch analysts having private concerns about companies they had positive public views and buy recommendations on. This resulted in charges that investors, including smaller private investors, had been misled. The negative publicity was such that Merrill Lynch’s share prices feel by over one-fifth. Merrill Lynch became the first investment bank to sign the global settlement on ensuring that research would be independent and paid $100 million to settle the charges. Dealing with these issues was considered impressive management action by the new chief executive officer and his new team. Following these actions, there were concerns amongst analysts and other that someone seen as a ruthless cost cutter might not be able to also grow the largest stockbroker in the world.

There was a major opportunity for growth in U.S. mortgages. The story is complex. That was why it led to absent management. At the end of this story, it will be simple why it was too complex to manage.

Mortgage-backed securities had added a layer of complexity to mortgage lending by packaging the mortgage loans and selling them on to investors. They had also changed the incentives for the lenders. Before mortgage-backed securities, lenders had to consider the risks associated with lending. These included how much could be lent and at what terms given the ability of the borrower to put up a cash deposit and pay back the loan. With the ability provided by mortgage-backed securities to sell these risks on to investors, lenders became incentivised to lend as much as pos-

sible in order to earn the commissions paid for originating the loans. Investors were in turn earning a return on the securities based on the interest paid by the original lenders but had taken over the exposures to the underlying mortgage.

Merrill Lynch became the leader of an even more complex asset class, collateralised debt obligations or CDOs. It makes sense to continue to call them collateralised debt obligations. CDO rolls of the tongue far too easily and provides a false idea that these instruments are simple and familiar. In this packaging of loans into a mortgage-backed security, there is a separation of the exposures into different tranches of mortgage-backed securities that are then sold to different investors. Junior tranches are more exposed to losses on the underlying loans and pay a correspondingly higher rate of interest. Junior tranches attract a lower credit rating because of their higher risk. The senior tranches are only exposed at a more severe level of distress of the underlying loans. Senior tranches pay a lower rate of interest. They attract a higher credit rating because of their lower risk. The most senior tranches were often able to attract the highest credit rating of AAA, indicating that credit rating agencies believed they were very unlikely to suffer losses. Collateralised debt obligations could be used for many types of loans, including mortgages, but also other types such as car loans.

When used for mortgages, collateralised debt obligations were a complex type of mortgage-backed securities. As innovation increased, collateralised debt obligations were structured for existing collateralised debt obligations rather than for original loans. These became known as collateralised debt obligations squared. These were a further step away from the original loans, making understanding their exposure a whole additional level more complicated. As one measure of complexity, it has been estimated that the number of mortgages behind a collateralised debt obligations squared was around 93 million with over 1 billion pages of documentation (Liechtenstein et al. 2009). Finally, collateralised debt obligations of collateralised debt obligations of collateralised debt obligations were structured, called collateralised debt obligations cubed. Understanding the true exposures of these various levels of structures would have been truly challenging if at all possible. The complexity is perhaps best illustrated by their names. The complexity was possibly not doubled or tripled, but multiplied, squared and cubed.

Another innovation was to construct collateralised debt obligations on credit default swaps. These were the hedges used to protect against credit losses and traded with individual counterparties rather than on an

exchange. Credit default swaps in turn were based on underlying credit quality of bonds and loans issued by corporates. Collateralised debt obligations involving credit default swaps were called synthetic collateralised debt obligations, because a credit default swap is a synthetic rather than a loan. It is a hedge, a derivative of an underlying loan.

Even with the benefit of hindsight reading this description of the complexity of how mortgages and other loans were transferred from the original lenders to investors should appear so complex that it would cause absent management. And it did. But at the time the concern was not to manage but to sell more collateralised debt obligations to earn the related commissions. It is not important to understand collateralised debt obligations just that they were too complex to manage.

The Merrill Lynch chief executive officer had taken the decision to expand the mortgage securitisation business shortly after his appointment in 2001. Merrill Lynch underwrote $3 billion of collateralised debt obligations in 2003, multiplying over 14 times to $44 billion in 2006 and earning fees of $800 million that year. Merrill Lynch was the collateralised debt obligations’ market leader by 2005 having hired a team from former market leader Credit Suisse only two years earlier.

In 2005, a third of the $35 billion of collateralised debt obligations underwritten by Merrill Lynch was backed by subprime mortgages. Partly to supply subprime mortgages for new collateralised debt obligations, Merrill Lynch acquired the First Franklin mortgage origination operations in September 2006 for $1.3 billion. First Franklin was one of the largest subprime mortgages’ originators in the United States (Ho and Guan 2008). The U.S. housing market had already seen weakness in 2006, after many years of increases. Subprime loans in particular were deteriorating. The acquisition of First Franklin was growth focused with little sign of risk management.

When a bank underwrites a mortgage-backed security, such as collateralised debt obligations, the assets stay on the balance sheet of the bank until all the assets have been gathered and the package has been sold to investors. This is known as warehousing. It means that the bank is exposed to the possibility of not being able to sell the mortgage-backed security or the collateralised debt obligations tranches. During the warehousing period, the bank can protect itself against deterioration in the warehoused assets by buying hedges (Ho and Guan 2008). Ultimately, the bank is reliant on the continued appetite of investors for buying mortgage-backed securities to be able to empty its warehouse, reliant on the music keeping playing.

Like Lehman Brothers and other investment banks, Merrill Lynch had significant risk management, with one department for market risk, focused on price volatility, and one on credit risk, focused on non-payment. These departments did not report to the chief executive officer but to the chief financial officer and the vice chairman. These risk management departments did not stop the underwriting of new collateralised debt obligations, although it had become apparent that it was more difficult to sell those collateralised debt obligations already underwritten and currently warehoused (Ho and Guan 2008). It would have been a complex decision to decide at what stage underwriting new collateralised debt obligations should have been stopped. It is possible that the focus of growth was so strong that it was difficult for risk management to stop it. There also appears to have been a lack of accurate internal reporting of the increasingly large stockpiling of unsold collateralised debt obligations in the warehouse. The combination of complexity and the focus on growth was so great that it led to absent management and in particular absent risk management.

There was, unsurprisingly, a particular complexity in the selling of collateralised debt obligations by Merrill Lynch, resulting in absent management. The very rapid growth had generated very large amounts of the most highly rated AAA tranches. These were the tranches at the top of the structures, furthest away from the risk of loss. By the end of 2007, the fairly conservative investment funds, life insurance companies and pension funds that had been important buyers of AAA tranches had stopped buying. These investors had already bought significant amounts and had concerns about the underlying credits. Merrill Lynch was still underwriting collateralised debt obligations as the market leader and started to retain the AAA tranches. With such a high credit rating, they would not weigh too heavily on the firm’s balance sheet. With a AAA rating, they were highly unlikely to default, according to the rating agencies. Merrill Lynch held $41 billion of subprime collateralised debt obligations and mortgage bonds. This was above its share capital of $38 billion. A very large proportion of the collateralised debt obligations exposure was AAA, perhaps as much as four fifths.

A combination of downgrades by the credit agencies and an inability to either sell or hedge the AAA tranches caused the value of these exposures to fall sharply (Fortune Magazine 2007). It did not require any of the original loans that had been packaged to default and cause losses to the tranches. Downgrades by the credit agencies and a lack of buyers for the

tranches were enough. Growth and complexity had caused an occurrence of absent management. Collateralised debt obligations were not badly managed; they were not managed at all.

There was also an absence of management effectiveness. In the first half of 2007, the chief executive officer and the Board requested that the mortgage department reduced the subprime exposure. However, Merrill Lynch was still the largest underwriter of collateralised debt obligations in the first eight months of 2007 underwriting $43 billion. Second was Citi with $34 billion, and UBS was third with $21 billon (Fortune Magazine 2007).

Merrill Lynch tried to save itself. Following the losses from the Bear Stearns’ funds, to which Merrill Lynch had been one of the largest lenders, the chief executive officer contacted the large commercial bank Wachovia about a possible merger. But he did so without advising the Board that he was having this conversation and was therefore promptly replaced in October 2007. The chief executive officer was quoted as saying that: “we got it wrong by being overexposed to subprime. It turned out that both our assessment of the potential risk and mitigation strategies were inadequate” (Wilchins 2007). ‘Inadequate’ is as blunt an admission of absent management as a Wall Street chief executive officer is ever likely to make.

As losses increased, the next chief executive officer sold Merrill Lynch’s 20 per cent stake in the Bloomberg, the major global provider of financial news, information and trading platforms, for over $4 billion in July 2008. But this capital raising was inadequate given the size of the losses. Once the failure of Lehman Brothers became increasingly likely in September 2008, the new chief executive officer contacted Bank of America (Meagher et al. 2008). On Sunday 14 September, as we went to bed in London, it was clear to many of us at Merrill Lynch that on Monday either we or Lehman would belong to Bank of America. Those working for the bank who was not bought by Bank of America would be going home early Monday afternoon with the contents of their desk in a cardboard box.

Very strong, very complex growth caused absent management in Merrill Lynch and was a cause of its failure and resulting rescue by Bank of America. Mortgage-backed securities and collateralised debt obligations in particular were too complex to manage, in terms of their actual exposure to underlying loans, particularly subprime loans. This complexity also meant that it was impossible to foresee how rating agencies would react to deterioration in the underlying loans. The extremely rapid growth

of the asset class made saturation amongst buyers a possibility. When that happened, Merrill Lynch retained the exposures least expected to cause loss. But the assets and how they were structured were too complex and had grown too quickly. The complexity of the structure and the continued growth, in the face of a deteriorating housing market, combined to leave Merrill Lynch unmanageable due to the losses of the deteriorating assets. These were assets even the world largest stockbroker in the world could not sell.

Bank of America was the largest bank in the United States when the chief executive officer was appointed in 2001, with a 7 per cent share of total deposits of $4 trillion. Originally called North Carolina National Bank, it had changed its name to Bank of America after the acquisition of BankAmerica Corporation in California in 1998 (Pozen and Beresford 2010). Bank of America had not been successful in becoming a major investment bank, in addition to being one of the leading commercial banks in the United States. It had made very significant acquisitions of over $100 billion, but they had all been commercial banks such as Fleet Boston Financial for $47 billion in 2004, credit card company MBNA for $35 billion in 2005 and La Salle for $21 billion in 2007. None of these had made Bank of America a significant investment bank. Organic growth in investment banking had been selectively successful, such as in the underwriting and issuing of corporate debt, where Bank of America could use its large deposit financed balance sheet to be a leader alongside JPMorgan Chase. However, it did not have the investment banking franchise to attract the best talent. In January 2008, Bank of America instead bought Countrywide, a large mortgage lender with a fifth of the total market for $4 billion. By 2008, the chief executive officer said that he “had all the fun I can stand in investment banking”. He then started shrinking the investment banking operations by reducing the workforce by 1100 people as mortgage losses rose (Meagher et al. 2008).

Bank of America was very close to a regulatory restriction of growth by acquisition of additional commercial banks in the United States. Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, banks could only exceed a tenth share of U.S. deposits through organic growth. By 2008, Bank of America had reached 9.98 per cent of the country’s $7 trillion deposits (Pozen and Beresford 2010). Growth by acquisition could now only come though non-deposit-taking financial institutions, such as investment banks, or outside the United States.

On 15 September 2008, Bank of America made an offer of $50 billion for Merrill Lynch paying $29 per share. This was about half of Merrill Lynch’s top value in 2007 when its market capitalisation had been $64 billion. The offer resulted in a downgrade of Bank of America’s rating by one notch on the rating scale, to AA minus from AA, by Standard & Poor’s rating agency, with likelihood of a further downgrade in the months to come (Pozen and Beresford. 2010). The market reacted negatively to the offer, and Bank of America’s share price fell by a fifth.

The decision by Bank of America to buy Merrill Lynch provides an interesting question of whether this was absent management. The only two days of due diligence and the subsequent deterioration in the estimate of Merrill Lynch losses for the fourth quarter from $5 billion to $12 billion during the months of November and December 2008 are indications that this was the case. The decision could be seen as driven exclusively by growth in the one area of United States banking open to Bank of America with commercial banking growth being restricted by the 10 per cent market limit on deposit growths by acquisition. Bank of America’s share price fell one fifth on 15 September, the day after the deal was announced. Management considered revoking the deal by invoking a Material Adverse Effects clause. An additional $25 billion was required from the government’s Troubled Asset Relief Program or TARP, of which more later, on top of the $25 billion already injected. All these point to absent management. But ultimately Bank of America Merrill Lynch did not fail and the acquisition did achieve the investment banking league position aspired to by the chief executive officer. So while questions about price paid and ultimate value of the combined entity can be disputed, the decision and the highly challenging integrations were managed rather than unmanaged.

The financial crisis also affected insurance companies. Not because of traditional insurance risks, but because they expanded into capital market activities that had previously been the domain of investment banking. Insurance companies also invested in subprime and other affected assets. Expansion into additional lines of business involves additional complexity as seen when commercial banks expanded into investment banking. In two past examples, Citi and Credit Suisse, the complexity of managing both major banks and insurance companies had contributed to the divestment of the insurance entities within a few years.

The expansion by insurance companies involved a level of complexity that often resulted in absent management. How this management com-

plexity arose from insurance companies expanding into traditionally investment banking areas can be illustrated by the difference between an insurance policy and credit default swaps. Credit default swaps were central to much of the insurance expansion and a large part of the losses.

Credit default swaps have always been and are still referred to as a type of insurance. However, insurance and credit default swaps differ in a number of ways, which means that being involved in both is not the same as only doing insurance and significantly increases complexity. Firstly, insurance and credit default swaps are regulated by different regulators for insurance and banking. Secondly in insurance, the value of what is insured does not change due to market forces. In contrast, the bond, loan or other financial instrument hedged by a credit default swap changes with the credit strength of the issuer of the bond and with credit market conditions. Thirdly, an insurer has to be trusted to be able to pay the claims for the duration of the insurance contract, even if the financial strength of the insurer deteriorates. In contrast, a seller of credit default swaps may need to provide collateral security to the buyer if the seller’s financial strength deteriorates and before any default has occurred or any payment is made.

A little more detail on the second difference, the valuation of what is insured or hedged. The purpose of insurance is to put the buyer in the same position as before a loss happened. What insurance must not do is to put the buyer in a better position than before the loss. Under most insurance regulation, this would be considered gambling and be prohibited. A factory can be insured against fire based on a valuation. If a wildfire approaches the insurance, policy is extremely valuable to the factory owners. In the tragic event where the factory is destroyed by fire and the insurance policy fully indemnifies the factory owners, they are in no better position than before the loss. So the value of an insurance policy does not go up and down.

For the insurance company providing the policy, there is a loss. Most importantly, the maximum value of the loss is the value of the factory as originally determined. Because this value is known and does not change, a well-managed insurance company can cover this loss by premiums from other policies and investment income earned on premiums. There is uncertainty regarding whether a loss will happen, how big the loss will be according to the damage caused by the fire, but not regarding the value of the property insured. This insurance characteristic is known as the principle of indemnity, of placing the insured in the same position as before the loss.

In contrast, the original purpose of credit default swaps is to provide a financial hedge for the default of a referenced bond, loan or other creditrelated instrument. The clue is in the name. The seller swaps, or exchanges, an obligation to pay up to the limit of the swap in return for the premium from the buyer. It is this exchange of risk for premium that causes credit default swaps to be considered a kind of insurance. However, it is not insurance but a financial transaction. In case of default of the underlying bond, the seller of the credit default swap is bound to provide the amount of referenced bonds that the hedge protects or cash equivalent to the buyer. This means that the seller’s potential pay out relates to the valuation of the underlying bond. And this valuation can change. In a fundamental difference from insurance, where the value of the factory is determined at the outset, the value of the underlying bond can go up or down. If the credit strength of the issuer of the bond goes down, the value of the bond goes down. But for the seller of the credit default swap, it will now require more bonds to settle a potential loss. So the potential pay out or value of the credit default swap, to add to the complexity, moves in the opposite direction. Should credit markets in general deteriorate and availability of credit default swaps reduce, the value of the credit default swap may increase further. The buyer may now be in a better position than when the credit default swap was bought. So a credit default swap is not insurance, is not a contract of indemnity, but a complex financial transaction, a derivative hedge. It derives its value from the value of another financial instrument, the underlying bond. And the value of this financial instrument can change.

As to the third difference between insurance and credit default swap, an insurance buyer has to trust the financial strength of the insurer to pay the insured loss. In contrast, the buyer of a credit default swap will want to make sure that the seller has adequate funds to pay a possible loss. Depending on the contract for the credit default swap, this could involve requiring increased collateral from the seller as the credit strength of the seller reduces. This could be triggered by the seller’s credit rating being downgraded by one or more credit agencies. Crucially, this requirement for increased collateral can be triggered simply because the seller’s credit rating is downgraded. The underlying bonds do not have to default. So insurance and credit default swaps are not the same, and the differences between them are highly complex.

American International Group (AIG) had been founded in 1919 in Shanghai and developed into the most international insurance company in the world with operations in 130 countries. One of its areas of leadership

was insuring large multinationals in all their many locations across the globe. Having moved to New York City in 1949 in response to the Chinese communist revolution, AIG went public in 1969. Under the same chief executive officer from 1968 to 2005, AIG expanded enormously (Nagel 2015). Through acquisitions such as SunAmerica, Inc. in 1999 for $18 billion and American General Corporation in 2001 for $23 billion, AIG became the second largest insurance group in the United States behind those owned by Warren Buffet’s Berkshire Hathaway. Operations included general and life insurance, retirement and financial services and asset management. AIG’s 116,000 people generated revenues of $110 billion with assets above $1 trillion in 2007 (Blair and McNichols 2009).

In addition to expansion geographically and by different lines of insurance, AIG expanded into the different, and highly complex, capital markets business, traditionally the preserve of investment banking. AIG hired a team from Drexel Burnham Lambert in 1987. Drexel Burnham Lambert would subsequently be involved in a major scandal involving trading on insider information and failed due to its leadership of the junk bond market in 1990. AIG’s investment banking activities were located in London. It was, however, not regulated by the United Kingdom banking and insurance regulator, the Financial Services Authority. It was regulated by the United States Office of Thrift Supervision, because this regulator also regulated a small savings and loans institution owned by AIG. The London activities included many types of financial derivatives and credit default swaps from the late 1990s when this market first developed (Nagel 2015). The credit default swaps sold by AIG were not regulated, as derivatives were unregulated under the United States Commodity Futures Modernization Act of 2000.

An important objective for the expansion was the opportunity to take advantage of AIG’s highly valued AAA credit rating. A credit default swap is a transaction between two parties and not bought and sold on an exchange. This makes the credit strength of the seller important. The buyer of the credit default swaps relies to a great extent on the credit rating of the seller. This is so the buyer can feel secure that the seller will be able to meet its obligations in case of default on the protected asset, such as the bond that the credit default swap is meant to protect. In addition, purchasing credit default swap protection from a AAA-rated entity such as AIG meant that the credit rating of the underlying, referenced bond increased to AAA for the buyer. This increased security reduces the capital needed by the buyer to hold the asset.

Some of the credit default swaps sold by AIG were particularly complex. As previously shown, the structuring of mortgage-backed securities involved different tranches rated from the lowest rated BBB to the highest rated AAA. When these tranches proved difficult to sell, further packaging was arranged, in collateral debt obligations or CDOs. This created a new package of a package with new tranches rated from BBB to AAA. Above the AAA tranche was a tranche called super senior because the risk of default was estimated to be even lower than AAA. These tranches would only incur losses after the tranches rated AAA had incurred a total loss. The collateralised debt obligation market grew by more than three times in as many years from $157 billion in 2004 to $551 billion in 2006 (Blair and McNichols 2009).

AIG became a major provider of credit default swaps of super senior tranches of collateral debt obligations. It sounds complex because it is. These collateral debt obligations contained BBB-rated tranches of mortgage-backed securities containing original loans. Just reading these sentences may be enough to make you feel slightly lightheaded, but show the complexity involved. From the original borrower to AIG, there were four levels of complexity, being the loan, the mortgage-backed security, the collateral debt obligation and the credit default swap.

An increasingly large proportion of these very large super senior exposures were retained by the investment banks, such as Merrill Lynch. These investment banks were underwriting the mortgage-backed securities and collateralised debt obligations and selling tranches to investors. Banks were estimated to be holding $216 billion of super senior tranches in 2007. By the end of 2007, AIG’s estimated largest counterparties for super senior collateralised debt obligation were Goldman Sachs with $23 billion, Société Générale $19 billion, Merrill Lynch $10 billion and UBS $6 billion (Blair and McNichols 2009).

In 2005, the chief executive officer of AIG since 1968 resigned in connection with regulatory investigations by the New York State Attorney General. These investigations focused on irregularities regarding transactions with General Re Corporation, owned by Berkshire Hathaway and allegedly aimed at making AIG’s profits appear higher than they were (Hawkins and Lynch 2011). The investigation was settled with $1.6 billion of fines. The rating agencies consequently downgraded AIG’s longheld and highly valued AAA rating to the still high rating of AA.

These credit rating downgrades, in turn, caused counterparties to require collateral to be posted under some of the credit default swaps sold

by AIG. The demands were for relatively small amounts as AIG was still highly rated and the chance of any default under the credit default swaps was considered remote. AIG did not write additional credit default swaps on super senior collateralised debt obligations with subprime exposures after December 2005 (Blair and McNichols 2009). This decision was made after AIG conducted internal discussion and criticism of the lack of understanding of the diligence of subprime mortgage-backed securities. There was thought to have been too much belief in the low risks of the credit default swaps, based on the view that house prices would not fall across the United States simultaneously (Hawkins and Lynch 2011).

The first call for collateral was for $1.8 billion made on 27 July 2007, later revised to $1.2 billion. AIG continued to dispute the amount but paid $450 million on 10 August (Hawkins and Lynch 2011). In October 2007, it paid a further $1 billion.

AIG then made an investor presentation stating that it did not expect to incur any losses on its total super senior exposure of close to half a trillion dollars. Of this $79 billion was credit default swaps on credit default obligations of which $64 billion had subprime exposure through mortgage-backed securities. The total exposure to posting collateral was $26 billion (AIG 2007).

Two major differences between credit default swaps and insurance now caused AIG to fail. Firstly, it had to continue to provide collateral to counterparties of credit default swaps while AIG’s insurance clients had to rely on its financial strength to get their insurance losses paid. Secondly, AIG had to value its credit default swap exposures according to the market, while insurance reserves related to the insurance losses and did not change based on financial markets.

Announcing its full-year 2007 result at the end of February 2008, AIG had posted $5 billion of collateral and recorded a $12 billion loss on credit default swaps. No losses had been paid under the credit default swaps, but the requirement to value them according to market valuation caused the loss. The chief executive officer of the capital market activities resigned the next day, and the chief executive officer of the group followed in June 2008. In August, the collateral requirements had risen to $17 billion, and credit default losses amounted to $26 billion. Following these results, AIG was downgraded by all three rating agencies on 15 September, the day Lehman Brothers failed. These downgrades further increased the need to post collateral by $15 billion (Hawkins and Lynch 2011).