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Happy Anniversary Lehmans

Tuesday 15 Sept. marks one of the most important financial anniversaries of the last 100 years...

IT'S A YEAR TO THE DAY since Lehman Brothers collapsed with no one willing to save it, writes Dan Denning in his Australian Daily Reckoning.

But how will investors celebrate? Or will they mourn? Or will even more of them start to Buy Gold, which traded at around US$1,006 in the futures markets?

The anniversary is the collapse of Lehman Brothers on September 15th 2008. It was like a financial "big bang," the end of one financial universe as we know it. But could there be more meteor strikes on the way for Planet Leveraged Earth?

"Some day this war is gonna end," said Lt. Kilgore on the beach in Apocalypse Now. He was almost wistful about it, in the same way you read a lot of investment professionals talk about the collapse of Lehman Brothers last year. They're discussing it as it if were ancient history.

Not Joseph Stiglitz. The economist told Bloomberg that, "In the US and many other countries, the too-big-to-fail banks have become even bigger...The problems are worse than they were in 2007 before the crisis." That does not sound promising. It sounds ominous, especially for banks and other financial stocks.

There certainly were a lot of casualties that resulted from Lehman's loss. Here in Australia the roll call of fallen firms includes Allco, Centro, Tricom, and ABC Learning. Some were killed in battle. Others were wounded and taken from the field. But is the war really over?

The press coverage would suggest that the war on the financial crisis-fought with unwieldy weapons like interest rates and fiscal policy by besuited warriors like Ben Bernanke and Wayne Swann – is not over, but not critical any longer either. It's as if the Germans have been pushed back east across the Rhine. Berlin hasn't been taken. But the beaches have been stormed and the Hun beaten back.

Yet if you examine the lessons of Lehman, you wonder if we have really learned anything. The collapse in global trade and output was the worse since World War Two, following the fall of Lehman. You can see it in quite shocking fashion from the chart below, courtesy of High Frequency Economics. But what does the chart actually mean?

The chart shows the first real and large fall in global trade since the 1970s. But we think it also shows that global output and trade have grown with the globalization of fiat money. The entire global economy expanded at a furious pace because of the amount of credit and leverage in the global system.

When you take away this leverage – a process that really hit the gas with the Lehman collapse – you find that a lot of economic activity disappears once credit vanishes. The huge slump in output persists. But what's crazy is that stock prices began to recover once the free fall in output seemed to end in March.
Stocks seem to be repricing a return to growth rates, pre credit crisis. But as we've argued here before, most of the first and second quarter earnings outperformance for publicly listed stocks was driven by cost cutting and inventory destocking, not any fundamental improvement in business conditions.

Another lesson from Lehman was that asset prices (across all asset classes) were much more heavily supported by leverage than anyone suspected. This was true for commercial and residential real estate. It was true for stocks. It was true for commodities. And it was true for bonds.

In fact, we'd argue that it's only government-backed leverage that is supporting the US bond market. You could even argue the rally in stocks was made possible by Fed-created liquidity, which banks and brokerages took advantage of to engineer a massive stock market rally which is now ending.

It's a mistake to think that letting Lehman collapse was only a mistake because Lehman proved to be so interconnected to the rest of the financial system. It wasn't just that Lehman was one of a handful of firms "too big to fail". This is the most under-appreciated point about the last two years.

The most important lesson from Lehman's collapse is that when you combine massive leverage with securitization and derivitization, you get a financial world that is inherently less stable. Statistically speaking, it's far more prone to volatility and collapse. The interconnectivity of the global economy showed how quickly instability could be transmitted across borders.

If you're a student of networks, this may seem counter intuitive. You might think that increasing the number of nodes in a network decreases instability. The more nodes and interconnections there are, the easier you'd think it would be for problem nodes (Lehman) to be bypassed or isolated before they can destabilize the whole system.

Yet it seems like the more complex the global financial system has become, the less stable it has become. Why is that? Maybe it's because there are several important connections we're talking about. For example, the fact that information and prices are communicated swiftly around the globe does not make the world economy less stable.

It may make trading more volatile as people try to figure out what news really matters. But the interconnectivity of the world has just upped the pace of business. It's forced everyone to have faster OODA loops (observe, orient, decide, act). So if sheer connectivity isn't to blame for instability, what is?
One likely culprit is complexity. We simply don't know how things are inter-related in the global economy. And by "things" we mean cross ownership of assets and obligations. What's made the system so unstable is that the asset side of the global balance sheet has become opaque. It's become derivative. It's become relative.

In the meantime, the liability side of the balance sheet grew and grew, setting up an inevitable "complexity catastrophe" to use Eric Beinhocker's term. As far as we can see, the complexity catastrophe is still unfolding as the value of bank collateral continues to deteriorate. Government's are trying to arrest the rate of decline to prevent massive unemployment, and meeting with some success.

But one year after Lehman, we feel confident in saying that someday this war is gonna end. But it's not today. And it won't be today for quite some time.

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Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

See our full archive of Dan Denning articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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