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What If Lehman Happened Today? What If Lehman Happened Today?

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Magazine / economy

What If Lehman Happened Today?

The euro crisis could trigger another American bank failure. Wall Street is better prepared this time, but U.S. regulators still haven’t mapped the new financial universe, written rules for it, or ramped up enforcement.

Object lesson: The Lehman Brothers building in 2008.(AP Photo/Mark Lennihan)

December 1, 2011

Slight, balding, and a bit birdlike in appearance, Gary Gensler is no one’s idea of a biblical David. But Gensler, chairman of the Commodity Futures Trading Commission, is fighting Goliath, and not just one Goliath—he’s challenging several at once. The stakes couldn’t be higher: If he doesn’t win, it’s possible that America could suffer a repeat of the 2008 crash.

There’s the Wall Street lobby, which never stops trying to open giant loopholes in the still-evolving Dodd-Frank regulatory overhaul from 2010 that Gensler is trying to implement. There’s the Republican-controlled House, which opposes Dodd-Frank, generally tries to make every loophole bigger, and (along with the Senate) recently sought to gut reform by slashing the CFTC’s budget request by a third. Making the fight even lonelier for Gensler is the coming retirement of one of the law’s chief champions, Rep. Barney Frank, D-Mass.

And now Gensler—a former Goldman Sachs executive whose stand against his erstwhile Wall Street comrades has won praise from progressives—is facing down the biggest Goliath of all. Europe’s raging financial crisis may not leave Gensler the time he needs to get a handle on the vast global market in derivatives, the arcane instruments used to bet on everything from interest rates to currencies to credit default swaps on the Continent. At $708 trillion (yes, trillion), the derivatives trade is already much larger than it was during the 2008 crisis. Just as last time, this opaque market may hold the key to whether the evolving eurozone disaster causes another market meltdown worldwide. With a staff of only 712 (roughly unchanged from the 1990s, when financial products where much less complex), the CFTC must regulate markets seven times the size of the futures market it used to oversee. Mostly, it supervises America’s $300 trillion portion of the global derivatives trade. “Until we complete this task, the American people remain at risk,” Gensler warned in an interview with National Journal at his office in downtown Washington. “We are midstream” in rule-writing and in requiring firms to report their trading positions, he admits. “The only thing that we would have right now is the data that banks and others are voluntarily reporting.” Even after the rules are written, Gensler says, “we won’t necessarily have the cops on the beat to oversee the market.”


Between the deepening euro crisis, political stalemate in Washington, a stubbornly slow recovery haunted by the threat of double-dip recession, and the vast deadweight of underwater housing, time is not on Gensler’s side. Market experts wonder whether another Lehman-type event is lurking—the failure of some large bank that could come out of nowhere and trigger a chain reaction. Just look at the ominous Halloween failure of MF Global Holdings, a broker-dealer that overloaded itself with European debt. If it happened, many critics fear that the regulatory response would hardly be better than it was last time, when every senior official from the Treasury secretary to the Federal Reserve Board chairman was caught by complete surprise.


It’s true that, with the wounds of 2008 still smarting, Wall Street is far more risk-averse than it was then, and U.S. banks are generally in stronger shape. They are flush with cash, making it easier to cushion shocks. “The United States banking system is a lot better capitalized than it was going into the crisis,” Treasury Undersecretary for International Affairs Lael Brainard said recently. Crisis-tested regulators remain on high alert, are in more routine communication with each other and their counterparts abroad, and are vigilant about ensuring that banks reduce their exposure. A senior U.S. regulator said that American banks likely have less than $45 billion in direct loan exposure to European banks. The Fed has begun a new series of stress tests focused on euro-debt exposure. Banks must turn in their results in January; the central bank plans to release its findings in March.

But the euro calamity has now become a debt and liquidity crisis with unnerving similarities to 2008. Instead of scads of bad housing debt, this time the culprit is dubious government debt. This time, too, there could be a run on the entire financial system. European bonds have fallen under such market suspicion that even powerful Germany failed to sell off all of its bonds at an auction last month. As in 2008, one of the greatest fears of catastrophe lies not in direct loans to European countries or companies but in the murky world of derivatives, especially in credit default swaps, which are intended to insure buyers of debt against default. “I don’t think regulators have a good handle on how well the CDS market will hold up if there is a major credit default in Europe,” one recently retired regulator, Sheila Bair of the Federal Deposit Insurance Corp., told National Journal.

The most frightening (but still very plausible) scenario is that some of the CDS dealers won’t have capital to pay off the swaps as they are “triggered” by the plummeting value of European bonds. That shortfall could lead to defaults on trillions of dollars in other types of derivatives. Something similar occurred when Lehman Brothers collapsed in September 2008; it failed to make good on nearly 10,000 contracts for swaps and derivatives. Lehman was severely over-leveraged, relied too heavily on short-term funding, and ultimately succumbed to a liquidity run. “That’s exactly what’s going to bring the system down,” says Michael Greenberger, a derivatives expert at the University of Maryland who once served as a senior CFTC official. “Here you’ve got people holding on to potentially valueless government debt.”

Perhaps what is scariest, say Greenberger and other critics, is that the dollar amounts are much larger this time around: If a country the size of Italy defaults on its debt, then even the titanic amounts of bailout money put up in 2008 and 2009 by U.S. authorities—recently revealed to be much larger than thought—would not be enough to save many institutions. “The political willingness to spend what some people say is $7 trillion [in bailout money] is simply not there this time,” Greenberger says.

A panic may be just around the corner. The International Swaps and Derivatives Association appears to be trying to tighten its standards for paying out credit default swaps on euro debt, making it more difficult to collect on them, the Financial Times reported this week. That decision has angered the firms holding the CDS insurance. The situation also has similarities to 2008 and the failure of American International Group, the world’s biggest dealer of credit default swaps, which required a $150 billion bailout by the U.S. government. AIG imploded because it couldn’t keep up with the triggers that required it to post more collateral. “The real problem is that CDS moves the financial consequences of a default much further up the line,” says Dennis Kelleher, the head of Better Markets, a D.C.-based activist group. “So, long before someone defaults, be it an institution or a country, anyone who has written insurance—ie, credit default swaps—has to start posting massive amounts of collateral.”

Worst of all, if European banks begin toppling, it’s unclear how to quantify the risks to the U.S. financial system or to specific financial institutions—an uncertainty that has undermined confidence in the markets. Although individual regulators (the Fed, say, or the Office of the Comptroller of the Currency) have a window into the contracts and counterparties connected to the euro debt of institutions they directly oversee, there is no clear metric for assessing risk if a systemic problem occurs. That information is not publicly available and is not collectively held, across institutions, by the Financial Stability Oversight Council, the intra-governmental body of regulators that tracks risk throughout the economy. “We still don’t have transparency in the swaps market,” Gensler says. “There is $20 of swaps for every dollar in our economy. So every time somebody fills up a tank of gas for, let’s say, $75 … that could be $1,500 of swaps somewhere in the economy behind it.” Greenberger compares it to scoring seats at a football game that only let you see 5 of the field’s 100 yards.

Sen. Jeff Merkley, D-Ore., asked credit-rating agencies, which failed to foresee the subprime crisis, how they would evaluate risk from European credit default swaps. They didn’t know. “The first expert said, ‘Well, there might be somebody who knows the answer, but I don’t.’ And the next two experts said almost exactly the same thing.” Merkley told NJ. “To really diminish the systemic risk, in America and in Europe, we’ve got to understand those pieces much better than we do now.”

The problem of unknown risks affects major institutions, too. The collapse of MF Global—the eighth-largest failure in U.S. history and the largest Wall Street bankruptcy since Dodd-Frank financial reforms became law—caught regulators off guard and sent a wake-up call to already jittery investors about the spillover threat from Europe’s sovereign-debt crisis. The broker-dealer had bet the wrong way on a potpourri of Italian, Spanish, Portuguese, and Irish sovereign bonds, despite its elite “primary dealer” status that allowed it to participate in government-debt auctions and required it to share information with the Fed and meet certain quality standards. “The problem is just like with [collaterized debt obligations] in the lead-up to the [2008] crisis, where the regulators had very limited information about what our bank exposures were,” says Josh Rosner, a managing director at the research firm Graham Fisher & Co., pointing out how blind regulators were to the frailty of MF Global. “By the second quarter of the next year, peripheral European banks that were already bailed out once will likely need to go back for more money.” That kind of event could trigger a default.

Other worrisome signs are appearing. Regulators with the Fed and the Federal Deposit Insurance Corp. are watching nervously as a weakened Bank of America seeks to shift huge amounts of risky derivatives positions from its Merrill Lynch subsidiary to a higher-rated entity that is federally insured with taxpayer money—precisely the kind of financial sleight of hand that some Dodd-Frank champions, such as former Federal Reserve Board Chairman Paul Volcker, had sought to block. Elsewhere, certain major European banks, such as Spain’s Santander, have begun asset sell-offs to raise desperately needed capital.

Meanwhile, Europe’s combustible mix of debt and political turmoil is shadowing Wall Street with other unknown risks—sluggish growth, a hangover of bad mortgages, and new requirements to stockpile unprecedented reserves to cover the rising risks of litigation. Despite trying to reassure markets, regulators have been candid that the U.S. economy could face another recession (or worse) in the event of the euro’s demise, the collapse of a significant European economy, a disorderly default in Greece, or a European banking crisis.

Gensler will not admit to worrying, but he and other regulators concede that they are still in the middle of writing rules that are supposed to alert them to the next crisis (by shining a light on the buyers and sellers of complicated swaps) and give them ways to fix it—even though that crisis may already be upon them. Only last week, Gensler says, firms began voluntarily reporting the first financial data under Dodd-Frank.

Other building blocks of Dodd-Frank aren’t in place, either. The much-vaunted Financial Stability Oversight Council was created to improve communication between “siloed” regulators. The council comprises the heads of all the banking agencies, including the Fed chairman; it is led by the Treasury secretary. But FSOC still hasn’t identified which institutions in the nonbank sector are “systemically risky,” or too big to fail—in other words, which institutions have to provide the self-liquidation plans known as “living wills.” Nor does FSOC have a research head to supply it with up-to-date market information and new thinking about crisis response. “We have got to get this person in place, particularly because, frankly, you read every day that no one seems to know who is holding all the credit default swaps on European sovereign debt,” says Sen. Jack Reed, D-R.I., who fought to create the position. “We don’t have one place that FSOC can turn and say, ‘Get us the best answers as quickly as you can.’ ”

Americans and Europeans don’t even agree, U.S. regulators admit, on what to do about the too-big-to-fail issue. Dodd-Frank gave U.S. officials “resolution authority” to take over and liquidate any institution, but Europe still coddles its giant banks on the “national champion” model, requiring less in capital reserves. That means the European governments would be far more likely to save their banks at any cost, even as U.S. regulators liquidate the American subsidiaries. “We could deal with one firm, maybe two—I doubt it—but when you look at what is happening in Europe and you look at a systemic problem, I don’t think that is a situation [where] any type of resolution mechanism is going to work,” says Sen. Bob Corker, R-Tenn.


Aside from implementation, the Dodd-Frank law has many weaknesses. Ironically, it may have harmed regulatory effectiveness, because the Fed no longer has full use of its formerly open-ended “13(3)” rule, the emergency lending authority enacted during the Great Depression that allows it to provide liquidity in case of panics. Instead, Dodd-Frank set up an enormously complex structure, multiplying the number of regulators rather than streamlining them. MF Global, for instance, fell through the cracks. Rigidity has replaced the regulatory elasticity of the past, complains one federal regulator who asked to remain anonymous. In the place of Fed experts wielding 13(3) power to quickly prop up a failing giant, the Fed would have limited authority to create broad-based lending programs for a set of solvent firms. “U.S. regulators do not have the same flexibility to respond to crises as they did in 2008,” says Amy Friend, a managing director with the Promontory Financial Group and the former chief counsel for the Senate Banking Committee under then-Chairman Chris Dodd, D-Conn., who has retired.

Dodd-Frank could take an entire decade to become operational, warns former Rep. Paul Kanjorski of Pennsylvania, who was the No. 2 Democrat on the House Financial Services Committee until he lost reelection. At any rate, no one who drafted the bill, including himself, thought it would result in “absolute regulatory control on a day-to-day-ongoing basis,” Kanjorski says. “It is merely an attempt to recognize that we had too much interconnectedness between particularly the systemically risky companies.”

Gensler, for one, says he’s determined to get the rules in place and stave off disaster. Europe is in some ways the least of his worries at the moment; he must fight a rearguard action by banks and their congressional allies, especially in the GOP, to thwart his attempts at creating more transparency in the opaque derivatives market. “Piece by piece, we will do this,” declares Gensler, perhaps one of the unlikeliest champions of Main Street in Washington. By all accounts brilliant, he rocketed out of the University of Pennsylvania and the Wharton School into a successful career at Goldman Sachs, where his mentor was former Treasury Secretary Robert Rubin. Gensler helped to open the way to massive deregulation in the 1990s, and progressive senators such as Bernie Sanders, I-Vt., and Maria Cantwell, D-Wash., later put on a hold on his CFTC nomination.

But Gensler has said that people didn’t really know his true passion. After serving as Rubin’s assistant secretary and then undersecretary, he didn’t return to Wall Street right away. Instead, he went to work as the senior adviser to liberal Sen. Paul Sarbanes, D-Md. After Enron crashed, it was Gensler who drafted the first version of what became the Sarbanes-Oxley law, which, though it was eventually watered down, was at least a start at improving the management of large corporations. As CFTC head, he has also turned out to be a champion of tougher regulation. “I don’t think there is anybody in the Obama administration who has a better grasp of what went wrong and what’s needed to correct it,” Greenberger says. The question is, will Gensler have the time and the resources to do so? Above all, will he—along with other regulators—open a window into the internal workings of the market in time to see and stop the next crash before it happens?

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