ECON­OMY

A DECADE AF­TER THE CATACLYSMIC COL­LAPSE OF LEHMAN BROTHERS SPARKED THE GLOBAL FI­NAN­CIAL CRI­SIS, HAVE THE LESSONS BEEN LEARNED?

CEO Middle East - - CONTENTS - BY ED­DIE TAY­LOR AND SHAYAN SHAKEEL

WHAT HAVE WE LEARNED A DECADE AF­TER LEHMAN BROTHERS’ SPEC­TAC­U­LAR COL­LAPSE A DECADE AGO IN SEPTEM­BER 2008?

WALL STREET’S WORSE DAY SINCE 9/11. The Dow plung­ing more than 500 points. The S&P down al­most five per­cent. The wreck­age un­prece­dented. Lehman bankrupt. AIG on the brink. Mer­rell un­der new own­er­ship… the be­drock of Amer­ica’s fi­nan­cial un­der­pin­ning rocked to the very core.”

Those were the words that greeted view­ers to CBNC’s clos­ing bell re­port on the evening of Septem­ber 15, 2008, as b-roll footage showed pan­ick­ing traders, ski-slope stock charts and fa­cades of the au­gust in­sti­tu­tions, com­plete with Ro­manesque pil­lars and shim­mer­ing lo­gos, that were sud­denly fac­ing ruin. The cap­tion that con­cluded the mon­tage asked a ques­tion that would be­gin to per­co­late through the global econ­omy over the sub­se­quent weeks and months: “Is your money safe?”

The im­plo­sion of Lehman Brothers, the fourth-largest in­vest­ment bank in the US, with debts of $619bn was, of course, just the start. A stag­ger­ing $10tr was wiped from global eq­uity mar­kets by the end of Oc­to­ber as the full im­pact of the cri­sis swept through the fi­nan­cial world and, as a re­sult, the wider econ­omy.

As we now know, it was all sparked by the “sub-prime” mort­gage in­dus­try in the US. In the early 2000s, banks and mort­gage providers, buoyed by the re­moval of reg­u­la­tions on de­riv­a­tives and credit de­fault swaps, and bro­kers mo­ti­vated by healthy com­mis­sions, had been serv­ing up home loans for peo­ple who didn’t have to prove they had the means to re­pay them – peo­ple who had pre­vi­ously been pro­hib­ited from ac­cess­ing the boom­ing hous­ing mar­ket. These mort­gages were then bun­dled into mort­gage-backed se­cu­ri­ties, given an A-plus rat­ing by the likes of Moody’s and sold to in­vestors – which then en­abled the banks to lend more money against the new funds.

It proved to be a huge house of cards. When a num­ber of mort­gages de­faulted as in­ter­est rates climbed, these over-lever­aged, un­der-cap­i­talised fi­nan­cial in­sti­tu­tions re­alised they were hold­ing billions of dol­lars of bad debt on as­sets – houses – that were rapidly de­clin­ing in value as fore­clo­sures started to spi­ral. That also im­pacted in­sur­ance firms such as AIG, who had been of­fer­ing cover­age for the fail­ure of such prod­ucts not be­liev­ing back in 2005 or 2006 that there was any chance of any­one mak­ing a claim.

The scale of the catas­tro­phe was such that it re­quired a se­ries of gov­ern­ment in­ter­ven­tions – in­clud­ing the forced sale of Bear Stearns to JP Mor­gan Chase and the merger that cre­ated Bank of Amer­i­can Mer­rill Lynch – that cul­mi­nated in a $700bn bank­ing bailout from the US Trea­sury on Septem­ber 2008. Chair­man of the Fed­eral Re­serve Ben Ber­nanke pref­aced the de­ci­sion with a warn­ing that if they failed to act, “we may not have an econ­omy on Mon­day”.

In time, it also prompted leg­is­la­tion to pre­vent a re­peat. The Dodd-Frank Wall Street Re­form and Con­sumer Pro­tec­tion Act – or just Dodd-Frank – be­came law in July 2010. Among its many pro­vi­sions were an in­crease in reg­u­la­tion of the rat­ings agen­cies, greater trans­parency to re­tail in­vestors, the es­tab­lish­ment of a Bureau of Con­sumer Fi­nan­cial Pro­tec­tion, the pro­hi­bi­tion of those who se­cu­ri­tise as­sets from hedg­ing or trans­fer­ring their risk and a re­quire­ment for any in­sti­tu­tion to re­tain no less than five per­cent of the value of any se­cu­ri­tised prod­uct on the bal­ance sheet.

DESERT STORM

The GCC didn’t have any di­rect ex­po­sure to the sub­prime mort­gage catas­tro­phe, but that didn’t pre­vent it from be­ing caught off-guard by what had turned into a liq­uid­ity crunch cas­cad­ing across global fi­nan­cial hubs. The ef­fects were felt most promi­nently in Dubai 14 months later af­ter Lehman Brothers

col­lapsed, eight months af­ter the US bear mar­ket had re­versed course.

On Novem­ber 25, Dubai’s in­vest­ment ve­hi­cle, Dubai World, which held nearly three quar­ters of its $80bn debt at the time, asked all fi­nanciers to “stand­still” for six months on bonds due to ma­ture. The world’s mar­kets pan­icked – a day af­ter the an­nounce­ment, the Dow Jones In­dus­trial Av­er­age fell 1.5 per­cent, Euro­pean stock in­dices by dou­ble that, and safe haven cur­ren­cies, the dol­lar and yen, spiked sharply. It wasn’t un­til a com­pre­hen­sive re­struc­ture took place that Dubai World was able to pay off its most im­me­di­ate obli­ga­tions, rene­go­ti­ate the rest with its lenders, and calm in­vestors around the world. By that time, as­set prices across the UAE had plunged as much as 60 per­cent, with Dubai World’s own port­fo­lio de­clin­ing in value by 35 per­cent to $12bn.

“Dubai is an im­por­tant part of the global fi­nan­cial sys­tem con­nected to oth­ers,” says Francesco Pavoni, head of MENA at PA Con­sult­ing. “What hap­pened here was a de­layed re­ac­tion to a set of de­faults trig­ger­ing a sys­temic col­lapse across mar­kets and fi­nan­cial hubs that af­fected its liq­uid­ity po­si­tion… the reg­u­la­tors and con­trol ar­chi­tec­ture were not ready to cope with a prob­lem of the mag­ni­tude of the im­ported cri­sis.”

For nearly half a decade af­ter the crash, the UAE’s econ­omy, much like the world’s, would lan­guished – in stark con­trast to the break­neck pace of growth it had ex­pe­ri­enced at the turn of the cen­tury. Be­tween 2008 and 2012, real av­er­age GDP growth was 1.6 per­cent, roughly a third of the growth rate be­tween 2002 and 2008.

Since then, the UAE has man­dated a raft of re­forms, in­clud­ing stronger cap­i­tal ad­e­quacy ra­tios ac­cord­ing to in­ter­na­tional reg­u­la­tory ac­cord BaselIII. Banks in the coun­try will, by 2019, main­tain cap­i­tal as­sets up to 15.5 per­cent of their risky as­sets port­fo­lio. In ad­di­tion, real es­tate in­vest­ments now in­volve funds be­ing de­posited in an escrow ac­count and mort­gages are capped.

“The mind­set of the fi­nan­cial man­age­ment ar­chi­tec­ture over the past few years [glob­ally and regionally]

“THE ONLY WAY WE COULD HAVE SAVED LEHMAN WOULD HAVE BEEN BY BREAK­ING THE LAW, AND I’M NOT SURE I’M WILL­ING TO AC­CEPT THOSE CON­SE­QUENCES”

has been to min­imse short term prof­itabil­ity [in favour of long-term sta­bil­ity],” ac­cord­ing to Pavoni, and it has come at an ex­pense. “As banks have im­proved com­pli­ance, like their global coun­ter­parts, prof­itabil­ity has been low.”

LO­CAL TROU­BLE

Re­cent de­vel­op­ments haven’t helped build con­fi­dence in the sys­tem, how­ever. As re­ports of the con­flicts of in­ter­est at the up­per ech­e­lons of Abraaj’s lead­er­ship gain clar­ity, a need con­tin­ues to grow for stricter prac­tices re­lat­ing to whom and how fi­nan­cial in­sti­tu­tions hire to man­age their busi­nesses, es­pe­cially lo­cally.

For in­stance, au­di­tor mis­man­age­ment stem­ming from ad­vi­sory firm Arthur An­der­son’s in­volve­ment with En­ron, the firm that trig­gered the burst­ing of the dot­com bub­ble in 2001, led to calls for ac­count­ing re­form in the form of the Sar­banes-Ox­ley Act and the even­tual es­tab­lish­ment of the Pub­lic Com­pany Ac­count­ing Over­sight Board (PCOAB). The lat­ter ef­fec­tively acts as a reg­u­la­tor for au­dit firms, the ste­wards of fi­nan­cial state­ments that in­vestors rely on to make buy­ing and sell­ing de­ci­sions.

Yet, even af­ter the col­lapse of Lehman Brothers, and Abraaj Group’s cur­rent prob­lems, no such or­gan­i­sa­tion ex­ists in

the UAE.

“It’s not nec­es­sar­ily the firms that are mak­ing the er­rors in many cases, but the sys­tem of cor­po­rate gov­er­nance that needs to be up­dated,” says Pavoni. “This is not to say that the world hasn’t made great strides in im­prov­ing the frame­work of fi­nan­cial man­age­ment ar­chi­tec­ture, but that while we’ve worked hard, we haven’t worked hard enough to use the steps taken as a di­rec­tion to­ward a sta­ble fu­ture.”

LESSONS LEARNED?

Ten years on, though, what has re­ally changed? In March 2018, the Repub­li­can-led Congress rolled back some of the Dodd-Frank pro­vi­sions, in­clud­ing the size of the banks that have to un­dergo an­nual stress tests – a move that the Con­gres­sional Bud­get Of­fice said would in­crease the prob­a­bil­ity of a big bank fail­ure.

In re­cent days, as the tenth an­niver­sary of Lehman’s col­lapse rolled around, the lat­ter has come into sharper re­lief. Writ­ing for CNBC, Vic­tor Li, pro­fes­sor of eco­nom­ics at the Vil­lanova School of Busi­ness, sug­gests that the fi­nan­cial cri­sis can not only “hap­pen again” but that “the cur­rent di­rec­tion in fed­eral pol­icy sug­gests it even may be likely”. Among the fac­tors he cites are the all-too-cosy re­la­tion­ship be­tween Wall Street and Wash­ing­ton DC and the sub­se­quent rolling back of reg­u­la­tion.

“It was pre­cisely the pre-2008 dereg­u­la­tory agenda, in­clud­ing the elim­i­na­tion of bar­ri­ers be­tween in­vest­ment and com­mer­cial bank­ing, that led to the de­vel­op­ment of com­plex fi­nan­cial in­stru­ments, such as credit de­fault swaps and de­riv­a­tive mar­kets, that led to banks tak­ing ex­ces­sive risk,” he says. “By rolling back these reg­u­la­tions and dis­man­tling por­tions of the Dodd-Frank Act, the Trump ad­min­is­tra­tion is re­mov­ing the safety net and cre­at­ing a per­fect storm that could lead to a cri­sis even worse than 2008.”

Across the At­lantic in Lon­don, Nicky Mor­gan, chair of the Com­mons Trea­sury com­mit­tee, sees sim­i­lar warn­ing signs. “Since the fi­nan­cial cri­sis ten years ago, the bank­ing sec­tor has be­come sig­nif­i­cantly bet­ter cap­i­talised, and the largest play­ers are much less de­pen­dent on one an­other for fund­ing,” she wrote in The Guardian. “Yet in many ways, this still-con­cen­trated sec­tor looks re­mark­ably sim­i­lar to the one that threat­ened to bring the global econ­omy to its knees… un­til the pub­lic is con­fi­dent that the sec­tor’s cul­tural flaws have been rec­ti­fied, trust in bank­ing will re­main low.”

It’s clear that be­ing weaned off easy liq­uid­ity will prove to be the first stress test the fi­nan­cial sys­tem will face. Many will ar­gue that the re­forms al­ready en­acted are enough, but con­sid­er­ing Lehman Brothers still serves as an ob­ject les­son in un­due risk, ev­ery­one ought to hope they are.

For­mer Fed­eral Re­serve chair­man Ben Ber­nanke said the US the gov­ern­ment’s re­sponse to the Lehman cri­sis was late but proved to be suc­cess­ful

Francesco Pavoni, MENA head at PA Con­sult­ing

Nicky Mor­gan, Com­mons Trea­sury chair

Af­ter the cri­sis, US leg­is­la­tors worked to en­sure that the fi­nan­cial sys­tem would be bet­ter pre­pared

Ex­perts be­lieve that sooner or later, an­other cri­sis will come to hit mar­kets world­wide

The cost of shoring up economies has left a num­ber of gov­ern­ments deeper in debt

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