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As China’s Evergrande implodes, what have we learnt from the Lehman Brothers crisis?

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Sasha Planting is a seasoned financial journalist and Associate Business Editor at Daily Maverick Business.

As events around China’s top property developer Evergrande unfold, I find myself reflecting on the Lehman collapse. And while the world’s financial whizz-kids assure us that the situation at Evergrande is not the same as Lehman, I can’t help thinking that it may be useful to remember the reasons Lehman got into trouble in the first place.

First published in the Daily Maverick 168 weekly newspaper.

“Debt, we’ve learnt, is the match that lights the fire of every crisis. Every crisis has its own set of villains – pick your favourite: bankers, regulators, central bankers, politicians, overzealous consumers, credit rating agencies – but all require one similar ingredient to create a true crisis: too much leverage.”

Most of us will be able to resonate with the words of Andrew Ross Sorkin, US journalist and author of Too Big to Fail, the blow-by-blow account of the events that led up to the collapse of financial services firm Lehman Brothers almost 13 years ago. Storm clouds had been gathering over Wall Street all year, but it was this event that triggered the epochal Global Financial Crisis, the consequences of which are still felt globally. Up until that fateful Monday in September, everyone believed that if push really came to shove, governments would offer a bailout to banks in trouble. After all, the Bank of England bailed out troubled mortgage lender Northern Rock in 2007, in early 2008 the US Federal Reserve orchestrated JP Morgan Chase’s takeover of Wall Street investment bank Bear Stearns that was careening towards bankruptcy, and in September the US government nationalised the heavily indebted mortgage companies Freddie Mac and Fannie Mae.

But Lehmans was a bridge too far and the Fed refused to be the lender of last resort, worrying about using taxpayer money to bail out an investment bank. Instead US Treasury Secretary Hank Paulson tried to persuade either Bank of America or Barclays to rescue the bank. But with $613-billion of debt, time running out to liquidate any of Lehman’s assets and no US government guarantee forthcoming, it quickly became evident to the men and women in black that saving the bank was impossible. The result was the largest corporate bankruptcy filing in US history. After 15 September, every bank – from HBOS (parent of the Bank of Scotland) in the UK to Goldman Sachs in the US – was perceived to be at risk. The financial markets went into free fall. On 16 September the $62.6-billion Reserve Primary Fund “broke the buck”, which meant the fund managers couldn’t maintain its share price at par value. A day after that, on 17 September, the collapse spread. Investors withdrew a record $196-billion from their money market accounts. If the run had continued, businesses wouldn’t have been able to get money to fund their day-to-day operations and in a matter of a few weeks, the economy would have collapsed. Credit markets were saved in the end by Congress, which reluctantly approved a bailout plan for the banks, hedge funds and pension funds that were holding the toxic mortgage-backed securities that threatened to sink them. By bailing them out, Paulson hoped to stabilise the global banking system and end the financial crisis.

As events around China’s top property developer Evergrande unfold, I find myself reflecting on the Lehman collapse. And while the world’s financial whizz-kids assure us that the situation at Evergrande is not the same as Lehman, I can’t help thinking that it may be useful to remember the reasons Lehman got into trouble in the first place.

But first, why is Evergrande relevant to us? The company is saddled with debt worth $300-billion and warned last week that it could not meet looming interest repayments. A collapse could harm the wider Chinese economy, and by extension the global economy. But what is interesting is that this default was precipitated by China’s regulators, who tightened legislation a year ago. Previously the Chinese authorities would take care of defaults such as this, without causing a ripple in the market. But Chinese President Xi Jinping is on a quest to reduce debt in the Chinese economy, and thus authorities introduced limits on the amount of debt that China’s big real-estate developers could take on. But it may be a case of too little, too late. For years authorities have looked away as developers ratcheted up cheap debt to fuel growth in China’s housing market. The IMF noted in 2018 that China’s strong GDP growth after the Global Financial Crisis was supported by booming credit and warned of the risks. “International experience suggests that China’s credit growth is on a dangerous trajectory, with increasing risks of a disruptive adjustment and/or a marked growth slowdown,” it said. But China has created a monster: it has to pump ever-increasing amounts of credit into the system to maintain its GDP targets. As everyone who borrows from one credit card to pay off another knows too well, eventually there is just no more road. Quite how China will tame the monster will no doubt be fodder for business school case studies in years to come. Meanwhile, it may be timeous to reflect on the reasons Lehman failed, which are articulated in a paper written by Rosalind Wiggins, Thomas Piontek and Andrew Metrick of the Yale School of Management – risk, culture, overconfidence and regulator inaction.

Risk because Lehman failed to match its liabilities with its assets – using short-term debt to fund long-term assets. This means that when the overnight wholesale funding markets began to dry up – from which Lehman borrowed billions of dollars each day to operate – it could not liquidate its assets fast enough to stay afloat.

Culture because the company rewarded managers for excessive risk-taking and ignored the advice of its chief risk officer. Overconfidence because the firm invested heavily in the real-estate market and the complicated products related to that, but chose to ignore signs, as far back as 2006, that indicated that the poor loan performance of subprime borrowers should be a cause for concern.

Lastly, regulators failed to take action in 2007 when it was becoming apparent that Lehman was taking on too much risk, and did not publicly disclose to rating agencies that the bank had exceeded risk limits. Perhaps it was a unique confluence of circumstances. But history has a way of repeating itself, so let’s hope China has learnt a few lessons from the past. Because whether it’s China or the US that sneezes, when they do we all catch a cold. DM168

This story first appeared in our weekly Daily Maverick 168 newspaper which is available for R25 at Pick n Pay, Exclusive Books and airport bookstores. For your nearest stockist, please click here.

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  • Interesting article. I had heard of Lehman (before they went bankrupt) but I had never heard of Evergrande. What the article lacks is any kind of perspective. Lehman went done with $613billion in debt, and $196billion was removed from the Money Market. Evergrande has debt of $300billion . . . . but how do all these figures compare with the overall size of the US economy in 2008, and the Chinese Economy now? Also, it wasn’t a case that it was only Lehman that was carrying too much Debt – the problem affected almost all the banks. Is there any evidence that other property developers (and other sectors) in China are also carrying dangerously high levels of debt? Bruce Danckwerts CHOMA Zambia