A ‘Brittle’ Financial System Persists, 10 Years After Crisis

PLANADVISER this week received a number of written commentaries highlighting the 10th anniversary of the collapse of Lehman Brothers; while some lessons have been learned, experts still worry about the “brittleness” of the U.S. and global financial system.

The clearest and most pressing common theme presented in the commentaries is unmitigated concern that many lessons seemingly learned in the months leading up to and following the collapse of Lehman Brothers are already being forgotten.

Brad McMillan, chief investment officer for Commonwealth Financial Network, writes that the anniversary is in fact an important date for investors to mark around the world. Here in the U.S., reflecting on the shock of the Lehman Brothers collapse for many on Wall Street and Main Street is “valuable for bringing a sense of perspective to the present moment,” he suggests. “But it’s not all that useful in outlining what we should really be thinking of today in light of that history.”

“The real lesson of the financial crisis, to my mind, was that the system was more vulnerable than anyone thought,” McMillan warns. “Because of that, investors did not realize the risks they were taking.”

Unrecognized risk is a theme regular readers of PLANADVISER will be familiar with. Unacknowledged risk in target-date funds (TDFs) is a prime example; despite the fact that target-date funds suffered significantly in the Great Recession, experts commonly warn that today’s TDF investors tend to seriously underestimate the amount of downside risk they are taking. This includes many Baby Boomers who are in the “retirement red zone” and seriously exposed to sequence of returns risk. 

While far from predicting an eminent sequel to the Great Recession, McMillan writes that “there are echoes of previous pre-crisis periods” clearly visible in the global marketplace today. “Confidence, both business and consumer, is very high,” he notes. “Investor complacency is also high.”

What’s the bottom line? “I don’t believe we can’t have another crisis,” McMillan concludes. “I also, however, don’t believe we have to have another crisis. The point here is that we simply don’t know and can’t know.”

McMillan’s prescription for investors is to set realistic objectives, remain humble and “remember the real lesson” of the Great Recession: “Risk, in the form of asset allocation, debt, or what have you, is what gets you into trouble. Even if our models and predictions fail, if we simply are not that exposed, the damage will be limited.”

Another commentator to write this week to PLANADVISER is David Lafferty, chief market strategist for Natixis Investment Managers. Like McMillan, he fears that investors are already letting the hard-earned lessons of the Great Recession go to waste.

“As we approach the 10 year anniversary of the seminal event of the Global Financial Crisis—the collapse of Lehman Brothers—investors may wonder if we’ve learned anything from past mistakes,” Lafferty muses. “Through the varying lenses of policymakers, investors, and markets, the answer is decidedly mixed.”

Lafferty credits policymakers around the world with making “some headway” in the area of bank vulnerability.

“While concentration risk among the major global banks has actually grown since the crisis, broadly speaking, leverage and trading risk are down while equity and capital ratios are up,” he explains. “Large bank failures remain a risk, particularly in the European periphery and emerging markets, but the gradual de-risking of banks should make the system less vulnerable to contagion in the next Lehman-like crisis.”

Where policymakers have made less progress is on the monetary front, Lafferty posits.

“Other than the U.S. Federal Reserve, the other major central banks remain in crisis mode today, unable to lift rates or unwind their massive quantitative easing programs,” he warns. “Balance sheets are bloated to the tune of $15 trillion with still close to $8 trillion in negative-yielding sovereign bonds, reducing the stimulative firepower of the major central banks to counteract the next recession or crisis. In the end, it may be fortunate that banks have ramped up their ability to absorb losses because central banks certainly have less power to prevent them.”

Echoing McMillan, Lafferty agrees that Millennial investors coming of age in the 2000s “may never look at equities the way the Baby Boomers did growing up in the bull market of the 1980s and 90s.”

“While some scar tissue has built up, investors have been forever altered. Ten years of [extremely low interest rates] have pushed them grudgingly out the risk spectrum and back into equities, but there is little doubt investor risk tolerance has been fundamentally altered,” he writes. “Investors are more skittish and therefore more likely to bail when volatility rears its head again.”

Lafferty concludes that “there can only be so much learned from looking back when every new crisis is sewn from different seeds.”

“All participants and policymakers can do is hope that the system is more flexible and therefore less fragile when the next crisis hits,” he warns. “On this score, we can only conclude that things have changed very little from the days of Lehman.”

In some ways, the Lehman Brothers collapse is actually still ongoing, as pointed out by another commentator this week. There are actually nearly 350 former employees of Lehman Brothers, with an average age of 77, still fighting in federal bankruptcy court to recover pension assets they say they are entitled to. According to lead attorney Rick Scarola, the former employees deferred up to half of their annual income into a pension plan that has been at least partially liquidated to satisfy creditors. 

“While this is hardly the first case where employees of private companies lose money when a company goes under, it does highlight the unusual structure,” the litigants suggests. “Like the securities that Lehman and other investment banks sold decades later, it was designed to maximize profit for the company (partly through tax loopholes) while leveraging the assets and handing many of the risks to the people who bought the financial products—partly by financial misconduct that was only uncovered much later and amplified in the Valukas Report.”

According to Scarola’s team, this issue is in fact the only remaining matter being litigated in the broader Lehman bankruptcy case. In other words, it is the only issue to be resolved before the bankruptcy can be fully closed. Scarola predicts a “three to five or more year timeline” for the conclusion of the litigation.