Reflections on Blowups and Bailouts

By Thomas Adams, Paykin Krieg & Adams LLP.

Denial Was Rampant in the Buildup to the Financial Crisis. Arguments that Lehman Should Have Been Bailed Out Show that Denial Continues Today.

While this week marks the first anniversary of the shocking collapse of Lehman Brothers, it is also the second anniversary of the events that triggered the demise of my former company. My old employer’s passing doesn’t generate much press these days, but the extensive coverage of Lehman has reminded me of a memorable meeting I had at Lehman’s office two years ago. At the time, Lehman sat in judgment we made the case that we were fundamentally sound and would survive the mortgage crisis.

In the many articles that discuss the Lehman collapse, the most common conclusion is that the Bush Administration made a major error by not bailing out the investment bank as they had done for Bear Stearns. The financial chaos that erupted after Lehman failed could have been avoided or minimized; the argument goes, if the government had thrown Lehman a lifeline.

My company was unable to convince Lehman, or anyone else, that we were worthy of a bailout. Today, I am thankful for that. Based on my own experience, I believe a Lehman bailout would have merely delayed the inevitable and, even worse, helped the company and the financial community avoid owning up to the many mistakes that had been made in the prior years. The fact that so many people continue to argue that a Lehman bailout was necessary, leads me to conclude that denial is still a big issue in the financial and political worlds.

In the years leading up to 2007, my company was an active participant in the mortgage backed securities (MBS) and collateralized debt obligation (CDO) markets. In fact, these were the areas I oversaw. I built my nearly 20 year career on being a careful and conservative analyst and I ran my groups accordingly. I wasn’t a cowboy and I always avoided the excesses that some folks in our industry embraced. I thought that this would protect me and my company against any downturns in the market.

In September of 2007, following the failure of the Bear Stearns hedge funds and the downgrade of billions of dollars of sub-prime MBS by the rating agencies, the market sentiment for the MBS and CDO business was souring rapidly. My company was receiving frequent inquiries from investors and clients about our financial condition. Our explanations of the rigorous analysis we used for MBS and CDO bonds were being met with increasing skepticism and, despite our efforts, the market was losing confidence in us. Our ability to get new business was being adversely affected.

We embarked on a series of meetings to assure people of our soundness and expertise. One of the big meetings we had in September of 2007 was with Lehman Brothers. Although the meeting was intended to be a big picture presentation on the overall financial condition of our company, the Lehman analysts were only interested in asking about our MBS business. I was charged with responding to their questions and I was grilled for over two hours on the details of our portfolio. As the meeting progressed, the mortgage traders fired increasingly hostile questions at me regarding particular bonds. Across the room, several analysts began whispering to each other and grinning. I continued my presentation, explaining how careful we were when we took the bonds on and how thorough we were when we reanalyzed the bonds, but my audience was hardly listening. One analyst asked how we could have possibly taken some of these deals into our portfolio.

A few days later, an investment bank published a report suggesting that our company might be seriously undercapitalized. As at the meeting, the report suggested that our MBS portfolio showed that we were foolish and much weaker than our competition. The report and our unsuccessful meeting with Lehman marked the beginning of the end for our company. Isn’t it odd, I mentioned to one of my co-workers, that Lehman and this report gave us such a hostile assessment, when both banks were big issuers and investors in the same MBS? Were they really that much smarter than we were?

Over the course of the next few weeks, our company struggled to address the market’s loss of confidence and announced plans to seek additional capital to get us through the market dislocation. Privately, however, I was losing confidence in our ability to survive. As we did more and more analysis on our portfolio, I began to realize that, even though I had been careful and conservative when I took those MBS and CDO bonds on, I had been wrong about their quality and value. I became concerned that the problems we saw in our MBS and CDO portfolios might infect the entire financial community. My dreams were haunted by visions of a massive financial crisis, bank failures, layoffs and a return to the bad old days of the late 1980s.

Despite my worries, the rest of the world seemed unconcerned. The stock market and New York City real estate prices were hitting record levels. Our competitors and other financial institutions assured the market that they were well capitalized and only the weakest players, such as my company, would be in trouble. Our management, though concerned, remained convinced that our company would survive.

The stress of trying to reconcile these competing views took a toll on me. I was out for a week with vomiting, headaches and fever. When I returned to the office, I continued to work hard on our analysis and tried to find solutions to our travails, but I no longer believed that we would survive. Eventually, my bosses lost confidence in me and began freezing me out of meetings and internal discussions. By December, I was informed that I would be let go as an example of accountability for the mistakes. By January, I was on the street and my long career in the industry, of which I had been so proud, came to an unceremonious halt. A few weeks later my company was downgraded and effectively out of the business, as well. Though my future was uncertain, I was relieved to be free of the stress of living in a world overrun with false optimism and denial. I blamed myself for my mistakes but I resolved to learn from them and move forward.

In January of 2008, most of the world still viewed the crisis as an isolated issue. Many people in the market would continue to blame the issues on just small segments of the market, such as sub-prime mortgages. As I talked to people in the industry, I was amazed by the finger pointing and denial, despite the problems they would soon be facing themselves. When Bear Stearns blew up in March of 2008, the dynamics of denial quickly triumphed again. Lehman aggressively assured the market that they were fine and much different from Bear Stearns who was, by implication, much weaker and more reckless than they had been. As the market seemed to take this blow up and subsequent issues in stride, I began to wonder if my fears of a coming doomsday were just another mistake I had made.

Eventually, the problems at Lehman mounted and they, like my former company, were no longer able to fend off the skeptics. Despite a relatively peaceful interlude after Bear Stearns collapsed, the broader world finally began to realize the implications of the issues that had been triggered by the sub-prime crisis. Many people were shocked when company as large and savvy as Lehman was brought down by problems in the previously obscure sub-prime MBS. The collapse triggered a panic throughout the global markets. I, on the other hand, was surprised it had taken so long for people to realize the extent of the problems in the market.

Of course, I am sorry that Lehman didn’t survive. I wish my former company hadn’t collapsed, as well. It took me a while but I eventually realized that I, and my company, had made a number of serious errors and we would have to pay the price for them. The sub-prime mortgage problems that emerged in the summer of 2007 were serious for the entire market, not just the weakest players. Avoiding and denying did little to make these same mistakes go away for Lehman. A bailout may have further delayed the final reckoning, but the truth was that they had made many mistakes on a large scale and they, or the taxpayers, would ultimately have to own up to them. Without Lehman’s failure, I have no doubt that many people would have continued to argue that the problem was isolated. In fact, the issues of bad investments, excessive leverage, inflated valuations and bad risk management (among others) reached virtually all corners of the global financial universe. Lehman’s failure exposed the depth of both the crisis and the rampant denial. In addition, the collapse finally forced the financial and political communities to own up to their mistakes. This, I believe, is the important less to remember as we mark the unfortunate anniversary of Lehman’s collapse.

Thomas Adams is an attorney at Paykin Krieg and Adams, LLP and works as a strategic consultant and expert witness on issues relating to the financial crisis. He previously worked at FGIC, Ambac, Moody’s and Thacher Proffitt and Wood. Tom can be reached at tadams@pka-law.com or thomasadams3@mac.com.