Looking back on the tumultuous week that almost led to a global economic heart attack, I’ve heard lots of theories for why Lehman failed, yet AIG and Merrill survived, albeit with massive government help.
Theories ranged from Lehman’s Dick Fuld having made too many enemies around the Street to Goldman driving an AIG bailout so they could collect the full face amount on their CDS.
I have two far more pedestrian explanations:
Not enough janitors
When I made the move to Wall Street in the early 80’s, it was reason 1 (good timing) that got me in. I answered an ad for a great-sounding job in the New York Times. It was with AG Becker, a small old firm that traded bonds as a Primary Dealer and did some investment banking.
I later surmised that the ad in the paper was there to get computer experts to come in to the search firm, which they then put into other jobs. By the time I called, the job they were listing had been the subject of dozens of interviews over a period of months.
I had been interested in Wall Street for years at that point, and I had even made my living trading a small account in options and “pairs” stock trades for a couple of years in the mid 1970’s. Still, my only computer experience with financial instruments had been to brute-force an early APL language computer (IBM 5100 anyone?) to produce the multiple moving averages a commodities trader used.
Worse yet, I had no experience at all on the type of machine the mortgage department at Becker had purchased. Just to make it even more unlikely, the position was for a System Manager who could help out with the programming.
I just happened to be the guy getting interviewed the day they decided they were tired of interviewing. Good timing.
They didn’t ask me if I had experience on that particular machine, which at that point had been big hunk of useless iron for months, because the initial sysgen (system generation, started with a paper tape load) still needed doing. Not that it bothered me once I got the job, since I had been a digital gypsy for a while at that point, doing consulting on whatever machine the customer bought. It was just another set of manuals to me.
I had learned a few tricks that Wall Street systems departments didn’t know, however.
For example, when I heard that our new machine wouldn’t have printers or terminals until the manufacturer could deliver them two months later, I called around until I found the biggest independent repair service for all brands of peripherals. I called with my shopping list, and offered them a chance to get the entire service contract if they could deliver reconditioned printers and terminals within a week, subject to a 1 year warranty on all the equipment they sold us.
Terminals and printers (especially printers) were the bane of any system manager’s life. They always screwed up. The computer itself never screwed up. But since the users and the bosses only really dealt with printers and terminals, as far as they were concerned, a non-working printer means the computer isn’t working.
A week later, we had very cool pen plotter, a dozen terminals on the trading desk, a line printer in the computer center, and two (extra) local printers right next to the traders. And we had saved 25% against the cost of fewer machines from the manufacturer of the computer itself. Best of all, we only had one number to call for anything other than the computer itself, and that service company had literally dozens of technicians minutes away from our office if something went wrong with the hardware they sold us.
Then came our six-figure software purchase for plotting and graphing software. It was also a long lead time, with a three-day installation requiring a specially trained factory rep. The next slot for an installation was two months away. In talking with the technical people at the software vendor, I found out they had developed their software on the same machine we owned. I agreed to pay the installation fee and purchase the software, if they would send a backup tape of their own system by express delivery.
I went onto the managers’ console of the machine, loaded the backup tape, and followed the procedure for recovering from a nasty system crash. In three hours we were in business. When the installer showed up two months later, he said he had never seen a customer self-install that was done correctly until he saw ours. I explained what I had done, and then asked that he spend his scheduled time with us doing demos and teaching our programming staff some of tricks the software could do.
Another thing I did in my first couple of weeks was to cancel more than $100,000 a month in timeshare contracts, and I made it my business to port the software from the outside machines to our own in the order of the cancellations, not the order of importance to the trading desk. The contracts with 30-day notice went onto our machine first, 60-day next, and the 90-day cancellations last.
Now you see why, when Becker laid off a quarter of the staff three months after I started, I was not among the unlucky ones. I was a competent janitor, good at cleaning up when that was the job that needed doing.
Which brings us to the week the market died and nearly took the world economy with it, in mid-September 2008.
About that time the midwest was having yet another 100 year flood, and the nightly news was full of stories of everyone pitching in — even prisoners from nearby penitentiaries. The thing that struck me is that everyone basically knows how to operate a mop and get sludge out of a house. We can all be janitors if we have to.
Not everyone knows how to calculate and file claims on swaps when a default occurs under ISDA documents (International Swap Dealers Association). Worse yet, there are still swaps hanging out from the early days that weren’t done under the standard swap contracts.
When Lehman went down, our derivatives people were swamped for a couple of weeks. I’m sure some banks and insurance companies had it much worse. As it was, even “plain vanilla” interest rate swaps were a problem because they involve each side of the trade nominally “paying” an interest rate, be it fixed or floating. When one side isn’t paying, what was a business of calculating differences between those rates became a business of calculating the actual rate of interest and filing a claim against a bankruptcy estate.
As if that wasn’t enough, nobody knew what was going to happen to swaps that were keyed to various Lehman bond indices. Would we substitute another index? Would both sides of every trade agree to the same index? Since there was no disclosure of the actual volumes of swaps outstanding, no one knew whether other banks had too much exposure to Lehman, which in essence could make other banks insolvent without anyone knowing, even if they had started the week with very low net exposure.
Now comes the fun part, and what caused the real world economy to stop: Once you don’t know whether the huge bank you’re facing is solvent, you won’t accept the risk of their credit for a period of weeks or months. As a result, Letters of Credit were suspect, and shippers of goods and raw materials lost the ability to finance their products while on the high seas. Every commodity or international trade supply chain broke, all at the same time.
Just to make it even more interesting in a version of the Shrodinger’s Cat conundrum, over the past three decades, virtually all the financing in the world has moved to LIBOR – the London InterBank Offering Rate. If no one will offer banks money beyond next week, then what is the rate for 3-month LIBOR? There are literally hundreds of trillions of dollars of swaps that reset every three months as spreads relative to 3-month LIBOR, which you could say didn’t exist for all practical purposes. At that point, all debt everywhere was basically impossible to value.
It’s as if all the scales in the world stopped working, but you needed to complete your business based on weight.
Just a few recollections of my thoughts last year, and a reason why every G-10 government got scared into backstopping their banks, whether or not their laws allowed it, and without regard to their political philosophies.
It was a shortage of janitors, so AIG and Merrill just couldn’t be allowed to fail.