Not so smart

IN 2008, as the financial system was collapsing, Alan Greenspan, the former chairman of the Federal Reserve and champion of free markets, admitted he had been wrong. “I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms,” he said. In other words: why would bankers destroy their own livelihoods?

Some clues to Mr Greenspan’s conundrum can be found in a new book* on Lehman Brothers, the American investment bank whose failure precipitated the worst of the crisis, and a recent report** on the collapse of HBOS, a British retail bank, that imploded soon after. Although the two banks had different histories, they made similar mistakes.

For a start, both strayed from their core expertise. HBOS was created through the combination of Halifax, a retail mortgage lender, and Bank of Scotland, one of Scotland’s two biggest banks. The merged entity wanted to gain market share in England and compete with the likes of HSBC and Barclays. The easiest way to increase business was to focus on smaller, riskier borrowers. The new lending book grew by 50% in 2007, just as the market was beginning to turn.

Lehman was best known for bond-trading, but moved heavily into property lending. Through a subsidiary called BNC Mortgage it was the 11th-biggest subprime lender in America; it underwrote more mortgage-backed securities than any other Wall Street firm and it made direct investments in property companies.

Managers of both firms thought they were taking advantage of profitable opportunities. By taking even more risk, even as others were retreating, they were gaining market share. They believed this would bring success in the long term. HBOS thought that retreating from lending in 2007 would damage its franchise. In essence, the pair thought they could survive only by moving forward, like sharks.

Risk-control systems should have saved managers from their mistakes, but didn’t. Lehman had a risk department that employed nearly 400 people, including former regulators; its approach to risk management had been praised by the Securities and Exchange Commission (SEC), an American regulator, in 2005. But the chief risk officer was overruled and risk limits were ignored; some investments in commercial property and private equity were excluded from internal stress tests.

HBOS conducted its own stress tests on its property portfolio, but used a hypothetical downturn milder than the recession of the early 1990s. A stress test conducted by external consultants in 2005 calculated that the bank would lose the equivalent of three years’ profits only once every 5,000 years; three years later, the bank needed a government rescue.

Both banks became heavily dependent on short-term funding in the wholesale markets, and thus vulnerable to any loss of investor confidence. That may explain why both banks were slow to write down the value of their assets: any admission of weakness could damage their reputation. And while both banks raised equity in their dying months, neither raised enough.

In neither case did the board control the managers. More than two-thirds of Lehman’s board had no significant recent experience of banking. The report on HBOS said its board lacked “knowledge and experience of banking”. To be fair, recruitment of experienced non-executives might have been difficult; anyone capable of overseeing a modern bank was presumably working for a competitor.

That points to a broader problem. Lehman had over 7,000 legal entities, of which 209 were registered subsidiaries; it had assets of $700 billion. Such a complex organisation was very hard to monitor, let alone control.

A long period of benign economic conditions and rising property values lulled executives at both HBOS and Lehman into a false sense of security. They thought they were brilliant and could handle the cycle; in fact, they had just been lucky. To go back to Mr Greenspan’s error, bankers did focus on their self-interest: they believed that if they didn’t expand their balance-sheets and keep pushing up profits, they would be replaced. They didn’t see the truck coming until it hit them.

^{*“Lehman Brothers: A Crisis of Value” by Oonagh McDonald, Manchester University Press}

^{**“The failure of HBOS plc” http://www.bankofengland.co.uk/pra/Documents/publications/reports/hbos.pdf}

^{Economist.com/blogs/buttonwood}