Happy Anniversary!

A year ago today, on September 15, 2008, Lehman Brothers, one of the largest and oldest investment banks in the U.S. filed for bankruptcy, and set off a financial collapse that was felt across the globe. It seems like a long-time ago, but it was only one year, but what a year it was! Lets review, shall we?

Economists are still debating (and will continue debating) whether Lehman Brothers should have been allowed to fail. Its bankruptcy caused Reserve Primary Fund to “break the buck” (falling below the normal one dollar per share for money market funds) because of their investments in Lehman and soon led to a massive $150 billion in investor withdrawals from money market funds. Commercial paper yields spiked and soon businesses could not fund their daily operations. Banks stopped lending and investors panicked, withdrawing money from bond and stock markets, market prices crashed, and the economy came to a screeching halt here in the U.S. and abroad. Short-term treasury yields briefly turned negative-people were willing to pay the government to hold their money for thirty days!.

Our free capital markets had frozen and ceased to function. The government, through a series of actions by the Federal Reserve, the U. S. Treasury, and eventually Congress, began to intervene in an attempt to restore confidence in the markets. The U.S. Treasury issued a temporary guarantee of all money market funds and the Federal Reserve began buying commercial paper direct from companies. Congress eventually approved the TARP plan and the Treasury began recapitalizing the nation’s banks.

Eventually the government would end up taking over AIG, the nation’s largest insurer, as well as auto giants General Motors and Chrysler. One year after the collapse of Lehman Brothers, the U.S. government is the largest shareholder in our nations banks, in our largest insurer, and our largest auto company. In addition, the government is now directly or indirectly involved in 85% of all new mortgage originations in the housing market.

Thankfully, the quick, forceful, and massive intervention of the U.S. government, as well as governments in Europe, China, and Japan, gradually restored confidence to the markets. Bond markets have recovered, stocks have rebounded, and the economy appears to be gradually exiting the recession. This time the recovery will be “jobless” for a while, meaning consumer spending and economic growth will be slower than in past economic cycles.

So what are the lessons of Lehman Brothers and the credit crisis that followed? They will fill the economic textbooks for several decades, but here are some:

Financial regulation is necessary. Investment and commercial banks do not police themselves very well. In the name of “financial innovation” they tend to overproduce the next product and consumers tend to overbuy. AAA ratings do not equal safe.

Housing prices do not always go up. It just seemed that way for a while. Thanks to shoddy underwriting and over-borrowing, almost one-third of mortgages are underwater and the housing market will need extra government support for years.

Global markets are connected. Correlations go up when you need diversification most. Just because different asset classes are normally negatively correlated, doesn’t mean they will be during a financial crisis.

Consumers cannot go on spending forever. Consumers will end up spending the next decade paying down the debt they piled up over the past decade.

Long-term investing means long-term. The last decade we saw the collapse of both the “tech bubble” and the “housing bubble”, resulting in a decade where stock returns have been negative. Hopefully we will see regulation that will prevent “bubbles” from forming again in the future.

We have short-term memories. The more the stock markets and the economy stabilize, the less urgency there is to fix the problems in the financial system and prevent it from happening again in the future. While lawmakers remain occupied with health care debates, no lasting regulation of the financial industry has been introduced since Lehman Brothers. Hopefully, lawmakers will return to the topic of financial regulatory reform soon. Investors deserve clear transparency, strong and responsible regulators, and a financial system that can absorb and manage the risks of a global economy without coming apart at the seams again.