World on collision course for Lehmans 2.0?

Four years after Lehman Brothers suffered the largest bankruptcy in US history, a former vice president at the investment bank has warned the financial system is on a ‘collision course’ for another 2008-style event.

Lawrence McDonald is a former proprietary trader who ran a $1bn portfolio for the bank, and author of the book A Colossal Failure of Common Sense: The inside story of the collapse of Lehman Brothers.

He expects Spain will be the next domino to fall on the world stage due to the excessive leverage in its economy and in the European banking sector, triggering a huge sell-off in financial markets. 

Lehmans was leveraged up as much as 40 times before the crisis, and while European banks may not be at those levels, they are three times more leveraged than the US relative to GDP, McDonald said.

“After Bear Stearns went down, Lehmans should have been aggressively trying to reduce risk. There was a moral hazard, Lehmans thought it was too big to fail, and the same thing is happening now with Spain,” he said. “A month ago, Spain’s 10-year yield was 7.56% and Spain said at that point it needed $100bn for the banks.

“Draghi did his OMT and he is threatening to use the bazooka, and Spanish yields are now down to 5.7%, almost 200bp. Now Spain’s Prime Minister Rajoy says he does not need the money. Rajoy is acting like Dick Fuld [the final CEO of Lehman Brothers].

“He should be embracing a bailout, he should be taking the money, but instead he is using this to buy more time,” he added. McDonald, who was senior vice president of distressed debt and convertible securities trading at Lehmans from 2004 until the bank folded, said the marked difference between the economies of Spain and Ireland is another warning sign.

Spain has yet to do stress tests on its banks, while Ireland brought in BlackRock to carry out tests on its financial sector two years ago, McDonald said. “Ireland admitted all its losses, which is why its stock market is up 60% from the lows. Ireland has just come back to the capital markets, while Spain is about to lose access.

There should not be that much difference between Spain and Ireland. It tells you that Spain is hiding a massive problem. “The market will get the truth out of Spain, and when it does there will be a big risk-off trade.”

Although European banks remain highly leveraged, US banks have cleaned up their act since 2008, according to McDonald.  Balance sheets are looking cleaner and risk reduction measures are increasingly being put in place, he said, but they still remain vulnerable to future shocks, including more pain from Europe’s financial sector. 

“Things got so bad that Goldman Sachs had to get money from Warren Buffett for a short-term loan. The problem now is the banks are still weakened by the crisis, they are weakened by the regulation and they are weakened by the LIBOR scandal. The last thing the US banks need is a real systemic event coming out of Europe.”


This article was first published on Investment Week

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