Lehman Brothers was a cultural marker, the kind of thing that sticks for generations because of all the wrong reasons. Hardly anyone had heard of the investment bank throughout its unbelievably long history stretching back to the middle of the 1840s (yes, eighteen forties). But being near the center of a multi-generational breakdown causing as yet-untold damage and misery extending far into the future (it’s still going as of 2020 near 2021) will erase even sixteen decades of otherwise silently effective effort.

But what really happened at Lehman, to this day hardly anyone knows. Subprime mortgages? Derivatives? Something bank reserves?

Like Bear Stearns and AIG, the reason we keep coming back to Lehman is what it can tell us about how conventional wisdom hasn’t been all that wise for a very long time. Worse, despite the massive pain its errors unleashed this hasn’t changed over the subsequent twelve years since its epic demise.

To begin with, money is supposed to be very simple. Incredibly easy. The Federal Reserve (or any central bank) does some things, voila, the world works like it’s supposed to, economic utopia at the flip of a single switch (open market operations).

Nope. Not even close. This is merely what the Fed wants you to believe (expectations policy), and it is what gets repeated from the moment you might begin Economics 101 all the way through to your daily adult life consuming commentary about what the media says takes place. Never ask questions, don’t you dare think about fighting the Fed.

On the contrary, as the Lehman story aptly demonstrates, the real monetary world is at the entire opposite end of the spectrum from simple. From the lack of role for bank reserves to the erasure of so many traditional boundaries, money from credit, national system from national system, this global regime can simply knock your socks off – and that’s on a good day.

Because of this, monetary officials who are very, very skilled at keeping up the pretense of knowledge and competence actually have little to no idea what’s really going on. Once you discard the notion that subprime mortgages played any substantial role beyond the initial phase of crisis, this is actually incredibly easy to see. After all, there was that whole GFC thing.

From these two factors, it would make sense, then, to appreciate this intricacy for what it means – even in 2020. Stop listening to central bankers and/or their mouthpieces in most of the financial media (this is starting to change, slowly), start listening exclusively to what the system itself is telling you.

This is no easy task, I assure you. After all, because of what used to be called “benign neglect” where officials let this eurodollar system run its own sort of monetary ecosphere for decades there’s very little direct knowledge of what’s going on. Really going on.

Curves, yields, the “bond market” is really our only window from which to peer inside and get a true sense. For the system itself to show itself in deed – not words from the occasional dealer bank CEO or Economist – as to its condition.

In retrospect, this is what the Lehman story does even if well after the fact. It corroborates the market signals while making a mockery of the “best and brightest” technocrats who don’t have the foggiest idea what they’re looking at most of the time – even when handed access to data and inside commentary in real-time that us mere mortals could only ever dream of obtaining.

To give people what I hope is a really good a sense of this, I wrote about the Lehman story at length last Friday from the inside perspective. Using emails and confidential data gathered by the Financial Crisis Inquiry Commission, when you parse through even a sample of them, you’re left with only this conclusion.

There were a couple of emails, however, I didn’t have the room to feature or include (despite using up ~2600 words, as usual) that are worth the extra effort (it does help to go back, if you haven’t, and read the other one since we’re picking up here in the middle of the story). It really drives home, I think, both of these main points.

In July 2008, Lehman Brothers was already experiencing a modest repo run around the edges of its massive repo funding book. How massive? About $200 billion of securities that required daily rolling over, almost all of it triparty and therefore run through JP Morgan as custodian (with money funds and other cash-rich dealers on the other side pledging cash).

As I recalled in that other article, things at that point were only beginning to sour:

On July 10, one step closer, Karl Mocharko, a Senior Trader at Federated Investors, a mid-level money market fund manager active in repo, emailed a bunch of people at both Lehman Brothers and JP Morgan advising them that Federated was pulling out of any triparty repo arrangements it had with Lehman over JPM.

Yes, the issue was Morgan.

That’s not a minor point; the problem had been JP Morgan unilaterally changing the language of custodial documents. Federal Reserve and Treasury officials looked at the problem in two ways: one, sigh of relief because it seemed like the issue wasn’t really the market rejecting Lehman, so, it was thought, once they talked sternly to JPM and told them to knock it off, everything would be fine; two, if there was any issue with Lehman, the PDCF would give the Fed flexibility to ring fence Lehman and cut off the problem where they saw it as they saw it.

When the problem wasn’t Lehman, nor really JP Morgan. So, here’s one of the emails I didn’t get a chance to include. It was written by Patrick Parkinson, a senior and well-respected (and connected) staff Economist at the Federal Reserve Board in DC. On July 20, 2008, about ten days after the big events at the center of my prior article, he wrote:

If some morning it [JPM] fears that the investors are unlikely to roll their repos, it may threaten not to unwind LB’s [Lehman Brothers] previous night’s repos. If it did that, LB would be done because the tri-party investors would control its securities inventory. The investors presumably would promptly liquidate the $200 billion of collateral and there is a good chance that investors would lose confidence in the tri-party mechanism and pull back from funding other dealers.

See, no. No. NO.

That was the very situation JP Morgan itself was trying to avoid via all its antics prior to that time. And in doing so, it was chasing those “investors” (like Federated Funds) away from getting stuck with unwanted collateral, too.

Of Lehman’s $200 billion repo book (actually it was $188 billion end of its fiscal Q2 2008), more than half ($105 billion) was “non-traditional” collateral. Some subprime, sure, but the vast majority other things like ABS and senior or super-senior prime MBS. Money good assets, in every case, but unwanted in the extreme nonetheless.

What drives cash lenders in repo are liquidity considerations above everything else. They don’t care about money good assets; they only care about whether or not tomorrow if the repos don’t roll and they get stuck with collateral they don’t want, when they go to liquidate it in order to make themselves whole, can they liquidate it?

If there is a smidgeon of doubt, doubts which had been established all the way back in the summer of 2007, what you do as a cash lender (“investor”) is you avoid any situation which would leave you stuck with something that you couldn’t sell to get back your cash. All your cash.

You never, ever lose money on lending cash in repo. The tiniest risk that you could defeats the purpose.

To the Fed and those like Parkinson who hold influence there, this was instead stuff Economists just throw up on the blackboard; academic assumptions like this: repo goes wrong, cash lender seizes collateral and liquidates it. All the Fed needs to do is step up for the dealer (Lehman in this case) to make sure that it unwinds in orderly fashion; like Bear, apparently.

The PDCF was designed, as Parkinson (and others) kept claiming, with this very situation in mind. Neither Federated nor JPM needed to worry about bad Lehman collateral since Lehman would just roll it over to the Fed using this window – in theory.

What really happens is quite different; was quite different. Again, even the hint, the smallest perception of being stuck with collateral that may not be reliably liquid, investors pull, they demand instead only collateral that is reliably liquid – and not just from the one questionable dealer – leaving the triparty custodians (where there even is one) to begin protecting themselves from any fallout of what is instead an interbank run on collateral.

You don’t give a damn about sorting out what might be good for PDCF, or if the cash borrower can access it. Give me Treasuries, or nothing! And in the worst cases, such as October 2008 or March 2020, give me OTR UST, or nothing!!

The PDCF in this instance is beyond worthless, even as the Fed kept thinking it was rock solid. What would it matter if Lehman could borrow from it? That solves nothing because the issue isn’t Lehman, it’s collateral systemwide – collateral that is multiplied six maybe eight times via repledging and rehypothecation.

What we’re talking about is ages-old currency elasticity, except the currency becoming inelastic isn’t cash nor bank reserves, it is collateral. Yes, currency-like collateral.

More from Parkinson:

We could try to dissuade JPMC from refusing to unwind by pointing out that if the investors don’t roll the repos LB can borrow from us through the PDCF. Even if we did so, for two reasons JPMC might still balk. The first is the non-PDCF collateral…The other reason is a fear that LB could be placed in bankruptcy intra-day, before the next day’s tri-party repos and any PDCF loans are settled, in which case JPMC would be stuck with $200 billion in secured loans to LB.

A couple hundred billion in “secured loans” secured by collateral JPM knows doesn’t have much of a functioning market. Does JPM, having done the Fed a huge favor with Bear, really want to be in that kind of a situation? Would it want to risk even the slightest chance to be near the edges of anything resembling that situation?

No. It would demand, and begin seizing, only the best collateral (collateral calls – and not just to Lehman) to make any estimated or even perceived potential shortfall. And that’s exactly what it did – at the same time everyone else was doing mostly the same thing. This is from the FCIC report itself (Chapter 18):

On Monday, September 8, more than 20 New York Fed officials were notified of a meeting the next morning “to continue the discussion of near-term options for dealing with a failing nonbank.” They received a list documenting Lehman’s tri-party repo exposure at roughly $200 billion. Before its collapse, Bear Stearns’s exposure had been only $50 to $80 billion. The documentation further noted that 10 counterparties provided 80% of Lehman’s repo financing, and that intraday liquidity provided by Lehman’s clearing banks could become a problem. Indeed, JP Morgan, Citigroup, and Bank of America had all demanded more collateral from Lehman, with the threat they might “cut off Lehman if they don’t receive it.”

The Fed instead went into the month of September 2008 confident that: the PDCF would be able to soak up any additional demand for secured borrowing among dealers; that the issue was at most JP Morgan being overly finnicky for no good reason (hero Ben Bernanke was already on the case!); and that if Lehman was left standing without a chair, no biggie.

This was very, very different in that it had been a months-long saga that had all along showed anyone honestly paying attention where the problems only began. As I wrote last week:

In other words, taken altogether, what Morgan had actually been doing was indirectly warning Federated (and others) about the collateral it was processing in repo from Lehman (and not just Lehman, others, too); thereby, moving with extreme prejudice to protect itself as triparty repo custodian who, in the event of insolvency or bankruptcy, might/could/almost certainly get stuck with this “non traditional” collateral as repo middleman.

But this wasn’t merely a repo/collateral issue, it was systemic in two ways (directions). The aggregate collateral pool had become suspect, poisoned thereby herding everyone into smaller and smaller subsets, leaving an entire global system to scramble for only the highest quality (most liquid) collateral – of which there just wasn’t enough (slightly negative T-bill rates in the Autumn of 2008, one example).

More importantly, as bad as this was and has been again (March 2020), it isn’t a straight repo problem nor does it lead to just “spillover” issues. Rather, the entire money dealing structure, upon which everything from plain vanilla loans to complicated syndications to all those derivatives you always hear about but no one seems to understand depends, it all starts in the repo book.

The fuzzy nature of collateral underpins everything; money dealers’ money dealing activities up and down the line, all across this global eurodollar system, depend upon collateral as its entire basis. From derivatives to plain vanilla lending, in the middle of all of it are these really complicated ways that securities are used and, really, abused as a “normal” part of doing business in this modern global money framework.

Collateralized lending in theory is really simple; in practice, it’s anything but.

This right here is the real story of Lehman.

The truth of the matter is that nothing of substance has changed since. Dealers have, on their own accord, shrunken their dealer activities ever since (actually going back to Bear, which led to Lehman). Can you blame them? JP Morgan isn’t even in the triparty repo business anymore; they got out years ago! The Fed isn’t nearly the backstop savior it had long held itself out to be; GFC1 had proven beyond a shadow of a doubt it was no backstop at all, not even a poor version. PDCF? Come on!

These people have no idea what they are doing.

Shrunken, however, doesn’t mean resilient, as Janet Yellen had grown fond of claiming, nor robust. It just means smaller. In many ways, it also could mean the margin for error is likewise lessened.

And then to have the Federal Reserve late in 2019, faced with another global money problem, do what? Not-QE, buying up exclusively T-bills! If you were actually trying to crash the system you wouldn’t have done any different. More proof of this shocking ineptitude, the inability of monetary officials to learn any important lessons on money.

Another global debacle, even if there didn’t end up being another Lehman. That’s the point, the wrong focus. It was never really about Lehman the first time.

That’s why its story explains so much of this year including the prospects of facing another permanent shock – and the consequences of it. The money system is far from simple. And monetary officials are far from competent. Even if they wanted to react in a more modern fashion than QE and useless bank reserves, they don’t even know what they are looking at in any given moment.

They’ve been promising an inflation-filled recovery ever since it happened. None has been forthcoming, and officials can’t figure out why. But – take their word for it! – there’s massive monetary inflation on the horizon this time. Pay no attention to bill or UST prices, after all, earlier this year they even brought back the PDCF.