The Guy Who Predicted Lehman Brothers' Fall Sees Big Trouble Ahead for China

A Q&A with former Lehman Brothers VP Lawrence McDonald

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Lawrence McDonald, author of the New York Times Bestseller "A Colossal Failure of Common Sense," gave International Business Times his views on the 2007 financial crisis, the collapse of Lehman Brothers and where the next big downfall is going to come from.

What do you make of the news that Bank of America Corp. is being replaced in the Dow by Goldman Sachs?

The Dow is an interesting index; it has 30 large cap companies. I'm not sure what you can make out of that. Goldman's market cap right now is $77 billion and Bank of America's is $157 billion. So it's unclear why they did this. One reason could be, Bank of America have had an extremely volatile stock price in recent years. I mean, it's made a bunch of round trips. In 2011 it hit $5.03, in 2009 it hit $3.87. Five years ago today it was trading at around $40 at one point. So it's had multiple periods of volatility.

Also, there is no investment bank in the Dow. Bank of America is a commercial bank. There's a lot of talk about Glass-Steagall, I wrote about in my book. They may break up the big banks over the next year.

What would you characterize as the successes and failures of U.S. policy in the crisis aftermath?

Successes are getting the banks in a much healthier leverage and higher capital ratios. That's the biggest success by far.

The failure is, and there's a theme in my book about this, capitalism doesn't work without transparency of risk. And if you listen to what Sandy Weill said about that, it's "in a capitalist system, dollars are votes."

And when you can see the banks risk and see the risk on the balance sheets, that's transparent banking. Let's just say our dad gave us $200 million and we wanted to invest $10 million it in Citigroup. You wouldn't put that money in if you knew they were sitting on toxic assets, and if you can't see the toxic assets, then capitalism doesn't work.

All of my systemic risk indicators are clearly pointing at Asia. Asia is back where we were in 2007; they have a trillion dollars of toxic assets off the balance sheets -- hidden.


Where they've failed: Here we are five years later and there isn't a lot of transparency in terms of what is on the balance sheets, so you have trillions of bank deposits sitting on top of very opaque black box type investments. Whereas in the '60s, '70s, '80s and '90s, if you walked into Chase bank you knew they had deposits and they had real estate loans but they didn't have credit default swaps. Credit default swaps are still not on public exchanges.

So if you buy 100 shares of IBM, that's on the exchange and everyone can see it. If you buy a million shares of IBM, everyone can see that so everyone knows about that bet. If you buy $1 million worth of credit default swaps, that's still invisible. There's no public exchange.

When Lehman went down it had $8 trillion in credit default swaps, so that's $8 trillion of bets on different organizations that nobody knew about, and that's when credit in the U.S. froze. If you look at GE and Goldman -– they had to get a loan from [Warren] Buffet because nobody would loan any money to anybody because credit was frozen.

Going forward, what needs to change?

More transparency. The key is to either break the banks up or bring back Glass-Steagall. The current banks, if they are not broken up, must be much more transparent and show us what's on the balance sheets.

For example, when I sat down to write my book I talked to people who are paid $10 million a year to stay five or six steps ahead of the regulators. These guys' entire job is just to be ahead. You know, "what are the regulators gonna do next?" It's like chess.
It doesn't matter what type of regulation you have, if the regulators don't have real experience on Wall Street, they can't execute.

Why, five years after Lehman, does most of what has happened in terms of regulation have to do with insider trading, which had nothing to do with the financial crisis? The financial protection bureau is consumed with these credit card bank fees. What's that got to with the financial crisis?

What they've done is: Dodd-Frank is like an eight-lane highway. Some cars are moving 10 mph and some are doing 90 mph, but the cars that are moving 90 mph are the least important to prevent another crisis and the cars that are moving 10 mph are the most important. That's the problem. They had a mandate to do something and they went to the low-hanging fruit.

Are we likely to repeat the mistakes that led to the last meltdown if there are people out there whose only job is to beat regulation?

There's no question that they've learned a lot, so you can say what you want about these guys trying to be five steps ahead, but they are not idiots and the banks are far better leveraged today.
The next financial crisis will not come from the United States. All of my systemic risk indicators are clearly pointing at Asia. Asia is back where we were in 2007; they have a trillion dollars of toxic assets off the balance sheets -- hidden. If you look at interbank lending, we meticulously measure every day how much banks trust each other, and that is a phenomenal leading indicator.

If you take summer 2011, the S&P dropped 20 percent in about 35-45 days. And sure enough, right before that, the interbank trust in Europe in May and June was completely breaking down because some banks in Europe, France and Germany own a lot of Greek bonds and the Greek bonds were in flames, dropping from 90, 70, 60, to 30, and there was hundreds of billions of these things and these losses needed to be borne back into the banks, so they banks were breaking down in terms of the trust.

And right before Lehman went down, five years ago in August 2008, interbank trust in the U.S. was almost gone. And if you meticulously track these indicators they will give you warning signs that the next elevator shaft is coming, and they are clearly pointing at Asia. It's mainly China. They've rallied in the last couple of weeks, but the bad real estate assets are adding to the 200 percent debt to GDP if you add the consumer debt. The U.S. has government debt and China has consumer and corporate debt. It's an unsustainable debacle coming.

They [China] are already trying to aggressively bail out out the banks. They are not letting them fail, they are lending them more money even though these banks have giant holes in their balance sheets, so essentially they are doing the same things as the U.S. [was] doing. Eventually that breaks. The government can only do so many things before the free market takes action. The good news is the Chinese banking system in the world is tiny relative to the U.S., so in other words, if you think of the U.S. banking system and everything in it, it's not as systemic. It will be a regional things and it will affect U.S. markets, but not in the same way as Lehman did.

What will happen to Fannie and Freddie in the future?

One theme that were seeing since Lehman is that politicians are making decisions that the free market used to make. So like when Lehman went down, Hank Paulson, as I said before, it is like a dictatorship where a small group of people are picking winners and losers. When GM went down, a small group of people were making decisions about who were the winners and losers. When Greece went down, the bondholders, same thing –- a small group of politicians that were picking winners and losers. And it's the same thing with Fannie and Freddie.

There is a bill to bring back and privatize Fannie and Freddie. Right now, 90 percent of all mortgages that are issued today will somehow be backed by either Fannie or Freddie. This is another ticking time bomb that won't be addressed because they don't want to rock the boat. So what's happening is, the U.S. taxpayer is getting longer and longer exposed to real estate.

In the '90s, Freddie and Fanie were only taking on 40 or 50 percent and the private sector was huge, but what's happened is the private sector market called securitization is really exploding on automobiles instead. It's actually working fine. Auto sales are up 15.7 million and securitization of auto loans is actually flourishing. So, if I'm a lender I can securitize those loans and sell them off to banks. I can take 1,000 auto loans and sell them to banks in China or in Europe.

Securitization in the mortgage space with home loans is not working, even five years after Lehman. And because of that every mortgage that is issued is a liability to the taxpayer, pretty much. If the bill succeeds it's going to create a super insurer.

In 2007, at least one and half times of economic growth was down to securitization. Now, a lot of those loans were good, but many were bad. Today not many of the goods ones are being done because Fannie and Freddie are broken and they haven't reformed. And that's a huge holdback.

The bottom line here is, it's holding back the U.S. economy because the U.S. economy doesn't have the securitization engine that the auto sales industry has. Auto sales are back above 2007 levels, but home sales are still down 60 percent and that's because there is no securitization in home lending.

For more information on Lawrence McDonald's new book and his financial insight, check out his website and Twitter: www.lawrencegmcdonald.com and @Convertbond

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57 Comments

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Condley

China is perhaps the most "capitalistic" country on earth today. Companies are moving their business to China because that is where the growth is. China and their neighbor, India, outnumber the United States 7:1. That means for every dollar of goods sold in the United States you have a potential of selling seven dollars in the China/India market. When you couple that with a GDP growth in China of about 7-8% compared with the United States at 1-2% it is even more impactive. People in the US are going to have to do a "reality check". The jobs being moved to China and India are NOT Untited States jobs. Those jobs belong to the stock owners of the corporations, and not the United States government. Corporations are not social programs. If you want more jobs to remain in the US, then you are going to have to make it easier to do business in the US. Our government has done nothing but make it harder to business here with every passing year.

September 13 2013 at 2:03 PM Report abuse rate up rate down Reply
CADNR

See my comment earlier? China is the tit. The rest of the world is ******* at it. If it dries up its ADIOUS BABY!

September 13 2013 at 12:05 PM Report abuse rate up rate down Reply
blueyeagle1

If China's economy has a big downturn the could have a revolution because of a huge loss of jobs....if that happens all these American companies that have made huge investments there could find their assets natioinalized! That is what you get for taking billions in investment money needed to support American job growth OUT of the US economy and investing it in a Communist country!! This was greedily done to take advantage of the Chinese people by supporting paying almost slave labor wages, you will pay for thjios and you should NOT be bailed out in any way!!

September 13 2013 at 12:00 PM Report abuse rate up rate down Reply
alfredschrader

China ? They are in the driver's seat. They are close to perfecting the "loop". What is the loop ? It's a steady flow of goods and recyclables. How it works is a product is produced, say a washing machine, it gets shipped say to Peru. It lasts about 5 years and is junk. It then goes to a Peruvian recycle center and loaded onto a barge for China who then disassembles it into iron, copper, aluminum, and plastics. Smelts it all down and re-mills it into material for manufacturing in a continuous loop, which they almost have perfected as you read this.

September 13 2013 at 11:27 AM Report abuse rate up rate down Reply
hsstempe

i know a canyon in Arizona where this jackass can jump off and save himself the troulbe and everyone else. this article doesn't pay lip service to china. this cat is a class a jerk with an ego the size of the empire state building. no more....send him packing.

September 13 2013 at 11:18 AM Report abuse rate up rate down Reply
CADNR

Billy Boy. Having problems? Clue. It's written in one of his books over 60 years ago. Good Luck!

September 13 2013 at 10:45 AM Report abuse rate up rate down Reply
CADNR

Billy Rogers your so smart. Right? Answer this. What famous world leader wrote, "The Yellow Man Will Eat You?"

September 13 2013 at 10:37 AM Report abuse rate up rate down Reply
Iselin007

Where were your last known ancestors in 1066?

September 13 2013 at 10:36 AM Report abuse rate up rate down Reply
erink91321

Lending for Houses or other major purchases can Never be secure since no one knows when the borrower , for what ever reason, will walk away from that loan

September 13 2013 at 10:13 AM Report abuse rate up rate down Reply
1 reply to erink91321's comment
Kent

The house is the security. What you're talking about is an unsecured loan. A credit card is an unsecured loan. If the card holder doesn't pay, Visa doesn't take away the items that the card holder bought with the card.

If a howe owner doesn't pay, the bank takes the house and resells it.

What got banks in trouble was letting people borrow large sums, with little equity in the house, and no verification of income. And banks weren't verifying home values. When I bought my house in 1998 and refinanced in 2008 and early 2008, the appraiser did a "drive by" appraisel, merely look at the house from the street and comparing it to previous sales.

When I did a refinance in 2009, the appraiser did a walk through the entire house and start pulling up numbers from the township appraiser for my house and other houses of similar size and style. That, despite the fact that I was borrowing less than half of what I thought the house was worth.

September 13 2013 at 10:47 AM Report abuse rate up rate down Reply
Iselin007

The middle class on down declines with every bust and recovery as the jobs become more crappy each time. Greed is so typical today a software program could replace the CEOs.

September 13 2013 at 9:59 AM Report abuse rate up rate down Reply
1 reply to Iselin007's comment
Kent

I heard Robert B. Reich say several years ago that the job of CEO is far more difficult today that it was 30 years ago, when companies did run themselves.

A CEO must evaluate the business model and operations almost daily, as well as the companies competitors. And competitors are now global and not just domestic.

Further, a CEO has to do a lot of traveling to various plants and offices around the world to get employee feedback. My father worked for a Fortune 50 company from the mid 1940s to the early 1980s. The CEOs never visited plants, even when a plant expanded, or a new plant opened. That often was left to division VPs.

By the same token, don't blame the CEO and the senior management team for greed. That comes from the major shareholders who want to get the stock price up quickly, so they can sell and take their money. Look at Carl Icahn and Norman Peltz, who buy up large amounts of stock, and then start trying to tell management how to increase earnings. Peltz actually told H.J. Heinz management that it needed to get more people to put ketchup on their french fries.

September 13 2013 at 10:41 AM Report abuse +1 rate up rate down Reply