Lehman Brothers – What It Can Teach The Cryptocurrency Business About Lending

Blockchain, FinTech, Innovation, Investing, Regulation | September 17, 2018 By:

In the years leading up to the economic meltdown of 2008, life was good. Housing prices were up, mortgages were being handed out like candy, and bankers were living large. It was all thanks to a niche security asset that had exploded in popularity: collateralized debt obligations (CDO), which packaged individual loans, such as credit card debt and mortgages, into a secondary market product for investors. In just six years, from 2000 to 2006, the CDO market exploded with sales multiplying from $69B to $500B.

Lehman Brothers, the fourth largest investment bank in the US, invested heavily into these securities, and enjoyed incredible profits as a result. In 2007, Lehman reported net income of $4.2B on $19.3B revenue.

There were, however, several glaring problems.

The majority of CDOs were comprised of subprime mortgages. Rated triple-B, at the bottom of investment-grade bonds, these mortgages had been distributed to borrowers with higher-than-average credit risk. Computer models had packaged these CDOs into “tranches” based on interest rate and risk, making CDOs incredibly opaque and complex. These models also assumed that the housing market would continue its upward trajectory.

Trouble started brewing when the market began to correct. Delinquencies on subprime mortgages rose. Bear-Stearns, the second-largest underwriter for these mortgage-backed securities, had two hedge funds fail spectacularly in August 2007, sparking a credit crisis. A year later, on September 15, 2008, Lehman Brothers shut their doors for good, a hallmark event in the downward spiral of the economy.

In the era of banks “too big to fail,” what made Lehman Brothers the exception to receiving government bailout money?

Simple — they didn’t have enough collateral to backup a loan from the federal government.

Even though the lack of regulatory oversight contributed to the recession, it is telling that when it came to their own resources, the Fed was much more prudent about how it distributed out loans.

STRUCTURAL SHIFTS NEEDED

Have the banks learned their lesson?

In an economy that is relatively stable but has yielded shrinking returns, CDOs are on the rise once more. According to analysts, these CDOs, now primarily comprised of corporate debt, are structured with safeguards against the risks that propelled the 2008 meltdown.

Still, there are no guarantees that outside market forces won’t impact these investments and create a snowball effect akin to the subprime mortgage crisis.

Our financial system certainly cannot operate without lending — but we doom ourselves to repeating mistakes of the past if we don’t make fundamental structural shifts. Implementing full reserve banking, most lucidly detailed in the Chicago Plan by professor Henry Simons and economist Irving Fisher, is a principled method for ensuring security and stability in banking.

Essentially, the Chicago Plan calls for separating monetary and credit functions in banking. It requires deposits backed 100% by government-issued money and financing bank credit through government-issued money or the borrowing of such funds from non-banks.

It boils down to the simple concept that banks shouldn’t have the ability to create money out of thin air.

It may seems obvious, but we’ve been operating otherwise for a long time. But the lesson of the 2008 financial crisis is clear — loans and credit must be backed by tangible collateral.

The collateral of the future

That brings us to the next evolution of finance: cryptocurrency.

These digital assets represent a new way to store wealth. They are built on a technology called the blockchain that enables decentralization and distribution of trust and consensus; banks no longer have to serve as the trusted mediator in financial transactions.

Not only does blockchain create a mechanism for transparent peer-to-peer lending, cryptocurrency serves as ideal collateral for fiat-based loans. Unlike a CDO security, which is backed primarily by debt, Bitcoin and other digital assets hold several key advantages:

  • The ability for instant liquidation

  • Prices determined by the market

  • The ability to be sold with a simple stop-loss order

The loan never needs to be auctioned off, because the value of the asset remains clear and the transaction retains simplicity. Involved parties have autonomy over the process, and borrowers can set terms based on the level of risk that they are comfortable with. Crypto also needs liquidity in order to mature; using it as backing for fiat loans is an elegant solution that many fintech companies are incorporating into their offerings.

AVOIDING THE EASY ROUTE

For crypto to grow into its full potential as an asset class, it is important to avoid the temptation of the easy route banks and regulators took in the years leading up to 2008. Especially for such a young market, the short-term gains aren’t worth the destabilization; crypto lending products must utilize solid collateral.

The economy can certainly appear to thrive when banks generate credit at their convenience, but as revealed by the Great Recession and the demise of Lehman Brothers, the house of cards eventually comes tumbling down. Prudence and rigor must be exercised, even if it doesn’t necessarily pay astronomical dividends — that means ensuring borrowers have the resources to justify credit they receive. The convenience of consensus and trust on the blockchain, as well as the use of crypto as collateral, solidifies the value of the loan and mitigates unnecessary risk in the lending process, contributing to a more stable, prosperous economy.