The Man Who Predicted The Fall Of Lehman Brothers Now Says Big Problems Looming For China And Asia: Q&A With Former Lehman Brothers VP Lawrence McDonald

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.

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 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 [that] Bank of America has 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, which 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 of 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.

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 do with the financial crisis?

What they’ve done is: Dodd-Frank is like an eight-lane highway. Some cars are moving at 10 mph and some are doing 90 mph, but the cars that are going 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 to 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 were hundreds of billions of these things and these losses needed to be borne back into the banks, so the banks were breaking down in terms of 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 the U.S. is 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 we're seeing since Lehman [collapsed] 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 the winners and losers were. When Greece went down, the bondholders, same thing – a small group of politicians 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