Laurence Ball, Professor of economics at Johns Hopkins University, says that key policy makers have not been transparent about the failure of Lehman Brothers. He claims that the Federal Reserve could have rescued the imperiled investment bank but chose not to because of political pressures.
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Professor Ball, the bankruptcy of Lehman Brothers shocked the world. What’s the main takeaway from the outbreak of the financial crisis looking back from the distance of a decade?
In the fall of 2008, all the big investment banks – Lehman Brothers, Bear Stearns, Goldman Sachs (GS 231.91 -0.85%) and so on – were in a fragile state for the same combination of reasons. First, they all had big investments in real estate which produced losses when the housing bubble burst. Second, they were highly leveraged so that once they started losing money on real estate, their low levels of equity got even lower and people started worrying that they might become unviable. The third factor that proved fatal was that these firms were so heavily dependent on very short term, often overnight, borrowing to operate their business. So, when people started to worry about their viability we had essentially a twenty first century version of a bank run: The investment banks were cut off from funding and couldn’t get cash to operate.
But why was Lehman the investment bank which went bankrupt?
All these investment banks had such different faiths and history has judged them so differently. For a lot of people, Lehman Brothers and CEO Dick Fuld were the great villains of the financial crisis. But Lehman didn’t do anything very differently from all the other investment banks. For instance, as of 2007 the magazine «Fortune» named Lehman Brothers the most admired securities firm. There was no obvious reason why Lehman should suffer a much worse fate than other investment banks.
Nevertheless, it was Lehman which went belly up in the fall of 2008.
The first thing to say is what’s not the explanation for that. Former officials of the Federal Reserve and especially Chairman Ben Bernanke have said repeatedly that the reason they didn’t rescue Lehman Brothers was that Lehman did not have enough collateral for an emergency loan. They say that under the law they could not lend to a firm unless there is adequate collateral. They also say that all the firms they did lend to – Bear Stearns, AIG and so on – did have enough collateral. So, it was legal to lend to them. But long story short: This is not true. Lehman had plenty of collateral. Actually, in the case of some of the firms the Fed lent to, the collateral was more questionable.
How do you come to this conclusion?
The policy makers today keep saying the same thing: The reason that they did not rescue Lehman Brothers was that the bank did not have enough collateral for the amount of cash that it needed to borrow. That is untrue in two distinct ways. It’s first of all untrue in the sense that they did not pay any attention to collateral. There is a lot of hard evidence from investigations by the bankruptcy examiner, by the bankruptcy court and by the financial crisis inquiry commission. So, you don’t have to do much guesswork. You can see what the policy makers were discussing. On one hand, they were talking about that a rescue of Lehman would be politically horrible. On the other hand, they were talking about that it might hurt the economy if they don’t rescue Lehman. But the concept of collateral legality was not brought up. This is a story that was invented after the bankruptcy as an excuse.
Then again, the situation in the fall of 2008 was very messy. Hardly anybody knew what exactly was going on in the financial markets.
But if the policy makers had actually looked at how much collateral Lehman had they would have found that Lehman had plenty of collateral. In my book, I do a version of the calculations they could have done in real time. Sure, Lehman had things like equity stakes in real estate developments or private equity firms which were very hard to value and very illiquid. But Lehman had also corporate equities, corporate bonds and mortgage backed securities on the balance sheet. The other investment banks – both before and after the Lehman failure – were borrowing money from the Fed using those securities as collateral. Of course, there are a lot of details. But the bottom line is that Lehman had plenty of assets that could have been pledged as collateral.
What’s the real reason for the Lehman bankruptcy then?
The real reasons had to do with the particular political and economic circumstances which lead the policy makers to rescue some banks and not others. Bear Stearns was the first investment bank to get into trouble and policy makers realized that a failure could do damage to the economy. So, they rescued Bearn Stearns. But then there was tremendous political criticism from all across the spectrum: The liberal Democrats were saying: «You give away tax payer money to Wall Street.» Conservative Republicans were saying: «This is socialism, you’re taking over the banking system, you’re interfering with free markets». So, Barack Obama and John McCain who were presidential candidates both came out against any more government help for big banks.
So, who’s to blame for the tragedy that unfolded with the Lehman crash?
First of all, a lot of people are to blame for the fact that there was a financial crisis. Certainly, the Lehman executives and the executives of other firms made risky bets that in retrospect they shouldn’t have done. Also (ALSN 117.2 -0.68%), people took out mortgages they shouldn’t have taken out. Banks made loans they shouldn’t have made. Regulators did not do as good a job. Actually, you could have a long list of people to blame why we ended up in a crisis situation.
And what about in the case of Lehman particularly?
Lehman Brothers had the misfortune to be the second bank to get in trouble. Given how much criticism there had been of the first rescue with Bear Stearns policy makers decided not to rescue Lehman. Maybe, they engaged in some wishful thinking that the economic effects wouldn’t be too bad. For this big mistake I think Treasury Secretary Henry Paulson, Fed Chairman Ben Bernanke and Tim Geithner, the head of the Federal Reserve Bank of New York, are to blame in somewhat different ways.
What do you mean by that?
Under the law at the time, the authority to decide whether the Federal Reserve could make a loan or not was entirely the Fed’s decision. With respect to this decision, the Treasury Secretary legally had as much authority as the Secretary of Defense or as the Mayor of Chicago or anybody else. But as far as I can tell, what happened in practice was that simply because of the force of his personality, Paulson arrived at the New York Fed and told Geithner what to do. Geithner followed his instructions and Bernanke stayed in Washington. That’s why I think one can blame Paulson for making the decision not to rescue Lehman for political reasons. One could also blame Bernanke and Geithner for not standing up to Paulson and saying: «This is none of your business». Legally they could have said: «We don’t care about your political problems. We are going to do what’s right for the economy.» But they didn’t do that.
It’s also no secret that Paulson and Lehman CEO Dick Fuld didn’t get along. How important was their tense relationship with respect to Lehman’s fate?
Dick Fuld and Henry Paulson were rivals on Wall Street when Paulson was the CEO of Goldman Sachs. I don’t know it personally. But what people say is that they didn’t like each other and maybe that Paulson was happy to have a chance to make Fuld’s firm fail. I think that is exaggerated at best. Paulson was not happy that Lehman failed. He tried very hard to avoid that outcome. In his book, he writes: «I worked night and day to try to rescue Lehman. I was desperate for them not to fail. I tried to arrange a take-over.» That’s true, just with the exception that when all else failed Paulson was not willing to allow the Fed to be the lender of the last resort for Lehman.
Read the full article here by Christoph Gisiger, Finanz und Wirtschaft
