On September 15, 2008, the global financial system was on the brink of a collapse. The trigger for the worst financial crisis in generations was the failure of the US investment bank Lehman Brothers. Key policy makers at that time have strongly assorted that they lacked the legal authority to save Lehman because the staggering financial giant did not have adequate collateral for the loan it needed to survive.
Laurence Ball disputes that explanation. In his new book, «The Fed and Lehman Brothers: Setting the Record Straight on a Financial Disaster», he debunks the official narrative of the crisis. Based on a meticulous four-year study of the Lehman case, he shows that the Federal Reserve could have rescued Lehman, but officials chose not to because of political pressures and because they didn’t understand the damage that the Lehman bankruptcy would do to the economy.
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 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 Bear 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, 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.
How about the executives of the other big Wall Street banks? How did they experience what happened during Lehman’s final days?
They were very worried. The whole story of the weekend of September 13 and 14 is very complicated. On Saturday, everybody thought there was a deal: Barclays was to acquire Lehman. But as a condition, Lehman was going to spin off about $30 or $40 billion of assets that Barclays didn’t want. This was similar to JPMorgan Chase saying Bear Stearns has to get rid of some assets before they buy them. The difference is that in the Bear Stearns case the Fed set up Maiden Lane to buy the unwanted assets. In the Lehman case, a group of the big Wall Street firms had agreed to finance the unwanted assets. So, Goldman Sachs, Citigroup, Credit Suisse and other firms were worried enough that they were willing to put up several billion dollars each to try to help rescue Lehman. But then on Sunday, at the last minute, the Barclays deal fell apart because of objections by regulators in the UK.
How much money would have been needed to rescue Lehman?
The policy makers made a bad mistake in the case of Lehman. To their credit, they recognized the mistake quickly within a day or two when they saw that everything was falling apart. At that point, they changed course completely and rescued AIG and everybody else. AIG got well over $100 billion in loans and Morgan Stanley got around $100 billion. Of course, we don’t know exactly how much funding Lehman would have needed. But I estimate it would have needed around $84 billion – and again: this sum could have been backed by good collateral. It wouldn’t have been such a risky loan.
Instead Lehman ended up as the largest corporate bankruptcy in US history. What exactly happened on September 15th?
This was the largest bankruptcy ever. It was incredibly complex. Actually, some bankruptcy proceedings are still going on today. Bankruptcy law is very complex. You do a lot of planning. You have a series of first day motions where you sign you’re going to go bankrupt on a certain day and when you go into court you already have a whole bunch of plans for what’s going to happen during the bankruptcy. For my research, I had a talk with Harvey Miller who was a famous bankruptcy lawyer and was the lawyer for Lehman Brothers. He stressed that there was an incredible lack of planning. The way he put it was, that the bankruptcy petition Lehman filed was one of the shortest bankruptcy petitions in history. It was written in a few hours although this was arguably the most complex bankruptcy in history. So, it was extremely inadequate and just chaotic.
In an alternative universe: What would have happened if Lehman was rescued?
We will never know for sure. But I feel pretty strongly that the whole financial crisis probably would have been quite a bit less severe. As far as Lehman is concerned, I think it’s possible that if Lehman had survived it could still be an independent firm today. It’s also possible that Lehman would have had to be wound down over time. But one thing is quite obvious: We would not have had this chaotic bankruptcy.
Then again, Lehman wasn’t the only big bank that got into trouble. The whole financial system was drowning in debt.
Of course, there were problems. We had a housing bubble and risky things were happening on Wall Street. People were going to lose some money. If you look at the weeks before the Lehman bankruptcy, the US unemployment had risen somewhat to 6%. There were falling house prices and there were problems in the economy. But nobody expected the catastrophe we saw. This was the result of the panic that broke out when Lehman failed. I think when Lehman would have been rescued we might look back at this episode the way we look back at the savings and loans crisis in the 80s or at the bursting of the dotcom bubble in 2000. Those were cases in which financial mistakes were made. Billions of dollars were lost and there was some effect on the economy. But nothing like the catastrophe of 2008/09.
What were the consequences of the Lehman crash?
Again, nobody can know for sure. But I think the whole crisis and the great recession would have been quite a bit less severe if Lehman would have been saved.
Also, a big question is how US politics might have been different. American voters turned out to be very angry in 2016. As a result, they elected the kind of person I might have thought would never be elected president. Maybe things would have been different if the economy had not suffered such a big blow.
So, what’s the big lesson of the Lehman crisis?
One big lesson is that the Federal Reserve should be ready to do its job as the lender of last resort. We don’t know when the next financial crisis will occur. This last time it was subprime mortgages, the next time it will be something else. Important is that at some point there will be another big financial institution in which people lose confidence. Therefore, we need the Fed to be ready to provide liquidity. It’s very worrisome whether that will actually happen because a lot of people have taken away the wrong lesson. I fear that the next time there is a crisis there will once again be political pressure on the Federal Reserve not to commit any funds. Also, the Dodd-Frank Act goes in the wrong direction in one way because it puts some legal restrictions on the Fed’s ability to lend. The details are a little bit complex. But if we had the same history and there was some firm just like Lehman in the same situation, it’s possible that under the current law it would be illegal for the Fed to rescue it.
Today, Mr. Paulson, Mr. Bernanke and Mr. Geithner are celebrated as courageous heroes who saved the global economy from the financial crisis. What are your personal thoughts on that?
I can imagine some kind of counterfactual world in which Fed officials said: «Well yes, we were not perfect. We did our best to combat the financial crisis on September 14 when we had a few hours to figure out what to do in this incredibly complex situation. We hadn’t slept, and we didn’t get it quite right. But when we realized our mistake we changed gears the next day and did all these great things.» So, I would not criticize them for not being perfect. But that is not what they’ve said. They have absolutely refused to own up to any kind of mistake. They stuck to this line that «we didn’t have the legal authority» – and that’s just not true.