A new study argues that the Federal Reserve could have saved Lehman Brothers from bankruptcy, but chose not to, partly because of political pressures.
Eight-and-a-half years ago, Lehman Brothers filed for Chapter 11 after failing to secure a bailout from the Federal Reserve. The immediate result was financial tumult, throwing the U.S. and much of the world into an economic crisis that led to widespread anger and frustration that contributed to the election of Donald Trump.
In the aftermath of the crisis, some commentators argued that much of the damage could be traced to the Fed’s decision to let Lehman fail instead of providing it with the liquidity it needed to keep operating. Some have suggested numerous reasons for this decision, from concern over potentially creating moral hazard to alleged hostility among former Wall Street executives in government and policymaking toward Lehman Brothers, their former competitor. The reason given by the Fed and other public officials is that they wanted to bail out Lehman but could not do so due to legal constraints: Lehman did not have enough collateral, and the Fed therefore could not legally provide them with loans.
Is that really the reason Lehman was not rescued? Laurence Ball, the chair of the Department of Economics at Johns Hopkins, spent four years attempting to answer this question, poring over the transcripts of meetings between Fed officials and other policymakers as well as other evidence that could shed light on decisions made before and after Lehman’s collapse. The result is a mammoth 218-page paper in which he tries to supply a definitive answer to the question of why Lehman was not rescued, while Bear Stearns, AIG, and many other institutions were.
Ball’s findings appear to contradict the official reason given by the Fed and other decision makers as to why Lehman wasn’t rescued. Contrary to claims that the Fed could not legally intervene, Ball analyzes the value of Lehman’s collateral and finds that the firm had assets worth at least $131 billion that could have been accepted as collateral. He also estimates that Lehman could have survived with a $88 billion loan from the Fed. But Fed officials, he argues, did not even discuss the quality of Lehman’s collaterals, let alone conduct any detailed analyses.
Instead, Ball argues that Lehman was not rescued due to the criticism of previous bailouts and takeovers such as Bear Stearns and Fannie Mae and Freddie Mac, and fear of political backlash, particularly by then-Treasury Secretary Henry Paulson.
In order to better understand Ball’s version of the events leading up to Lehman’s collapse and those after, we recently interviewed him for ProMarket.
Q: Determining why Lehman was not rescued and whether it could have been rescued is a big project. You worked on this study for four years. Can you explain how you approached this material?
It is a little unusual, though it is very easy. Everybody has an opinion about Lehman Brothers and why the Fed did what it did and whether it was political or not. Actually, there were two investigations: the bankruptcy examiner Anton Valukas’ report and the Financial Crisis Inquiry Commission. They both had subpoenae power, they interviewed everybody, they got all the emails between people at the New York Fed on the final weekend, and they both have very user-friendly websites. So it’s very easy to look at what New York Fed members were saying to one another on September 14, 2008.
A lot of it is a matter of looking at a record that’s very accessible—it does take a while to interpret it, but there’s a lot of information available.
Q: Did you start with any hypothesis or narrative in mind?
I got interested in what was the reason they let Lehman fail. The Fed gave us a very clear story, that it wasn’t political, that they weren’t trying to do something about moral hazard, that it was not legal to lend to Lehman because they did not have enough collateral to borrow the amount of money they needed to survive, which is a legal requirement for them to lend.
So I just wondered if that’s true, and pretty quickly it looked to me as though it’s not true. Then it became a matter of trying to document: the heart of the paper is just trying to document how much collateral Lehman had and what their liquidity needs were and to show they could have been rescued and kept going—that their collateralized loans weren’t risky for the Fed and were therefore legal.
There’s also another aspect—and the Financial Crisis Inquiry Commission actually mentioned this in their report but didn’t emphasize it: the story that there wasn’t enough collateral and that’s why we didn’t lend, that’s something they have said only since the bankruptcy. There’s this big record of discussion before the bankruptcy among policymakers and they’re discussing what will happen to the economy if Lehman fails, how much political criticism they were going to get if they rescue them.
We can put it somewhat bluntly that the explanation that Fed officials give is something that they developed after the event, to try to give justification that doesn’t fit the facts.
Q: Can we say that the two main conclusions of your study is that the Fed did not even discuss the possibility that Lehman doesn’t have enough collateral, and that had they had this discussion they could have bailed Lehman, as they did other financial institutions?
That’s a good summary of the two main points. You can’t quite prove the negative, that nobody ever talked about it, yet there is this tremendous record of what they did talk about and there’s no mention of the collateral issue. When Ben Bernanke testified before the Financial Crisis Inquiry Commission, he said people at the New York Fed determined there wasn’t enough collateral, and they repeatedly asked him, in the hearing and in a follow-up letter, to give them details: Who did the study? How much collateral did they have or not have? And he just didn’t answer the question. The logical conclusion is that they didn’t look at that.
In a sense, what I try to do in the paper is what the Fed could have done: make estimates of how much Lehman needed to borrow and then look at what collateral they had. And that seems pretty clearly to me to show that there was plenty of collateral, and also that in fact the quality of collateral was higher and the degree of risk was lower than in other cases where they made loans, especially AIG.
The Fed officials say very clearly, ‘We lent to AIG because they had plenty of good collateral; we didn’t lend to Lehman because they did not have enough collateral.’
I think the facts are closer to the opposite of that. Lehman clearly did have good collateral, and it’s very doubtful whether AIG had good collateral. They were taking on substantial risk with AIG and also with the Maiden Lane vehicle that helped rescue Bear Stearns.
Q: How risky were Lehman’s collaterals compared to other banks that were later directly or indirectly bailed out?
What Lehman needed was to keep going for a while, look for a better long-term solution. After Lehman failed, Morgan Stanley and Goldman Sachs got huge amounts of lending from the Primary Dealer Credit Facility overnight repo lending. What Lehman needed was very similar to what Morgan Stanley and Goldman Sachs actually received.
That kind of lending is less risky. In the case of Maiden Lane, which they set up to buy assets from Bear Stearns, the haircut on the collateral was not very large, and critically, it was a loan for an indefinite period of time—it was not overnight loans. As the Fed stresses, in the end they didn’t lose any money on Maiden Lane or any of the lending programs, but there was a long period when asset prices went down, when the assets owned by maiden Lane were worth substantially less than the money that Maiden Lane owed to the Fed, so they were underwater. In the end the financial system recovered and the Fed got their money back, but that wasn’t pre-ordained. Ex-ante, they took on risk.
With AIG there’s the whole story that the collateral was equity in AIG’s insurance subsidiaries, and long story short, it is very unclear how much the insurance subsidiaries were really worth and how much that collateral was worth.
I actually put in a Freedom of Information Act request to the Fed to get some information about the collateral of the AIG loan and how the Fed valued it and they turned down my request. I sued them in federal court and I lost the case, so there’s information sitting at the Board of Governors about the collaterals, but it is not publicly available.
Q: You said you used the websites of the examiner’s report and the Financial Crisis Inquiry Commission. Are those the only sources you used, or did you also rely on interviews with insiders involved in the financial crisis, from the Fed or the banks?
There were some other sources of information. There were other inquiries; there’s a lot of information in the 10-K and 10-Q forms filed by Lehman Brothers over the years and books people have written that give firsthand accounts.
I actually tried to talk to insiders who were involved about what happened—I was a little bit successful but not very successful. I talked to three people who were in the room when some of the things happened, or were involved in the investigations later on—they basically gave me some background information to help me understand it.
But this is a piece of academic research, as opposed to investigative journalism, in the sense that everything I report is documented. So there isn’t any point where I say “an unnamed person in the New York Fed told me this is what really happened.”
Q: In the paper you suggest that in order to explain the decision to not bail Lehman, we have to look at other reasons why they do it, what you call political reasons, and specifically moral hazard. Why is it that the Fed was and still is so reluctant to say that this decision had something to do with moral hazard?
I am not exactly sure. To understand why the decision was made you have to know who made the decision, and I think the answer to that was Treasury Secretary Hank Paulson who made the decision.
Q: And who, as you say in the paper, had no legal authority to make this decision.
That is correct. The Dodd-Frank Act changed that, so under the law today the treasury secretary has to approve Fed lending, but that was not the law then. Legally, he had the same role as the secretary of agriculture or mayor of Chicago—he didn’t have any legal role.
But what seems to have happened, and reporters’ accounts and people’s memoirs are all quite consistent on this, is that Henry Paulson took an airplane to New York and arrived at the Federal Reserve of New York and started telling people what to do and what was going to happen. And people essentially acted as though he was the authority, even though that wasn’t what the Federal Reserve Bank Act said.
The evidence is consistent that Henry Paulson was very sensitive to politics. There was a huge political backlash against the rescue of Bear Stearns, and Paulson is widely quoted as saying “I can’t be Mr. Bailout.”
It’s impossible to really get inside somebody’s mind or figure out exactly their motivation, but I think [Paulson] was extremely reluctant politically to have headlines “The Government Bails Out Lehman.” It’s the Federal Reserve’s money, but the public doesn’t really know the different between the Fed and the government.
I think there was hope that maybe they could let Lehman fail, and they took a number of actions to expand lending to other investment banks to protect them. The Lehman holding company filed for bankruptcy immediately, but they made a plan for winding down its broker dealer. I think they had a plan and were hopeful that the damage to the financial system would not be too bad.
It only took them a day to figure out that that wasn’t working very well— this is most logical explanation to understand why they shifted with AIG. It’s one thing to say I don’t want to be Mr. Bailout politically, but when it’s clear the economy is headed for something worse than the 1930s…going down in history as Mr. Bailout is not as bad as going down in history Mr. Greatest Depression Ever.
Q: It’s out of the realm of this paper, but do you think that had they bailed out Lehman, we might have prevented or mitigated the financial crisis?
So that’s a fascinating question. It is out of the realm of the paper, but I can speculate as well as anybody else. That’s very controversial, but some people would say that inevitably there was a crisis and if Lehman hadn’t failed somebody else would have failed.
Let’s say we put aside political constraints, and the Fed is going to to do whatever they need to do from a policy point of view to minimize the crisis, I think it’s possible that no big institutions would have declared bankruptcy, and that consequently the financial crisis would have been a lot more limited. It’s also possible even that the Fed and the government would have had to do less: with AIG there was actually a tentative private sector arrangement for a bunch of banks to lend AIG money, and that fell through at the last minute on September 16—I think, partly, because of the panic induced by the Lehman failure.
I think it’s quite possible that if they just made a decision to rescue Lehman, then the whole financial crisis would have played out differently. It’s still not as if nothing would have happened, but it might have been more like when the tech bubble crashed in the early 2000s and the stock market fell and that caused unemployment to rise from 5 percent to 6.5 percent for a little while. Maybe there would have been a recession, but it would have been possibly much less severe, and the economy would be much more healthy today.
Q: What about the risk of moral hazard?
This is obviously a matter of debate, but Ben Bernanke actually gave an analogy which I think is a fairly good analogy: if someone carelessly sets his house on fire and the house is burning down, do you say “Let’s not send the fire truck because other people would care less about smoking in their houses”? I think most people would say that having the house burn down is too big a cost; we have to rescue the person and going forward we have to have better building codes to prevent that from happening in the future.
I would say the right combination of policies would be to say we can’t let the economy burn down, but then let’s try to take some lessons of what regulations we need in the future. Letting Lehman fail so that everybody can learn a lesson was certainly very costly for the world economy—hard to imagine that was the best approach.
Q: In a way, the narrative you present in this paper could be interpreted as saying that the cause of the crisis was not reckless behavior by the banks and regulatory capture and corruption. That policymakers had made one major mistake with Lehman, and much of the crisis stemmed from that major mistake, and therefore we don’t need dramatic reforms in the banking system.
Possibly, that would be one way to interpret it. I am certainly not saying that everything was perfect in bank regulation, and I would probably be in favor of not letting investment banks have capital-to-equity ratios of 40. However, one way to put it is that the big problem, certainly with Lehman Brothers and a lot of other institutions, was primarily a liquidity problem. They had liquidity crises which caused Lehman to go bankrupt and almost caused other institutions to go bankrupt until they were rescued.
Another way to put it is that Lehman had assets of $600 billion, and they lost $30-$50 billion, something like that. There’s this language that all their assets were worthless or that they were extremely insolvent. That’s exaggerated.
I am uncomfortable coming out as saying we don’t need financial reform, but the logic is right. To the extent that we say we need to have financial reform because this crisis was so horrible, I think one point against that is that if the existing policy tools had been used the way they should have, the crisis would not have been as bad.
Q: In the aftermath of the crisis, there were rumblings that the reason Lehman was allowed to fail while other institutions were bailed out had something to do with the fact that the government was filled with former competitors of Lehman, and they were the ones calling the shots.
I read that. I don’t think that’s really true. There were also stories about Henry Paulson who had been in charge of Goldman Sachs and supposedly didn’t like Richard Fuld, who was head of Lehman Brothers—that may be true, I don’t know, but I think it’s pretty clear that Henry Paulson did not want Lehman Brothers to fail and did not think this was a good thing or tried to get back at his rival on Wall Street. Paulson knew that at best he was taking a very big risk, and he did work very hard to try to arrange for some kind of private sector rescue of Lehman. The last big hope being the Barclays acquisition that didn’t work out, and he was very unhappy. In the end he did everything he could to prevent Lehman’s bankruptcy, whether he liked or didn’t like Richard Fuld. Except he wasn’t willing that the Fed put in money because of the political consequences of that.
Q: Eight years after Lehman’s collapse, what conclusions should policymakers draw from your paper? What can we do differently next time?
There are two or three possible lessons: first, I think that the Fed had the tools available to provide safe liquidity support for Lehman and probably prevent its bankruptcy, and that it would have been better if they had done that. The Dodd-Frank Act goes in the wrong direction in making it harder for the Fed to have future rescues.
Just recently the Fed announced a rule that any lending program has to help a substantial number of firms, I think they define that as at least five firms, so you can’t have a specific rescue for a specific firm. That would have made what they did for Bear Stearns or AIG illegal. So one lesson, I would say, is that the restriction on the lender of last resort is a step in the wrong direction.
Another lesson in terms of Fed governance is that people in the Fed and elsewhere talk a lot about how the Fed is independent from politics, and how the fed is transparent about its policies, and how important it is to be transparent with the public and Congress about what you’re doing. I think this is an example of what may be the most important decision in a long time, and they were not politically independent—they did what the Treasury Secretary wanted—or transparent, in that they did not give an accurate accounting of why they did what they did.
Q: Your paper puts the onus on regulators and policymakers. Do you feel comfortable with a narrative of the crisis in which it was not caused by Wall Street recklessness but government incompetence?
No, I certainly would not put it that strongly. I certainly think financial institutions did some things which in hindsight were imprudent. If it’s a question of who’s to blame for the financial crisis, I tend to think that basically everybody you can think of shares in it: people were buying houses that they couldn’t afford, banks were lending money to people who they should not have been lending money to, people were securitizing mortgages that were of low quality and should not have been marketed, lawyers who were supposed to be looking in detail at how they were securitized were not paying attention, regulators were not paying attention, academic economists were not paying attention.
I think that just about everybody involved in finance or policy or the mortgage market, in retrospect, made mistakes. As to exactly what percentage of the blame to give to Wall Street vs. the government vs. people who didn’t pay back their mortgages, I am not sure.