Bernanke, Geithner and Paulson ‘have invented alternative history’ of Lehman collapse, professor says
Nearly ten years ago, Lehman Brothers, declared bankruptcy after a frantic weekend of unsuccessful talks to find a buyer at the New York Fed.
Lehman’s collapse followed the takeover of Bear Stearns in early March by J.P. Morgan Chase JPM, -0.08% that was assisted by a Fed loan and the government takeover of Fannie Mae FNMA, -0.34% and Freddie Mac FMCC, -1.24% .
The outcome has always been controversial.
After rescuing Bear Stearns and the GSEs, no public money was provided Lehman to stay afloat. Days later, the Fed reversed course, providing assistance to two other investment banks, Goldman Sachs GS, -0.50% and Morgan Stanley MS, -0.65% through access to loan programs. Goldman’s total borrowing peaked at $69 billion while Morgan Stanley’s peaked at $107 billion. The Fed also rescued American International Group AIG, -1.02% through an initial $85 billion line of credit. This was followed by the broad $700 billion bank bailout that Congress passed, known as the Troubled Asset Relief Program.
Ben Bernanke, Timothy Geithner and Henry Paulson have all said that they wished to rescue Lehman but that their hands were tied because Lehman did not have enough collateral to allow the government to provide a financial lifeline.
Laurence Ball in a new book “The Fed and Lehman Brothers, Setting the Record Straight on a Financial Disaster,” debunks this official narrative.
An economics professor at Johns Hopkins University, Ball says there was no discussion of Lehman’s collateral or the legality of a loan during the crucial weekend. In addition, he said that Lehman did have enough collateral, if anyone had looked. Other analysts, including Joseph Gagnon of the Peterson Institute for International Economics, have argued that Lehman was probably deeply insolvent at the time of its bankruptcy.
MarketWatch sat down with Ball to discuss the findings of his book.
Henry Paulson said this recently:
“The thing we get the most criticism for is letting Lehman go down. Despite the fact that the three of us have all said , you know, we did everything we could to save Lehman. We didn’t believe then and don’t believe now a single authority we had that would have worked. Many people say well “they were able to save Bear Stearns, they were able save AIG, why couldn’t they save Lehman?“ We answer it and most people still don’t believe us.”
You don’t believe them.
I don’t believe them. They have been asked that question again and again and they have given the same answer again and again. And when I first started researching this I didn’t know what the right answer was — there were such starkly different claims. But having spent four years looking at the evidence — and there’s a lot of evidence, what Secretary Paulson is saying there is just simply not true.
What the three officials say is that Lehman didn’t have enough collateral so that the Fed couldn’t legally give them a loan.
Yes, that’s the sense of it. And actually that is absolutely incorrect in two related, but distinct, senses. First of all, in terms of their decision-making— again there’s a big record from some investigations with subpoena power about what people were discussing in that weekend — they were discussing various economic and political ramifications of letting Lehman fail or not letting Lehman fail. They were not discussing does Lehman have enough collateral – do we have the legal authority. So that was not the reason that they made the decision. In addition, at this point it is possible to go back and put together the numbers, there is enough data on what Lehman’s assets were, what its liquidity needs were, and if one actually does that exercise, it is clear that Lehman did have ample collateral for the loan it needed to survive. So, if the Fed had asked is there enough collateral, the answer would clearly have been yes. They could have made a loan, it would have been legal, it would not have been very risky, and probably the whole financial crisis and Great Recession would have been less severe.
Paulson was trying to say to Wall Street, we’re not going to bailout Lehman, let this be a lesson for you. In essence that’s Elizabeth Warren’s anti-bailout view. But it didn’t last more than a day or two.
What I, in my opinion, establish with absolute certainty in the book, is that the official explanation about legal authority and collateral was simply not correct. Again the fact that those three impressive people say it again and again, very strongly, does not make it true. As far as what then is the real reason, there we have to be a little bit more speculative, and my conclusions there are not terribly original: I think it was political.
Of course, many people have said all along obviously it was political but everything I’ve seen is consistent with that. It wasn’t just Elizabeth Warren, it was everybody. It was the one completely bipartisan issue with Bernie Sanders saying this is a giveaways to the rich and conservatives saying this is socialism taking over the banks. The two presidential candidates Barack Obama and John McCain both issued very stern statements. This was right after the takeovers of Fannie Mae FNMA, -0.34% and Freddie Mac FMCC, -1.24% . Obama and McCain issued statements saying we can’t have any more of this nonsense. So there was tremendous political pressure. In addition to that, there was an underestimation of the damage the failure would do, maybe some wishful thinking.
And you’re absolutely right that there was a 180 degree turn in a day-and-a-half when they rescued AIG. I would put a positive interpretation on that.They made a bad mistake, one that they have not owned up to. But at least they quickly saw what a bad mistake it was. Henry Paulson widely was quoted as saying I can’t be “Mr. Bailout.” But I think he realized pretty quickly that being “Mr. Caused The Worst Depression Since The 1930s” would be even worse, so we’re lucky that he and the other policy makers at least were flexible enough to shift course.
Because Lehman was the accelerant on the financial crisis?
Yes. Federal Reserve economist several days before the Lehman bankruptcy predicted that the unemployment rate would peak at 6% because of strains on financial markets. Lehman was the event that caused strains on financial markets to turn into… people use metaphors like tsunami, trainwreck and so on.
Earlier in 2008, in March, Bear Stearns has been rescued. Lehman failed in September. What happened in between?
There were the big five investment banks and Bear Stearns was the fifth biggest and they were very invested in real estate. So there was a lot of speculation that maybe this could happen to another one of these investment banks. And the fourth biggest, Lehman Brothers, was also heavily invested in real estate, so there was speculation perhaps Lehman Brothers could be the next one to go. Lehman Brothers actually had a very sharp shift in its business strategy. Up until the Bear Stearns event, they were continuing to try to expand in real estate. They actually thought “Gee, this is great. Real estate prices are depressed and we will buy low and make a lot of money.” But after Bear Stearns, they realized they had a big problem and they tried hard to raise capital, they looked for an acquirer, and Secretary Paulson was very involved trying to be a broker for that.
Now I think they talked to basically every global investment bank, every sovereign wealth fund, Warren Buffett, Carlos Slim, anybody with money, and no deal was done. I think various people I think including Secretary Paulson think the problem was that Richard Fuld, the Lehman CEO, didn’t fully face reality and had an unrealistically optimistic view about what his company was worth and wasn’t going to engage in a fire sale. Of course that changed at the very, very end, when they faced bankruptcy. I can certainly understand why Paulson and Fed officials were very frustrated. They did work very hard for six months to try to arrange at Lehman takeover and were not successful.
The problem with the investment banks is they had long term investments funded by short-term paper?
The basic mechanism by which they got in trouble is well understood. It’s really the same story for all five banks: Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman and Bear. They all had similar problems with then quite different outcomes. But there were three interrelated problems. Number one, they made these big bets on real estate during the housing boom and they lost a lot of money on those. Factor number two was they had very low equity and once they started losing money on real estate it didn’t take long before their equity started getting close to zero and people started to question their solvency and their viability. And then problem number three was exactly what you said: reliance on short-term funding -largely overnight repos – so that once people lost confidence, you had essentially the same phenomenon as a bank-run. The people who were providing them funds on a daily basis said: “We don’t want to be providing funds for somebody who might go bankrupt.” So Lehman Brothers filed for bankruptcy at 1:45 a.m. on a Monday morning because they were supposed to open for business in a few hours and pay somebody a billion dollars and they just didn’t have billion dollars. They were out of cash because their short-term financing was not rolled over.
The Fed’s job is to step in when there is a bank run.
That’s right. According to classic central banking doctrine, going back to Walter Bagehot in the 19th century, the central bank is the lender of last resort, if there is a bank run, a panic. And again, it could be an old fashioned bank run with the depositors running and taking their cash out or it could be this 21st century version of repurchase agreements cut off. The central bank’s job is to provide enough cash to keep things going. Lehman could have been kept going long enough to work out some kind resolution that was better than just telling them you have six hours to prepare a bankruptcy petition for the largest bankruptcy in US history.
Instead of acting, the two Fed officials, Bernanke and Geithner, deferred to Paulson?
The politics are interesting. Under the law at the time, it was the Fed’s sole responsibility to decide whether or not to make emergency loans. There was a procedure in which, if the New York Fed had chosen to, they could have told the Board of Governors in Washington we’d like to make a loan and to get approval for that loan by a vote of the Board of Governors. The role of the treasury secretary legally in that process was exactly the same as the role of the secretary of agriculture or the mayor of Baltimore. Now, what actually happened was that Paulson got on an airplane and flew to the New York Fed and started telling Geithner and others what to do, and at some point said: “Lehman has to declare bankruptcy.”
As far as I can tell, just by force of personality, he took over and told people what to do. I should say Geithner, in his most recent discussions, made the point that the Dodd-Frank Act has limited the Fed’s ability to be the lender of last resort and that’s possibly dangerous as far as handling future crises. One of the ways in which the Fed’s authority has been limited is now the law says the secretary of treasury has to approve [a loan]. I worry because the treasury secretary is inherently a political appointee that that might lead to politically motivated decisions. I have to say it is ironic that Geithner would bring up that point, because again he chose to follow the instructions of the treasury secretary, even though at the time he wasn’t legally required to do so.
What are the lessons for today?
There are takeaways at several levels I think. One is I think the whole financial crisis has confirmed the traditional thinking about central banking. I think we saw how beneficial it was when the Fed did perform its role as a lender-of-last-resort with AIG and Bear Stearns. We saw how damaging it was when the Fed did not step up to the plate at the key moment with Lehman. So, one narrow thing we learned is that be part of the Dodd-Frank Act that restricts the Fed’s ability to be lender-of-last-resort was a mistake and that’s dangerous and that ought to be repealed. Now, of course, in reality a number of parts of Dodd-Frank probably will be repealed and it’s not going to be the lender-of-last-resort part but maybe someday. I think more broadly, from my research , became persuaded the financial crisis didn’t have to be nearly as severe as it was. People have told a story in which there were these big mistakes made involving the real-estate bubble and too much debt and risky behavior on Wall Street and when you sin like that there has to be punishment. I think the punishment didn’t have to be so bad. I think if Lehman have been rescued we might be looking back at that episode the way we look back at the savings-and-loan crisis of the 1980s or the dot-com bubble of the early 2000s. Those were cases in which people made mistakes, financial institutions lost a lot of money, there was some effect on the economy, but much much milder. The whole Great Recession was not necessary.
I can’t help saying the other thing we learned is you’ve got to really be careful listening to government officials. Paulson, Bernanke and Geithner are correctly viewed as the class of government officials as far as very intelligent, competent, dedicated public servants, but still the story they’re telling is just not accurate.
If what Paulson, Bernanke and Geithner were saying was “Hey we did a pretty good job overall, yes at 2 a.m. on September 14th we didn’t quite get it right on Lehman Brothers in this incredibly crazy confusing situation,” I would be the last person to insist on perfection in that kind of situation.
But what irks me is that they have not owned up at all to any kind of mistake and they’ve invented this alternative history of what happened on the Lehman weekend that just isn’t accurate.
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