Commentary / World

Still arguing over the Lehman collapse

by Robert Samuelson

Who lost Lehman Brothers? Could it have been saved?

As we approach the 10th anniversary of Lehman’s collapse on Sept. 15, these questions won’t go away. The Lehman bankruptcy is portrayed as the pivotal event that converted severe — but familiar — disruptions in financial markets into a full-blown panic. Nothing like it had occurred in the United States since the Great Depression of the 1930s. Stocks fell; unemployment soared. The skeptics argue that if Lehman had been rescued, the economy would have fared much better.

The officials who handled the Lehman bankruptcy aren’t having it. They contend they did all they could. Lehman was too far gone to be saved, except at exorbitant public expense. That’s the position of former Treasury Secretary Hank Paulson, ex-Federal Reserve Chairman Ben Bernanke and Timothy Geithner, then president of the New York Federal Reserve.

The most biting criticism comes from economist Laurence Ball of Johns Hopkins University, who has written an angry book on Lehman (“The Fed and Lehman Brothers: Setting the record straight on a financial disaster”). Even those who reject Ball’s conclusions will find his analysis highly detailed and clearly written.

He has few doubts. “The truth is that Lehman’s failure could have been avoided, and that policymakers did not need to be particularly clever to achieve that outcome,” Ball writes.

Recall the nature of Lehman’s business.

Like other investment banks — say, Goldman Sachs — it borrowed short-term money, with maturities as brief as one day at low interest rates, and used these funds for lending and investing at (hopefully) higher interest rates and returns. As of Aug. 31, 2008 — two weeks before its bankruptcy — Lehman had about $600 billion in assets (bonds, stocks, other investments) and $572 billion in borrowings. Shareholder equity was $28 billion ($600 billion minus $572 billion).

From these numbers, you can see why Lehman was vulnerable. If its assets fell 5 percent ($30 billion), its stockholders’ equity would be whipped out. If its short-term lenders wouldn’t renew their loans, Lehman’s assets would have been dumped onto markets at distressed prices. Both misfortunes befell Lehman. Its assets lost value, and its short-term lenders deserted.

The Fed could have rescued Lehman by lending it the money needed to replace the fleeing short-term lenders, Ball argues. The response from Paulson and company was: Legally, we couldn’t do it.

The loans probably would have been made under Section 13(3) of the Federal Reserve Act, which permitted the Fed to make emergency loans under “unusual and exigent circumstances.” But the Fed’s freedom was not unfettered; it couldn’t just throw money at the problem. Fed officials felt that there had to be good prospects that the loan would be repaid — and they couldn’t make that finding.

Here’s where Ball’s analysis becomes questionable.

At times, he almost accuses Paulson, Bernanke and Geithner of lying about Lehman. This is unfair and inaccurate. Up until the bankruptcy, they tried to find a private buyer for Lehman. There were no takers; talks with Bank of America and Barclays broke down.

At this point, Paulson seems to have decided — for personal, political and policy reasons — that letting Lehman fail was the least bad alternative. Personally, Paulson despised the label “Mr. Bailout,” which had attached to him after the rescue of Bear Stearns, another investment bank, in March 2008. Politically, Wall Street bailouts were enormously unpopular.

Finally, letting Lehman fail might be good policy. It would discipline speculation. “Too big to fail” would be repudiated. Paulson and many economists seemed to take this view. After Lehman’s bankruptcy, Harvard economist Ken Rogoff wrote approvingly in The Washington Post that the decision showed Wall Street that financial regulators “are not such cream puffs after all.” This reasoning soon disappeared as Lehman’s wider effects became apparent.

Ball also strays in suggesting that rescuing Lehman would have subdued the financial crisis. This seems doubtful. It didn’t happen after the bailout of Bear Stearns; it didn’t happen after Paulson seized Fannie Mae and Freddie Mac. The central causes of the crisis were years of lax credit decisions that left many financial institutions riddled with losses. These couldn’t be wished away.

If Lehman were rescued, runs on other institutions would almost certainly have continued. The decisions were being made under enormous time pressures and incomplete information: the fog of crisis. One way or another, a debacle was unavoidable.

What’s necessary now is to draw the right lessons from this financial calamity. Unfortunately, we’re going in the wrong direction. Reflecting public hostility toward Wall Street “bailouts,” Congress tightened the rules governing Fed lending under Section 13(3) in 2010. This made perfect sense politically — and no sense economically. In some future crisis, the Fed needs the freedom to protect the financial system. Restricting that freedom flirts with chaos.

Robert J. Samuelson writes an economics column for The Washington Post. © 2018, Washington Post Writers Group