Laurence M. Ball is the Chair of the Economics Department at
Johns Hopkins University. He has been researching and writing papers about the
events that led to Lehman Brothers’ filing for bankruptcy on September 15,
2008. This research has led to him writing an important book aimed at an
audience beyond financial economists and other financial industry professionals,
The Fed and Lehman Brothers: Setting the
Record Straight on a Financial Disaster. The thesis of the book is quite
simple: the real reason that the Federal Reserve did not extend loans secured
by Lehman collateral in order to stave off bankruptcy and give the firm a
chance to survive, as it did with other firms before and after Lehman’s
bankruptcy, was due to political considerations. He bluntly states that the
argument that Ben Bernanke, Timothy Geithner, and Hank Paulson, who, during the
2008 financial crisis were respectively the Chairman of the Federal Reserve
Board, the President of the Federal Reserve Bank of New York, and the Secretary
of the Treasury, make that the Fed lacked the legal authority to extend a loan
to Lehman Brothers due to its insolvency and lacking sufficiently good
collateral is flatly wrong.
The first part of the book is important but a bit of a slog
to get through. Ball examines in detail Lehman’s balance sheet, the law with
respect to Fed loans to non-members of the Federal Reserve System, Lehman’s
assets available as collateral for a loan, and the reasons for its liquidity
problems. After reading Ball’s analysis of these matters, it is hard to see
what convincing rebuttal Bernanke, Geithner, or Paulson could offer. The last
part of the book is somewhat easier to read as it analyzes what various
officials said to the committees of Congress and to the Financial Crisis
Inquiry Commission. The author conclusively demonstrates that the decision not
to extend a loan to Lehman to buy time so that Barclays could go through the
procedures UK regulators were insisting to purchase Lehman or for some other
arrangement, including in the worst case an orderly liquidation, could be made.
The person most responsible for this political decision, Ball argues, is the
one who had no legal authority in this matter, Secretary Paulson, who from all
reports can come on forcefully, making other fearful to oppose him. One does
not become the head of Goldman Sachs, his previous job, with a self-effacing or
modest manner, as Bernanke, who is obviously a brilliant economist, often does.
Geithner, whom I know, is no shrinking violet and can be charming or, if he
believes the situation demands it, will display a calculated show of anger,
apparently felt it judicious in the fast-moving crisis to defer to Paulson. It
is not clear whether Bernanke or Geithner totally agreed with Paulson. They may
have, or they may have harbored doubts.
Paulson seems to have come to his decision for two related
reasons. The first is that he believed that bailing out Lehman would increase
moral hazard. That is jargon for saying that, if firms know that they are going
to be bailed out if they get into trouble, they are more likely to take more
risks than they otherwise would. The other reason is that Paulson did not want
to be known as “Mr. Bailout.” That, one notes, means that even though he lacked
the legal authority to decide on Federal Reserve policy in this matter, he was
cognizant that public perception, as well as the underlying reality, was that
he was the official effectively making the decisions.
After the failure of Lehman, the Federal Reserve and
subsequently the Treasury with the creation of the Troubled Asset Relief Program
fund bailed out various financial institutions. In particular, Ball points to
the bailout of AIG. Ball, though, could have pointed out that there was an
enormous exposure of various firms to a unit of AIG, because many of them had
entered into credit default swaps with AIG in seeking to reduce their exposure
to possible defaults on home mortgages. It is likely that a failure of AIG
would have been even more calamitous for the financial system and the economy
than Lehman’s was. In this connection, it is worth mentioning, though Ball does
not because his focus is on Lehman, that it was a failure of the various
financial regulators to notice the risk that firms subject to regulation and
oversight were collectively off-loading to AIG. The Office of Thrift
Supervision (OTS) was theoretically responsible for overseeing AIG, because its
ownership of a savings and loan made it a thrift holding company, but OTS did
not have the resources to do this. The other financial regulators had access to
the information about the transactions their charges were doing with AIG and
could have inquired. They all seem to have missed this and did nothing.
Also, while Ball clearly believes that the failure to stave
off Lehman’s bankruptcy was a mistake, he could have addressed a contrary
argument made by then New York Times financial
columnist Joe Nocera in September 2009 in an article headlined “Lehman Had to
Die So Global Finance Could Live.” Nocera argues that, even if Lehman had
been bailed out, the financial crisis would have proceeded, and the next
financial institution to be on the brink of failure would have been a larger, more
significant institution (for example, AIG). The failure of Lehman, unfair as it
was, turned out to be necessary because its aftermath demonstrated the need to
bailout other institutions. Nocera writes: “John H. Makin, a visiting scholar
at the American Enterprise Institute, wrote recently, ‘If the Lehman Brothers’ failure
had not triggered the panic phase of the cycle, some other institutional
failure would have done so.’ I’ll go a step further: it is quite likely that
the financial crisis would have been even worse
had Lehman been rescued. Although nobody realized it at the time, Lehman
Brothers had to die for the rest of Wall Street to live.” Of course, no one
knows what would have happened if Lehman had been bailed out. Would the
government have bailed out each institution as it came to the brink of failure
and avoided the financial calamity that took place?
I would be a bit more
forgiving than Ball of the decision Paulson and others made about Lehman. They
were under a great deal of pressure and thought that the market would not react
too badly to a Lehman failure. What is more difficult to understand is why the
three principals and others have stuck to a story about a lack of legal
authority to have done something different. They have not made a convincing
argument that this was true, and Ball has demolished this story convincingly.
It would have been, and still would be, better to admit that this was not the
real reason, or, in the alternative that their understanding of Lehman’s financial
situation and the applicable law was imperfect. They could also argue that
pursuing another course would also have been disastrous.
