Wednesday, October 3, 2018

Book Review: The Fed and Lehman Brothers by Laurence M. Ball

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.