Case Number One: Letting Go of Lehman Brothers

There are other things the Treasury might do when a major financial firm assumed to be too big to fail comes knocking, asking for free money. Heres one: Let it fail.

Not as chaotically as Lehman Brothers was allowed to fail. If a failing firm is deemed too big for that honor, then it should be explicitly nationalized, both to limit its effect on other firms and to protect the guts of the system. Its shareholders should be wiped out, and its management replaced. Its valuable parts should be sold off as functioning businesses to the highest bidders perhaps to some bank that was not swept up in the credit bubble. The rest should be liquidated, in calm markets. Do this and, for everyone except the firms that invented the mess, the pain will likely subside. How to Repair a Broken Financial World, by Michael Lewis and David Einhorn, The New York Times, January 4, 2009.

Should Lehman Brothers have been allowed to fail? This is one of the lasting debates over the U.S. governments actions, or in this case inaction, in its attempts to fix the failing U.S. financial system in late 2008. Allowing Lehman to failit filed for bankruptcy on September 15, 2008 was in the eyes of many in the global financial markets the individual event that caused the global credit crisis which followed.

Lehman Brothers was founded in 1850 in Alabama by a pair of enterprising brothers. After moving the firm to New York following the American Civil War, the firm had long been considered one of the highest return, highest risk small investment banking firms on Wall Street. Although it had lived and nearly died by the sword many times over the years, by 2008 the firm was holding an enormous portfolio of failing mortgage-backed securities and the future was not bright.

Lehmans demise was not a shock, but a slow and painful downward spiral. After two major Bear Stearns hedge funds collapsed in July 2007, Lehman was the constant focus of much speculation over its holdings of many of the distressed securities behind the credit crisisthe collateralized debt obligations and credit default swaps that had flooded the market as a result of the real estate and mortgage lending boom of the 2000 to 2007 period.

Too Big to Fail

The too big to fail doctrine has long been a mainstay of the U.S. financial system. The U.S. Federal Reserve has long held the responsibility as the lender of last resort, the institution that is charged with assuring the financial stability and viability of the U.S. financial system. Although it has exercised its powers only rarely in history, the Fed, in conjunction with the Comptroller of the Currency and the Federal Deposit Insurance Corporation (FDIC), has on a few occasions determined that an individual large banks failure would threaten the health and functioning of the financial system. In those cases, for example Continental Illinois of Chicago in 1984, the three organizations had stepped in to effectively nationalize the institution and arrange for its continued operation to prevent what were believed to be disastrous results.

The doctrine, however, had largely been confined to commercial banks, not investment banks who made their money by intentionally taking on riskier classes of securities and positions on behalf of their investorswho expected greater returns. Lehman was clearly a risk taker. But the distinction between commercial and investment banking was largely gone, as more and more deregulation efforts had successfully reduced the barriers between taking deposits and making consumer and commercial loans, with traditional investment banking activities of underwriting riskier debt and equity issuances with a lessened fiduciary responsibility.

Many critics have argued that for some reason Lehman was singled out for failure. One week prior to Lehmans bankruptcy, the Federal Reserve and U.S. Treasury under Secretary of the Treasury Hank Paulson, Jr., had bailed out both Fannie Mae and Freddie Mac, putting them into U.S. government receivership. Two days following Lehmans bankruptcy filings, the Federal Reserve had extended AIG, an insurance conglomerate, an $85 billion loan package to prevent its failure. So why not Lehman?

Why Not Lehman?

Lehman had already survived one near miss. When Bear Stearns had failed in March 2008 and its sale arranged by the U.S. government, Lehman had been clearly in the cross-hairs of the financial speculators, particularly the short sellers. Its longtime CEO, Richard Fuld Jr., had been a vocal critic of the short sellers who continued to pound Lehman in the summer of 2008. But CEO Fuld had been encouraged by investors, regulators, and critics to find a way out of its mess following the close call in March. Secretary Paulson had gone on record following Lehmans June earnings reports (which showed massive losses) that if Lehman had not arranged a sale by the end of the third quarter there would likely be a crisis.

But repeated efforts by Fuld at finding buyers for different parts of the company failed, from Wall Street to the Middle East to Asia. Fuld has since argued that one of the reasons he wasnt able to arrange a sale was the U.S. government was not offering the same attractive guarantees it had put forward when arranging the sale of Bear Stearns. The Fed has successfully arranged the sale of Bear Stearns to J.P. Morgan Chase only after the Fed agreed to cover $29 billion in losses. In fact, in August 2008, just weeks prior to its failure, Lehman believed it had found two suitors, Bank of America and Barclays, that would quickly step up if the Federal Reserve would guarantee $65 billion in potential bad loans on Lehmans books. The Fed declined.

Another proposal that had shown promise had been a self-insurance approach by Wall Street. Lehman would be split into a good bank and a bad bank. The good bank would be composed of the higher quality assets and securities, and would be purchased by either Bank of America or Barclays. The bad bank would be a dumping ground of failing mortgage-backed securities which would be purchased by a consortium of 12 to 15 Wall Street financial institutions, not requiring any government funding or taxpayer dollars. The plan ultimately failed when the potential bad bank borrowers could not face their own losses and acquire Lehmans losses, while either Bank of America or Barclays walked away with high quality assets at the price of a song. In the end, only one day after Lehmans collapse, Barclays announced that it would buy Lehmans United States capital markets division for $1.75 billion, a steal according to one analyst.

Secretary Paulson has argued that in fact his hands were tied. The Federal Reserve is required by law only to lend to, and is limited by, the amount of asset collateral any specific institution has to offer against rescue loans. (This is in fact the defining principle behind the Feds discount window operations.) But many critics have argued that it was not possible to determine the collateral value of the securities held by Lehman or AIG or Fannie Mae and Freddie Mac accurately at this time because of the credit crisis and the illiquidity of markets. Secretary Paulson had never been heard to make the argument before the time of the bankruptcy.

It also became readily apparent that following the AIG rescue the U.S. authorities moved quickly to try to create a systemic solution, rather than continuing to be bounced from one individual institutional crisis to another. Secretary Paulson has noted that it was increasingly clear that a larger solution was required, and that saving Lehman would not have stopped the larger crisis. Others have noted, however, that Lehman was one of the largest commercial paper issuers in the world. In the days following Lehmans collapse, the commercial paper market literally locked up. The seizing of the commercial paper market in turn eliminated the primary source of liquid funds between mutual banks, hedge funds, and banks of all kinds. The crisis was now in full bloom.

Executives on Wall Street and officials in European financial capitals have criticized Mr. Paulson and Mr. Bernanke for allowing Lehman to fail, an event that sent shock waves through the banking system, turning a financial tremor into a tsunami.

For the equilibrium of the world financial system, this was a genuine error, Christine Lagarde, Frances finance minister, said recently. Frederic Oudea, chief executive of Socit Gnrale, one of Frances biggest banks, called the failure of Lehman a trigger for events leading to the global crash. Willem Sels, a credit strategist with Dresdner Kleinwort, said that it is clear that when Lehman defaulted, that is the date your money markets freaked out. It is difficult to not find a causal relationship. - The Reckoning: Struggling to Keep Up as the Crisis Raced On, by Joe Nocera and Edmund L. Andrews, The New York Times, October 22, 2008.

Question#2: Many experts argue that when the government bails out a private financial institution it creates a problem called moral hazard, meaning that if the institution knows it will be saved, it actually has an incentive to take on more risk, not less. What do you think?