The Fed and Lehman Brothers

I haven’t read Laurence Ball’s book, but I did see the movie working paper. Ball’s thesis is that the Fed could have and should have lent Lehman the money to enable it to reach a more orderly resolution than declaring bankruptcy at the peak of the financial crisis of 2008.

Long after the episode, Fed officials justified their (in-)action by claiming that Lehman lacked adequate collateral, and that this lack of adequate collateral made it technically illegal for the Fed to lend the amount required. Ball points out that at the time, this legal argument was not used in the internal discussion. Instead, Chairman Bernanke and others were thinking that (a) the Lehman bankruptcy would not cause major new problems and (b) public hostility toward the perceived “bailouts” of Bear Stearns and other firms made it politically dangerous to lend to Lehman.

My own views:

1. I am inclined to cut Bernanke and the Fed officials some slack in allowing them to dissemble about the rationales for not bailing out Lehman. I think that the case against bailing out Lehman is pretty strong, and I am not persuaded by the view of Ball and others that a Lehman bailout would have worked wonders for resolving the financial crisis. Even if Ball is right, I think that the officials’ view that a bailout had low economic benefits and high political costs was reasonable ex ante.

2. The doctrine of “lender of last resort” does not suggest that you have to lend to any particular firm. The point is to provide liquidity in order to keep the crisis contained. So, contrary to what Ball seems to be saying, the Fed could perform its lender-of-last-resort function without bailing out Lehman.

3. During the crisis, I thought that more attention should have been paid to reducing the demand for liquid assets, not just trying to make more supply available. A lot of the “collateral calls” and “haircuts” were outlandish. I would have used jawboning to try to scale those demands back to something more reasonable.

4. I am intrigued by analysis suggesting that the actual banking crisis was more severe in Europe than in the U.S. European finance is more concentrated in its banking system. If every financial institution with heavy exposure to U.S. mortgage securities had failed, the U.S. would still have had a lot of functioning banks and other financial institutions. Not so in some European countries. I don’t think that Lehman bailout would have solved the problems in Europe.

6 thoughts on “The Fed and Lehman Brothers

  1. 1. According to Andrew Ross Sorkin in Too Big to Fail, Richard Fuld of Lehman kept waiting for the Fed to come rescue him like they did Bear Stearns, and repeatedly delayed taking the serious action necessary to reduce Lehman’s exposure.

    2. From the same source, John Thain at Merrill Lynch also assumed the Fed would step in to help Merrill if necessary. He began to consider a merger with B of A only when he realized the Fed would not help Lehman, and could see that Merrill would be next to fall.

    I therefore infer the real problem was not the Fed’s failure to help Lehman; the real problem was the Fed and Treasury action in helping Bear Stearns earlier in 2008, which set expectations that the Fed would step in to help all investment banks.

  2. If the Fed is the contingent owner of all US banks, the Fed should proactively assign Fed account numbers to every bank account holder in the US.

    That way, if the Fed decided that a bank was going to go under, the actual transition to Fed ownership of all customer assets would go smoothly. The management would be fired in stages and replaced by Fed employees, who would assist customers with recovering their assets.

    Or we could cut out all the middlemen and just bank with the Fed directly.

    • There is no good reason anymore to aggregate the functions of deposit holding, interacting with the payment and transaction system, extending credit, insurance, and investing. These functions can and should be decoupled, which would make the system structurally more sound by making runs pointless and isolating fallout.

      The Fed is run-proof, which means there are low-hanging fruit efficiency gains to be had by eliminating deposit insurance, and inspections or other regulatory compliance overhead.

      People should at least have the option of storing currency-denominated deposites with the central bank for the same interest rate any other entity is eligible to receive.

      People could still choose intermediary companies that handle the mandatory in-person or other “retail operations” of that process for ordinary consumers, which could offer to provide superior service for a small fee.

  3. The longer we are past the Financial Crisis the more I see the reality was we had Minsky moment on an asset (and lifestyle) that mostly had a 60 year (1947 -2007) bull run and it needed to break at some point. A lot of the groundwork was laid in teh 1980s with bank consolidation and the Reagan Revolution/Housing Market just overheating after decades of growth. (However the reality is California coast housing prices are nearly as high today as 2007 which is probably the analysis weak point. However, housing borrowing is not going up by more than 1 – 3 % per year so consumer balance sheets are not out of whack as it was in 2006.)

    1) The biggest reason why I don’t agree with this analysis is there was bailouts of Bear Steans and Fannie & Freddie in 2008 and Myrill Lynch was going to need one in 60 days and BofA after Countrywide and Citibank were going to need one in 180 days. The line was going to be drawn at some point. Throw in WaMu and Wachovia somewhere as well.

    2) I tend to think the bailout modestly worked because it signaled to investors who was surviving and who was going away which was the logic of the 1933 Bank Holiday.

    3) I don’t disagree that Europe might have been bigger because of the concentration where as in the US it was the second tier banks and lenders that were the worst players. (Countrywide, WaMU, Wachovia were leading worst lenders.) I would correspond that Europe model was closer to Japan issue of the 1990s whereas the US went 70% Japanese we were able to put some institutions out of business and clear up balance sheets.

    Also, the further we get from the 2008 Crisis, the more I accept that every nation simply goes down their version of the 1990s Japanese economy and this is going to hit every developing economy sooner or later. (A combination of middle income trap, our economy is different and decreasing family formation.) In terms of China, I don’t see them slowing down immediately but they really look they are following the Japanese model very closely from 1960 -.

    • The further we get from the 2008 Crisis and observe what’s happened after, it appears more and more likely that it was deeply driven by fundamentals and not cyclical hysteria. In fact, it may have been the most rational thing to happen to the economy in decades.

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