A year after Lehman declared bankruptcy, the state owns or controls very large pieces of the financial sector as also key industries, notably automobile, in the West.

On September 15, 2008, Lehman Brothers filed for bankruptcy under U.S. laws. That date has become a landmark event with profound consequences for the global finance and economy.

Lehman was not the only investment bank floundering during the second quarter of 2008. Practically all major financial institutions and some smaller ones were reeling under the impact of the sub-prime home loan mortgage crisis that had manifested itself at least a year earlier in the U.S. and in Europe.

The securitised mortgage backed debt obligations and their derivatives that Wall Street’s financial wizards had created out of the sub-prime home loans turned ‘toxic’ seriously imperilling the U.S. financial sector. Nearly all the prime banks had bought these securities, often using borrowed money.

Complex instruments

The other distinguishing feature of these financial instruments was their extreme complexity. Using advanced mathematics and computer models, the creators of these instruments probably did not comprehend where the risks from these investments would surface. The practice was universal and the faith in financial engineering strong. Very few thought they would fail.

What proved to be the undoing of the models was their assumption of rational behaviour that had not taken into account the possibility of consumers panicking in the face of well publicised bank failures.

Also ignored was the fact that sub-prime loans are poor risks. That fact could not be hidden by pooling these loans with others of varying risks and selling the securitised instruments.

Selective rescue act

A few of the bigger ones, notably Merrill Lynch and Bear Sterns, were in as deep a trouble as Lehman was but were saved by the U.S. authorities who cobbled together a rescue package, whereby these two firms were absorbed by J. P. Morgan Chase and Bank of America, respectively.

One reason why Lehman was allowed to go under, while a few others were saved, had to do with the growing public distaste for the concept of ‘too big to fail’. There was also the belief that it would be possible to contain the fallout of Lehman’s demise on the rest of the system.

There is of course no denying the fact that the decision to rescue a specific institution or not was a subjective one, made under extreme pressure when normal logic and reasoning are apt to count much less than in more normal situations.

The failure of Lehman was to have catastrophic consequences for the global financial system. The global inter-bank market froze and credit dried up throughout the world. There was extreme aversion to counterparty risk. In retrospect it looks as though the U.S. Federal Reserve and the Treasury seriously underestimated the systemic implications of the failure of the sub-prime mortgage market and Lehman’s bankruptcy. The U.S. Treasury, soon after letting Lehman go bankrupt, rescued the insurance giant AIG, on the verge of bankruptcy, citing reasons of its size and the fact that its operations extended to the farthest corners of the global financial system.

The U.S. government took a direct stake in the company: by the middle of 2009 and injected almost $180 billion into the share capital of AIG.

The injection of money into AIG has been spectacularly large. It was but one of the actions the U.S. authorities took at great speed to financially support the ailing financial sector. The U.S. Congress authorised some $700 billion to be spent by the Treasury to buy the toxic assets.

Almost all banks were compulsorily capitalised with public money. Many of them have since returned the money. In a related development, the U.S. government announced a $787 billion economic stimulus package to combat the economic crisis.

Active intervention

Active state intervention with very large amounts of public money and backed by a super-soft interest regime have been the principal features of the U.S. government’s response to the crisis. This model has been emulated by many other western countries. The financial sector and large portions of certain key industries such as automobiles came under government ownership in the U.S.

The New York Times in a recent report has this to say of the U.S. economy.

“One year after the collapse of Lehman Brothers set off a series of financial interventions, the government is the nation’s biggest lender, insurer, automaker and guarantor against risks for investors large and small.”

Financial rescue missions and economic stimulus packages account for a bigger share of the nation’s economy -- 26 per cent -- than at any time since World War II.

Experience in India

The Indian banking sector, among the best regulated, did not indulge in any of the excesses committed by their much larger and more influential western counterparts. Public ownership of a large part of the banking system has always been a virtue. It came into sharp focus at the height of the crisis. Nobody questioned the stability of the financial system.

The task is to build on the strengths of the public sector banks by giving them greater operational freedom, for instance.

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