On September 15, 2008, > Lehman Brothers , one of the big five investment banks in the U.S. at the time, filed for bankruptcy. The failure caused widespread panic and chaos in the financial markets. Many believe that it worsened the > financial crisis and the Great Recession that followed.
Indeed, the expression ‘Lehman moment’ has entered the lexicon as a byword for any event that spells calamity for the financial system. Commentators were asking recently whether Brexit — Britain’s exit from the European Union — would constitute a ‘Lehman moment’ for the world economy. Each anniversary of Lehman’s demise — the eighth is due a month from now — is remembered religiously, much like the anniversary of > 9/11 .
A political, not financial, call? The official position on the Lehman failure — expressed by Ben Bernanke, then Chairman of the > U.S. Federal Reserve , and Henry Paulson, then Treasury Secretary — is that the authorities knew that letting Lehman fail would devastate the markets but couldn’t do anything about it. There was no way that the Fed could have saved Lehman while staying within the laws governing the Fed.
Wrong, says Laurence Ball, chairman of the economics department at Johns Hopkins University. In a paper titled ‘The Fed and Lehman Brothers’ — prepared for a meeting of the U.S. non-profit research organisation National Bureau of Economic Research’s Monetary Economics Program on July 14 — Mr. Ball dissects the Lehman failure at length and comes to damning conclusions.
The Fed did have the necessary legal authority to save Lehman. The decision not to save the firm was a political decision taken by Mr. Paulson. The authorities did not fully anticipate the disastrous consequences that followed their decision. Bad judgment on the part of people at the highest levels of decision-making may have deepened and prolonged the agony wrought by the worst financial crisis of the last century. This is a serious indictment of those at the highest levels of decision-making in the U.S.
Banks can face a run on their > deposits in situations of panic even when they are solvent (that is, the value of their assets exceeds the value of their liabilities). If they do not get access to funds, they will be forced to resort to distress sales of their assets. This can push even a solvent bank into insolvency.
To prevent this, central banks act as lenders of last resort. They lend to financial institutions in distress after they have satisfied themselves on two counts: (i) the bank is solvent; and (ii) the bank can offer enough collateral against the loan. This facility is typically offered only to banks. However, the Fed is empowered by law to lend to other financial institutions as well in exceptional situations.
In 2008, the situation in the U.S. was undoubtedly exceptional. The crucial questions that Mr. Ball addresses are whether Lehman was solvent at the time and whether it could offer adequate collateral against the loan it would require. His answer is ‘yes’ on both counts.
The question of solvency On August 31, 2008, Lehman had assets of $600 billion and liabilities of $572 billion. This meant that it had a positive net worth of $28 billion. This was on paper. In reality, most analysts thought that Lehman had overvalued its assets by anywhere between $15 billion and $30 billion. This meant that its net worth was in the range of –$2 billion to $13 billion. Thus it was somewhere on the border between solvency and insolvency.
Mr. Ball emphasises that this valuation was based on market values. In times of panic, asset values tend to fall way below their true or fundamental values. If Lehman was on the border line based on market values, it would have been quite solvent on the basis of fundamental values.
Others are sceptical of Mr. Ball’s calculations. They say that Lehman’s net worth was negative to the tune of as much as $100 billion to $200 billion. They also make the point that Lehman could not find a buyer although it tried hard — proof, they say, that the markets did not see the firm as having any value.
It’s hard to be sure who’s right. But Mr. Ball makes a valid point: the Fed has failed to back its claims that Lehman was insolvent with any analysis of the balance sheet. It should have substantiated its decision with figures that showed that Lehman was a hopeless case. Given that the decision to let Lehman fail has proved hugely controversial, it is surprising that the Fed has not done so.
Mr. Ball then tackles the second crucial question: did Lehman have adequate collateral to offer against loans required from the Fed? As we have seen above, Lehman had assets roughly equal to its liabilities. The liabilities included $115 billion in long-term debt.
This meant that, in an extreme situation in which Lehman had to meet all short-term liabilities, it would have needed $455 billion in liquidity support ($570 billion of total liabilities minus $115 billion in long-term liabilities). This was covered by $570 billion in assets, which meant that Lehman’s collateral (its assets) exceeded its maximum liability needs by $115 billion, or about 25 per cent. This is an extreme scenario. On a realistic basis, Mr. Ball estimates that Lehman would have needed $88 billion in liquidity support for which it had acceptable collateral of at least $131 billion.
Why, then, did the Fed not do the obvious thing, which was to provide liquidity that would have enabled Lehman to keep going for weeks or months? The facts that Mr. Ball presents are fascinating.
Different strokes for different folks In his initial testimony to the U.S. Congress on September 23, eight days after the collapse of Lehman, > Fed Chairman Bernanke said that “the Federal Reserve and the U.S. Treasury had declined to commit public funds” because “we judged that investors and counterparties had had time to take precautionary measures”. He made no mention about collateral or legal barriers to assisting Lehman.
This seems to suggest that the Fed believed did not want to save Lehman because it had judged that the impact of a Lehman failure could be managed.
Later, in 2010, while testifying before the Financial Crisis Inquiry Commission, Mr. Bernanke said he regretted having given the impression earlier that Lehman could have been saved. He said he had not been straightforward in the matter for fear of undermining confidence at a time of tremendous stress in the system.
Mr. Ball underlines that the Fed was coy about lending to Lehman when it opened its tap readily to other investment banks. In lending to two other investment banks, Goldman Sachs and Morgan Stanley, the Fed was happy to accept types of collateral that Lehman had in ample measure.
In saving the investment bank, Bear Stearns, and the insurance giant, AIG, the Fed took bigger risks than it would have had it rescued Lehman. Lehman only required overnight, collateralised loans. Bear Stearns was given long-term finance for illiquid assets. AIG was provided finance against collateral that included equity in privately-held insurance companies, the value of which was highly uncertain.
Catastrophic consequences So, if the Fed could have saved Lehman while operating within its legal framework, why did it not do so? Mr. Ball’s view is that the decision to let Lehman fail was a political decision taken primarily by the Treasury Secretary “even though he had no legal authority over the Fed’s lending decisions”. So much for central bank independence in the world’s biggest economy.
Mr. Ball contends that Mr. Paulson was influenced by the strong political opposition to financial rescues. He didn’t want to go down as “Mr. Bailout”. Secondly, neither Mr. Paulson nor Mr. Bernanke fully anticipated the damage that a Lehman failure would cause.
The damage was of catastrophic proportions. Confidence in financial institutions completely evaporated and asset prices plunged even further following the Lehman failure, not just in the U.S. but in other parts of the world. Bank losses increased and so did the fiscal costs of bank bailouts everywhere. The Lehman failure thus exacerbated the cost of the financial crisis and led to economic recovery stretching out longer than otherwise.
Preventing financial crises should, of course, be a priority for economies. However, given that such crises cannot be wholly avoided, transparent mechanisms for handling the ones that erupt are of the utmost importance. If the Lehman failure illustrates anything, it is that decisions in such crises must be thoroughly documented and subject to oversight by parliament. Financial crises are far too important to be left to the whims or predisposition of particular individuals.
T.T Ram Mohan is a professor at IIM, Ahmedabad. E-mail: ttr@iima.ac.in
