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Getting Lehman Profoundly Wrong

Tuesday, September 21, 2010

The bankruptcy of Lehman Brothers is widely misunderstood: We have inverted a morality tale about individual recklessness to become one about collective culpability through inaction.

This month marks the second anniversary of a colossal failure that has shaped financial officials’ response to the ongoing global crisis, legislators’ attitudes toward reform, and the public’s perception of fairness. The failure is the fundamental misunderstanding of the events surrounding the bankruptcy of Lehman Brothers. We have inverted a morality tale about individual recklessness to become one about collective culpability through inaction.

Lehman failed as it should have failed. That we have ex post made it the fulcrum of the financial crisis misrepresents events in three material ways.

First, while it is hard to remember, prior to March 2008, no one really believed that the Federal Reserve would lend to an investment bank, in part because it had not done so in sixty years. We still do not know why the Fed lent to Bear Stearns. Were there alternatives short of lending to a nondepository? Fed officials have never explained why they twisted its discount window away from its original purpose. The Fed’s lending facility, which was designed to deal with illiquidity, became an equity-acquisition vehicle to cope with insolvency. This was the first step of a journey in which the nation’s central bank would undertake fiscal policy—that is, put taxpayer funds at risk. It was also the first of several missteps caused by treating a solvency problem as one of illiquidity.

Fed officials have never explained why they twisted its discount window away from its original purpose.

Lending to Bear Stearns put a spark to the notion that many institutions were too big or too interconnected to fail. Therein lies the second problem with stories that put all their weight on Lehman. As the crisis wore on and the bailout tab got bigger, appointed officials recognized the need to get the approval of Congress. Since the political system does not get into gear easily, that required saying no to someone, sometime. The Fed drew the line at Lehman. They might have been able to let the process run a few weeks more and let the tab get bigger, but ultimately they would have to stop. And when they did, expectations would be dashed and markets would adjust. If Lehman had been saved, someone else would have been left to fail. The only consequence two years later would be when we commemorate the anniversary of the crisis, not that there would be a crisis.

Third, not helping Lehman shifted market participants’ perception about the perimeter of the safety net. Within the week, government officials would act in a way that elevated uncertainty about the form of intervention. In the putative resolution of Wachovia, regulators arranged that debtors would be kept whole. At the same time, different regulators required haircuts for the facilitated takeover of Washington Mutual. Those actions, well within the regulated sphere, were as consequential as Lehman’s failure for the interbank market. Moreover, subsequent official comments to justify their actions and to build support for congressional legislation to fund a bailout seriously damaged confidence.

Government officials acted in a way that elevated uncertainty about the form of intervention.

But we like neat stories and a tight timeline. We also are at the mercy of event studies. If stock prices go down, we need to trace our path back for a trigger. But Lehman’s failure was a mistake of our own making that marked the culmination of a process involving decisions by unelected officials. And it was not an isolated policy misstep.

There has been another casualty caught in the wreckage of Lehman Brothers over the past two years: Financial authorities have surrendered some of their credibility. As a case in point, Federal Reserve Chairman Ben Bernanke has offered three different descriptions of the rationale for not extending unusual support to the investment bank. He first told a congressional committee in the immediate aftermath that “counterparties had had time to take precautionary measures.” Inaction was described a year later in another congressional appearance as an unavoidable calamity, in which “The Federal Reserve fully understood that the failure of Lehman would shake the financial system and the economy. However, the only tool available to the Federal Reserve to address the situation was its ability to provide short-term liquidity against adequate collateral.” That is, the government had an inadequate range of tools to the circumstances. In the past month, however, the Financial Crisis Inquiry Commission was told by the Fed chairman that “any attempt to lend to Lehman would be futile and would only result in a loss of cash.” Evidently, it was not that markets were prepared or that nothing could legally be done. Now we have been told that nothing would work.

Recognize that this is not a Rashomon effect, the same events remembered in different ways by different people. Nor is this a refined understanding brought about by unearthed information. This is the same person, at different points in time, characterizing policy makers' thought processes in mid-September 2008. By default, it must be that convenience dictated this sequence of “needn't, couldn't, and shouldn't.” This sequence, unfortunately, is informative of the reliability of future public disclosure.

Vincent Reinhart is a resident scholar at the American Enterprise Institute.

Image by Rob Green/Bergman Group.

FURTHER READING: Reinhart advises, “Beware Those Who Think the Worst Is Past,” and begins “Setting the Table for Fiscal Restraint.” John Makin gives us “Keys to Sustainable Recovery,” Desmond Lachman evaluates “The Global Economy's Second Day of Reckoning,” and the Shadow Financial Regulatory Committee explains “Regulation of Broker-Dealers and the Dodd-Frank Act.”

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