The Great Recession of 2008 was a waste of human capital on a scale most Americans had never seen before. It left 15 million people out of work with over $7 trillion in housing losses and $11 trillion in stock market declines. Eric Holder’s Department of Justice used the crisis to load up on $200 billion in penalties against banks. As it turned out, his motive was not personal, as the Godfather would say, but political. Investor’s Daily reported that “buried in the fine print of the (settlement) are a raft of political payoffs to Obama constituency groups.” Ironically, the penalties were the result of the big banks acquiring failed institutions so the government would not have to bail them out — and why JP Morgan’s Jamie Dimon called it the Obama “double cross.”
Now, in a new book by Laurence Ball, Professor of Economics and Department Chair at Johns Hopkins University, we learn why the government was so quick to lay blame on the bankers: The Fed and Lehman Brothers: Setting the Record Straight on a Financial Disaster. I had the chance to interview professor Ball about how the Federal Reserve could safely have prevented Lehman Brothers’ failure.
Lehman Brothers filed for bankruptcy on Monday, September 15, 2008. You believe this action “greatly worsened the crisis and the Great Recession that followed.” Why?
Lehman’s failure caused extraordinary panic. Technically, some of the damage can be traced back to its effect on the money market funds because Lehman defaulted its commercial paper. Absent the Lehman failure, the recession would have been less severe and handled correctly, this period would look more like the dot-com bubble bursting or the savings and loan crisis of the 1980s. There was an effect on the economy, but not nearly the worst recession since the 1930s.
Did Fed Chairman Ben Bernanke lie to the country when he said, “The only way we could have saved Lehman would have been by breaking the law?”
That implies a state of mind or intent that I can’t judge. What I know is that many things Bernanke has said are inconsistent with the facts. He said that Lehman did not have enough collateral. They did.
What did you discover about Lehman’s collateral in your research?
In my book, I argue that from a detailed examination of Lehman’s finances, the firm had more than enough collateral to prevent a disorderly and destructive bankruptcy with negligible risk to the Fed. I estimate that Lehman needed to borrow $84 billion to stay in operation, and it had at least $114 billion of available collateral that was acceptable at the Fed’s Primary Dealer Credit Facility (PDCF). Thus, the Fed could have rescued Lehman. Instead, Fed policymakers chose to restrict Lehman’s access to the PDCF for political reasons, as I explain.
How was the Fed able to justify this?
When Fed officials were questioned, as I wrote, they repeatedly said that Lehman was insolvent, but never supported this claim with an analysis of the firm’s balance sheet. When pressed, officials have offered explanations that confused the concepts of insolvency and illiquidity.
Did the Fed miscalculate Lehman’s collateral?
There is a vast amount of evidence from the bankruptcy examiner and the Financial Crisis Inquiry Commission, and e-mails between Fed officials on the final weekend before the bankruptcy, that what they talked about was what happens if Lehman fails. There are no discussions about collateral.
Lehman was the second institution to fail after Bear Stearns. Was that the problem?
After the rescue of Bear Stearns, there was a huge political backlash and Henry Paulson is widely quoted as saying about Lehman, “I can’t do it again. I can’t be Mr. Bailout.” So at some level, they weren’t willing to accept the political backlash and believed, or at least hoped, that they could take actions to mitigate the effects on the economy, and it wouldn’t be so bad. It took them 24 hours to figure out that they were wrong.
Did that affect how they responded to AIG’s subsequent failure?
When it was AIGs turn, we had now seen some of the consequences of letting a big institution fail. Politically, Henry Paulson’s fear of, “I don’t want to be Mr. Bailout,” was overcome by the fear of, “I don’t want to be Mr. ‘Caused a depression worse than the 1930s.”
You wrote that in a conference call between NY Fed president Timothy Geithner and Fed Chairman Bernanke, Treasury Secretary Paulson says “there would be no public assistance for a Lehman bailout.” Why was Paulson making this decision?
Throughout the Lehman crisis, Paulson was giving orders to Geithner. Bernanke was in Washington getting periodic reports, which seemed odd because under the Federal Reserve Act at the time, the authority to lend or not lend was entirely a decision of the Federal Reserve Bank of New York and the Board of Governors. Paulson was not supposed to be involved. He just came and started giving orders.
What might have happened if the Fed had provided a short-term lifeline to Lehman?
If the Fed had sustained Lehman through this short-term period, it would have ended up either as part of Barclays or broken up into the good bank/bad bank spin-off, and either would have kept Lehman going long enough to survive or allowed a more orderly unwind. In Bernanke’s memoir, he says, “Lehman didn’t have time to execute that.” The reason was that the Fed wouldn’t give Lehman liquidity support.
Why does President Bush play such a small role in these discussions?
For better or for worse, I think in no small degree, he relied on Treasury Secretary Henry Paulson. There are discussions between them where Bush is questioning, “We don’t want to do bailouts, do we?”
Under Dodd-Frank, the Fed has even less discretion to aid failed institutions than it did before the crisis?
As it stood in 2008, we had the law just about right. It had specific criteria that allowed the Fed to fix liquidity problems before they caused disasters. Now, under Dodd-Frank, the Treasury Secretary has veto power, making these decisions more subject to politics.
Did anything surprise you about the reception to your book?
I published an op-ed in The Guardian newspaper on the topic and when I saw I had 150 comments, one after another was like, “the big mistake was not locking up all those Wall Street crooks.”
To what extent do you blame Lehman for their troubles?
The people at Lehman had a lot of company. Economists and the Fed calculated losses on the order of three percent of GDP, which I think is the same scale as the savings and loan crisis. This is why the failure of Lehman is so critical as it led to financial disruption and panic that were so out of proportion to the losses from the decline in real estate.
(Editor’s note: I served on the board of a bank that was acquired by a major bank during the Financial Crisis.)