The Fed and Lehman Brothers: A new narrative

Laurence Ball

Much of the damage from the Great Recession is attributed to the Federal Reserve’s failure to rescue Lehman Brothers when it hit troubled waters in September 2008. It has been argued that the Fed’s decision was based on legal constraints. This column questions that view, arguing that the Fed did have the legal authority to save Lehman, but it did not do so due to political considerations.

In 2008, liquidity crises threatened the survival of many of the large financial institutions in the US. The Federal Reserve rescued firms such as Bear Stearns and AIG with emergency loans, but it did not rescue Lehman Brothers when a run on that firm left it without enough cash to operate. Lehman declared bankruptcy on 15 September 2008, leading to a dramatic acceleration of the Global Crisis.

Why didn’t the Fed rescue Lehman?

Students of the financial crisis have suggested a number of factors, including political opposition to ‘bailout’ of Wall Street firms, policymakers’ concern that moral hazard was encouraging reckless risk-taking, and failure to anticipate the damage that Lehman’s bankruptcy would do to the financial system and economy.

Yet Fed officials insist that none of these factors is relevant. The people in charge in 2008, from Ben Bernanke down, have said repeatedly that they knew Lehman’s failure would be disastrous and wanted to prevent it, but could not do so because they lacked the legal authority.

When the Fed lends to a financial institution, the Federal Reserve Act requires “satisfactory” collateral to protect the Fed if the borrower defaults. In Lehman’s case, according to Bernanke (2009), “[T]he company’s available collateral fell well short of the amount needed to secure a Federal Reserve loan of sufficient size to meet its funding needs. As the Federal Reserve cannot make an unsecured loan... the firm’s failure was, unfortunately, unavoidable”.

According to Bernanke (2010), “[T]he only way we could have saved Lehman would have been by breaking the law, and I’m not sure I’m willing to accept those consequences for the Federal Reserve and for our systems of laws. I just don’t think that would be appropriate”.

An alternative narrative

In a recent monograph, I seek to set the record straight on why the Fed did not rescue Lehman Brothers (Ball 2016). To that end, I examine in detail the voluminous record on the firm’s bankruptcy, much of it from investigations by the Financial Crisis Inquiry Commission and the Examiner for the bankruptcy court. Both of these authorities had subpoena power, and they interviewed hundreds of people and gathered documents and emails from Fed officials and Lehman executives.

I conclude that officials’ explanation for the non-rescue of Lehman is incorrect, in two senses.

First, a perceived lack of legal authority was not the reason for the Fed’s inaction; and

Second, the Fed did in fact have the authority to rescue Lehman.

I base these broad conclusions on several findings, given below.

First, before the bankruptcy, Fed staff extensively analysed Lehman’s liquidity risk and how the Fed might assist the firm. In the record of these discussions, there is little concern about the adequacy of Lehman’s collateral, and nobody suggests that legal issues might preclude a Fed loan.

Second, arguments about legal authority made by policymakers since the bankruptcy are unpersuasive. These arguments involve flawed economic reasoning, such as confusion between the concepts of illiquidity and insolvency. They also include factual claims that are not supported by evidence. The Financial Crisis Inquiry Commission repeatedly asked Ben Bernanke for details about Lehman’s collateral problem, but Bernanke was unresponsive.

Further, from a de novo examination of Lehman’s finances, it is clear that the firm had ample collateral for a loan to meet its liquidity needs. In particular, I estimate that Lehman could have survived with $88 billion of overnight lending from the Fed’s Primary Dealer Credit Facility (PDCF), and the firm had at least $131 billion of assets that were acceptable as PDCF collateral.

Also, Fed officials did not stand by passively as Lehman failed, but rather took action to ensure that the firm filed for bankruptcy. Specifically, the Fed denied access to the PDCF to Lehman’s broker-dealer subsidiary in London, forcing that part of the firm into default. (A week later, the Fed granted PDCF access to the London broker-dealers of Morgan Stanley and Goldman Sachs.)

Finally, the Fed took on more risk in rescuing Bear Stearns and AIG than it would have if it rescued Lehman. In the case of AIG, the collateral accepted by the Fed included equity in privately-held insurance companies, which is hard to value. The collateral might have been worth less than the $85 billion that AIG borrowed.

What could have been

Liquidity support from the Fed would have bought time for Lehman to seek a long-term resolution of its crisis. We will never know what the outcome would have been, but one possibility is that Lehman would have been acquired by the British bank Barclays. Barclays and Lehman made a tentative acquisition deal before the bankruptcy, but the deal was held up at the last minute by problems with British regulators. With time, these problems might have been resolved and the Barclays deal completed.

Alternatively, Lehman might have survived as an independent firm. This outcome would have been likely if Lehman succeeded with a plan to spin off some of its assets to a real estate investment trust. At worst, Lehman would have proven unviable and eventually been forced to wind down its business. An orderly wind down, however, would have avoided much of the damage to the financial system from Lehman’s abrupt bankruptcy filing.

Concluding remarks

If legal constraints do not explain the non-rescue of Lehman, then what does? The available evidence supports the theories that political considerations were important, and that policymakers did not fully anticipate the damage from the bankruptcy. The record also shows that the decision not to save Lehman was made primarily by Treasury Secretary Henry Paulson. Fed officials deferred to Paulson even though they had sole authority to make the decision under the Federal Reserve Act.

References

Ball, L (2016), “The Fed and Lehman Brothers”, Johns Hopkins University

Bernanke, B (2009), “Reflections on a Year of Crisis,” Federal Reserve Bank of Kansas City Jackson Hole Conference, 21 August

Bernanke, B (2010), Testimony before the Financial Crisis Inquiry Commission, 2 September

Financial Crisis Inquiry Commission (2011), Report, with supporting documents

Valukas, A (2010), Lehman Brothers Holdings Inc. Chapter 11 Proceedings Examiner Report, with supporting documents