The Real Lesson of Lehman

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Thomas Nast

What would have happened if the federal government had saved Lehman Brothers back in September 2008? Could the Great Recession have been avoided? These questions have acquired new purpose following a New York Times report this week showing that there was more serious disagreement inside the Fed about the decision to let Lehman go bankrupt than previously disclosed. The Fed may well have been able to prevent the Lehman bankruptcy had it wanted to do so—and thus avoided the catastrophic results. Tempting as this conclusion may be, however, it misses a deeper point about the causes of the economic crisis.

There is no question the decision about Lehman had far-reaching effects. Lehman’s bankruptcy on September 15 precipitated a collapse in the nation’s credit markets, leading to the greatest economic crisis since the Great Depression. In view of the government’s other big bailouts that year—Bear Stearns back in March 2008, the housing agencies Fannie Mae and Freddie Mac just days before the Lehman decision, the insurance giant AIG days later, and the $700 billion TARP program launched that October—the refusal to save the investment bank seems in retrospect highly irrational.

At the time, Fed Chairman Ben Bernanke defended the decision by claiming the Fed didn’t have the authority to save the bank. But The New York Times now tells us that some bankers within the New York Fed had contended there was indeed a legal right to save the bank and that it was as solvent as some of the other bailed out companies. Their assessment just didn’t get passed up to the highest circles, they now say. Really?

There’s little doubt that saving Lehman would have mitigated the credit collapse, and the ensuing Great Recession would have been less punishing. Millions of people lost jobs and houses, stocks collapsed. Europe has still not recovered from the blow.

Yet passing judgment is complicated for a number of reasons. Back in mid-2008, the Wall Street community was becoming skeptical of bailouts, and then-Treasury Secretary Henry Paulson later said he was tired of being accused of too readily saving these companies. One school of thought on the street, and among economists, is to let the chips fall where they may; it was time to teach those who take big risks a lesson. It also seemed, at least momentarily, that the economy was getting stronger in the summer of 2008.

The Washington decision-makers thought it only logical that the bankers were smart enough, after the go-around with Bear Stearns, to prepare themselves for a possible catastrophe by reducing risky exposure. Faith in the rationality of market participants is a cornerstone, of course, of the Invisible Hand used so often to justify laissez-faire government. The policymakers were wrong. Wall Street wasn’t ready at all.

We should keep in mind, however, that some kind of recession was likely no matter what happened to Lehman. The bubble in home prices was beginning to burst by 2007, and mortgage securities were losing value, which is what brought on Lehman’s troubles in the first place. And a Lehman rescue might well have had other damaging consequences about which we can only speculate. Without the financial and economic punishment, the nation would certainly have not passed the Dodd-Frank financial reforms. Nor would there have been enormous pressure on other federal agencies, including the Securities and Exchange Commission and the Commodities Futures Trading Commission, which as a result have become more vigilant.

By sending a signal that even big Wall Street risk takers would not have to face the consequences if things went south, saving Lehman in 2008 could have further reinforced the cavalier attitude that Wall Street had had for years—one that helped lead the big investment houses toward ever-riskier financial markets.

Consider, for example, the rescue of Long-Term Capital Management back in 1998, which was engineered by Alan Greenspan’s Fed. The possible failure of the giant hedge fund struck fear into the hearts of financiers, not least the Fed chairman himself. But then the government intervened—and what happened? The rescue succeeded and Wall Street returned to more or less the same practices that led to the LCTM debacle to begin with. Greenspan did nothing about tightening regulations so that firms like LTCM couldn’t borrow the towering sums they did. The Clinton administration was just as remiss in not pushing for banking reform. With Greenspan’s support, it refused to allow agencies to regulate derivatives, the highly leveraged securities based on other securities that would later be at the heart of the 2008 collapse. A mindless high-technology stock market boom got underway, based on aggressive Wall Street banking tactics and high monopolistic fees for doing deals.

Ending the last of the Glass-Steagall restrictions—the 1933 legislation that had separated commercial banking from securities trading and insurance—the Clinton administration allowed Sandy Weill’s Traveler’s Insurance to merge with Citicorp, to create the giant Citigroup. With its mammoth size, the new entity felt it could take on loads of risk, such as making huge loans to questionable high-technology giants like Enron and WorldCom, both of which soon went bankrupt. Then, later in the 2000s, it wrote all manner of securities on subprime mortgage debt, holding quite a bit on its own books. Other financial institutions were doing the same. No one was restricting them.

Regulators had lots of tools to dampen speculation. They could have raised capital requirements, established maximum debt levels for financial firms, and even prohibited some kinds of securities. They surely could have regulated derivatives, in particular forcing their trading and pricing out in the open. Even in conservative economics, the principle that prices should be transparent is held as central. Economists didn’t seem to make much of a stink, either.

After the shock of the Lehman collapse and the ensuing crisis, the government passed the Dodd-Frank bill. But it shouldn’t take the bankruptcy of millions of savers, workers, and homeowners to get the government to regulate the financial industry. And in fact, even with these reforms and increased vigilance, implementing the new regulations has been slow. This August, Federal regulators shocked eleven major banks when they told them they did not have credible plans for how they would unwind themselves in case of financial failure—the so-called “living wills” required by Dodd-Frank.

What the Lehman story ultimately makes clear is the extent to which the ideologically-driven, laissez-faire approach of the government toward banking regulation was itself a culprit in the crisis. The lax enforcement of Dodd-Frank is already worrying evidence that the painful losses of 2008 are being forgotten. The nation needs regulators who fully understand that financial markets need vigilant supervision—whether or not there is an imminent threat of bank failure.