Should Lehman Brothers have been allowed to fail?

On the question, briefly

I was recently asked the question: “Should the investment bank Lehman Brothers have been allowed to fail in the summer of 2008”? I’d like to sketch out a couple of points about the question and its answer, mainly to make myself feel better after realizing I did not have an answer ready and responded so inarticulately.

Background

For a more thorough introduction to Lehman Brothers, I suggest scanning this post at Investopedia (http://bit.ly/1mJP8nM) and the Wikipedia entry entitled ‘Bankruptcy of Lehman Brothers’ (http://bit.ly/ZXfoBe). A search for ‘Lehman Brothers’ on Amazon reveals a number of books about the firm, none of which I have read. Here are some key points.

  • Lehman Brothers was an American, New York-headquartered investment bank–fourth largest in the States–with global operations. It had been part of American Express until that company decided to divest its banking and brokerage operations in 1994. The new entity, Lehman Brothers Holdings, Inc. was listed on the New York Stock Exchange. The company operated in three segments: capital markets; investment banking; and investment management.
  • In 2003 and 2004, the firm acquired mortgage lenders that were engaged in high-risk practices, namely subprime lending. The source of growing revenues in its capital markets division was securitization techniques, and revenues in this division surpassed other areas in the company shortly after acquisition. Record profits were reported from 2005 to 2007. Incidentally, rapid growth in profits is a tell-tale sign of an accounting control fraud.
  • Defaults on subprime mortgages began to increase over late 2006-early 2007. By August 2007, Lehman stock dropped substantially following the failure of two hedge funds associated with investment bank Bear Stearns. Lehman began shuttering its mortgage businesses, but continued to underwrite mortgage-backed securities. Global equities and fixed-income markets brushed off the hesitations earlier that year that profitability would suffer as mortgage and housing markets registered rising defaults.
  • Bear Stearns collapsed in March of 2008, and Lehman’s stock price dropped by almost 50 percent. Lehman was able to raise capital through preferred stock, however. In June, the company announced a loss of $2.8 billion but continued to raise capital from investors. It further announced it had increased liquidity, decreased assets, lowered exposure to mortgages, and decreased leverage. The stock price continued to drop over the summer and investors spurned management.
  • In September, the collapse in talks between Lehman and Korea Development Bank precipitated a new drop in the stock price as investors (hedge funds and short-term creditors) began to withdraw funds and limit exposure. The stock continued to drop as its cash reserves dwindled, losses and write-downs were reported, and restructuring programs were announced. A final attempt at a rescue by Barclays and Bank of America failed over the weekend of September 13 and on that Monday, the company declared bankruptcy.
  • Bear Stearns was in a similar position to Lehman Brothers, in that it was not a chartered institution, was publicly-listed, was an investment bank, and faced financial distress from its risky positions and unsound management practices. It was, however, the recipient of an emergency Federal Reserve loan via JP Morgan, earlier in the summer. The reasons for this, contrasted against the lack of such a loan to Lehman, are discussed below.

Is the question relevant?

My first comment is that the phrasing of the question “should Lehman have been allowed to fail” is actually quite misleading. A more pertinent question is “Could Lehman have been saved?” The answer, I think, is no. Recall that the rescue of Long-Term Capital Management in 1998 was orchestrated by the Federal Reserve of New York, but involved no public funds. That is, the Fed compelled creditors of Long-Term to recapitalize the firm. There were several attempts at a private sector recapitalization of Lehman Brothers; there was simply no appetite by its creditors or competitors to intervene.

Why is it the case that after the inability to recapitalize privately there was no recourse to a public recapitalization or any other preventative action by a government agency? Just as was the situation with Long-Term, Lehman was not a chartered bank. It’s primary regulator was the Securities Exchange Commission (SEC); the FDIC and (New York) Federal Reserve were not its supervisors. The SEC has no powers like the FDIC or Fed, and can really only intervene through review of a company’s risk management and investor protection policies. It can also levy fines on its supervised entities. In other words, it probably would have been illegal for the FDIC or the Fed to have used public funds to support Lehman Brothers. Furthermore, the SEC and the New York Fed have a long and combative history. Again, even though the Fed could not have provided any kind of balance sheet support, we should at least recognize that these turf wars prevented a lot of meaningful interagency communication.

In the absence of any consensus by private companies to support the bank, there was very little the state could do within the parameters of existing banking and macroprudential law to prevent the bankruptcy of Lehman. Specifically, with no chartered bank, the FDIC could not intervene by seizing the bank and its assets. The US Treasury could not have organized a direct loan nor could it have offered funds under various emergency programs related to the preserving the integrity of the dollar. And the SEC has no such powers in any event.

The exception is Section 13(3) of the Federal Reserve Act, which authorizes the Federal Reserve Board to permit a Federal Reserve Bank to extend loans under exigent and unusual circumstances. So essentially the question is really why Lehman Brothers was not offered an emergency loan as was Bear Stearns. What explains this discrepancy? In the words of Fed Chairman Ben Bernanke:

A public-sector solution for Lehman proved infeasible, as the firm could not post sufficient collateral to provide reasonable assurance that a loan from the Federal Reserve would be repaid, and the Treasury did not have the authority to absorb billions of dollars of expected losses to facilitate Lehman’s acquisition by another firm. Consequently, little could be done except to attempt to ameliorate the effects of Lehman’s failure on the financial system (underline mine).

The underlined portion is actually very important. Pursuant to Section 13(3) of the above stated Act, the Fed cannot extend a loan with the knowledge that the loan cannot be repaid. The perception on Wall Street prior to Lehman’s bankruptcy was that it was insolvent; it could not repay any loans extended to it. Certainly, this does not explain why the Fed did not extend such a loan many months before, but then hindsight is twenty-twenty, and there are limits to what these regulators know (especially in light of the turf wars just mentioned). So, the state was effectively unable to save Lehman Brothers.

So what?

The next pertinent question is, what does it matter that Lehman Brothers failed? Many would stipulate that its bankruptcy was the triggering mechanism of the banking panic that fall. I suggest this is wrong. There are several relevant points here.

First, housing markets began to buckle in late 2006 and early 2007. This manifested in liquidity problems at a host of non-bank financial institutions, including two hedge funds associated with Brazilian firm BNP Paribas in 2007 and Bear Stearns as mentioned. Saving Lehman would not have prevented housing markets from tanking or prevented the liquidity problems associated with the failure of mortgage markets and products. The Lehman bankruptcy was only one event in a long series of events that dried up credit and lending. Interbank lending in particular had already seized up.

Second, it is arguable that US financial markets were already in a state of panic before the weekend that Lehman failed. Again, note the experience of Bear Stearns. There are other examples: Countrywide Financial experienced a run in August 2007 before being acquired by Bank of America; IndyMac Bank suffered a run in July 2008 after Senator Charles Schumer stated to the media that he believed the bank was unstable; Washington Mutual witnessed massive withdrawals by its retail customers beginning on the same day as Lehman announced its bankruptcy. The financial panic, not only in the ‘shadow’ financial sector as well as in retail, therefore, was already underway when Lehman failed.

And finally, the stock markets “crashed” beginning on September 16, 2008, the day after Lehman declared bankruptcy. Indeed, during several trading sessions in September and October of 2008, US stock markets lost two to five percent of their value. However, again, equity markets had begun to decline beginning in 2007. If Lehman Brothers had not failed, then stock markets likely would have responded to similar triggering mechanisms, of which there were many.

These points support the conclusion that at a certain stage in the financial evolution of the US economy between 2003 and 2006, a financial crisis became inevitable. This was due to the construction of balance sheets, the dependencies erected between sectors of the economy, the rampant fraud and corruption in markets, etc. Lehman stands out principally due to, I suspect, the animus held by many on Wall Street for state regulation and action that doesn’t suit their wishes. The Lehman Brothers bankruptcy is partly an instance of scapegoating–‘the government failed to act’ narrative–and a failure of imagination, specifically the failure to grasp the roots of financial crises as endogenous and nonrandom.

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