Lehman Brothers And The Financial Crisis: What Went Wrong?

Milton Ezrati

Chief Economist

This tenth anniversary of the Lehman bankruptcy would seem to demand reflection. Common wisdom, after all, holds that the failure acted as the detonator of the great financial crisis and recession of 2008-09. A review of what went wrong might offer a way to avoid such disasters in the future. More needed perspective might emerge from a shift from this common wisdom and a consideration of an alternative explanation for what happened in 2008, that Lehman’s failure was less a problem in itself than a sign that the authorities were in over their heads and did not know what they were doing, feelings primed to create a financial crisis.

Washington at the time – the Treasury and the Federal Reserve – certainly acted in a chaotic way. At the beginning of the troubles, when the investment bank Bear Stearns suffered liquidity problems, official Washington, led by the Fed, forced its sale to J.P. Morgan at bargain prices. Treasury Secretary Henry Paulson then pushed for Washington to create a $700 billion fund to rescue major financial firms. That is big money, even by Washington’s standards. Congress initially rejected this Troubled Asset Relief Program (TARP) fund, as it was called, but the administration pushed harder, and eventually, it passed. The loans it extended to major firms, Citibank and others, came too late for Bear Stearns, of course. Washington had already seen to that. The investment bank and its shareholders had already lost out to the benefit of J.P. Morgan. Then, while pouring TARP funds into some institutions, Washington decided to let Lehman fail. Shortly after that, the authorities decided to give the insurer AIG loans, but unlike the other firms to which it lent money, the authorities in this case also took over management.

It is easy to see how such a potpourri of solutions would prompt investors to wonder what Washington’s plan was or if it had a plan at all. If some firms got emergency loans, with conditions to be sure but were otherwise left alone, why were others taken over or compelled to sell themselves or to go bankrupt? The pattern could only make everyone also wonder what would happen to the next company that faced liquidity problems or worse. What novel “solution” did the authorities have in store for it? The uncertainty of the situation prompted people and firms to pull back from trading, fearing that counter parties would fail to meet their obligations.  More than any particular failure, it was this reluctance by financial people and firms to deal with each other that froze financial markets late in 2008 and precipitated the crisis. This might well have happened otherwise, but surely Washington’s uneven behavior contributed meaningfully.

Contrast this ad hoc behavior with Washington’s much more coherent approach to the savings and loan (S&L) crisis of the 1980s. At that time, newly eased regulations had allowed S&Ls to become more aggressive than in the past. Many extended themselves beyond their expertise and got into trouble, enough to make financial markets as a whole see all S&Ls as vulnerable. More dangerous still, those questions about S&Ls led financial players to worry about which banks and other financial institutions were vulnerable to the weaker S&Ls. The situation threatened to undermine people’s confidence in the system.  A crisis was in the making. Washington, rather than handle each phase differently than the last, as in 2008, chose instead to get ahead of the situation with a coherent plan. To ensure that trading, as well as borrowing and lending, continued, it established the Resolution Trust Corporation (RTC) to handle the trouble in a consistent and coherent manner, one that could restore confidence.

To do this, the RTC treated all in an evenhanded way.  It relied on well-established bankruptcy procedures for firms that encountered trouble, what the courts would have done on a case-by-case basis.  It took charge of failing S&Ls and put out their managements and boards.  Just as in a conventional bankruptcy, it then sold off viable assets to pay what debts could be paid immediately.  It held onto the questionable assets with an eye to working them out over time.  Because the approach was comprehensive and evenhanded, because it followed rules with which all executives were familiar, the RTC quickly brought calm.  People believed that the authorities were on top of the situation.  Fears quieted and with it came a renewed willingness among financial players to trade and borrow and lend. The panic lifted. The approach did put taxpayers at risk for the questionable assets, but as it turned out the improved environment lifted values and the RTC actually turned a profit for taxpayers over the longer run.  The only losers were the managements and boards of the incompetent firms.

Some might look at the contrast and suggest that Washington’s more recent behavior speaks to incompetence. Others might suggest, more ominously, that it reflects a kind of favoritism–or even, one might say, cronyism. The authorities in 2008-2009 certainly picked winners and losers, and the winners, either by accident or design, were in fact the better-connected, better-established firms.  In a manner that inverted the results of the RTC, many managements and boards at incompetent firms this time kept their jobs even as the antics of the Fed and the Treasury exacerbated the crisis for most of the rest of the county. Certainly, none of the authorities acting at the time, neither Treasury Secretary Paulson nor Fed Chairman Ben Bernanke, has ever given an adequate answer as to why they chose to rescue one firm and take over another or let a third fail.

Financial historians, those with a forensic bent, will perhaps sort this out one day.  The evidence we do have suggests that at the very least the kind of quiet thoughtfulness and competence that effectively quelled the 1980s crisis eluded Washington ten years ago. That fact might well guide official behavior next time.

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