Lehman's Fall: The What-Ifs Linger

What would the past year have been like if the government had bailed out Lehman Brothers? There's no easy answer

Around every memory of Lehman Brothers' bankruptcy filing one year ago hangs the question: What if Lehman had been saved? Wouldn't we all be better off—and a little less stress-worn—than we are today?

It was Lehman's failure that was the immediate cause of the Panic of 2008, now a landmark in financial history. The credit markets had been rattled for months by the deterioration of the housing market and only a week earlier by the steps the federal government took to prop up mortgage financiers Fannie Mae (FNM) and Freddie Mac (FRE). But it was Lehman's bankruptcy that sent the global financial system into outright crisis mode.

When Lehman stopped paying on its commercial paper—the short-term corporate IOUs it used to borrow from money market funds—individuals and corporate treasurers alike rushed to withdraw their cash from money funds all over. The funds, in turn, scrambled for cash and took back what money they could from banks on both sides of the Atlantic, freezing up lending everywhere. In the following weeks, governments around the world had to take unprecedented steps, such as guaranteeing money market funds and pumping hundreds of billions of dollars into shaky banks, before the financial system would begin to thaw.

"We Had to Let It Fail"

Officials in charge at the time, from the Bush Administration and Federal Reserve, argue to this day they had no choice but to let Lehman fail. They say they lacked the legal authority and funds to intervene with the investment bank. Fed Chairman Ben Bernanke told Americans in an unprecedented televised "town hall" appearance in late July that while the Fed had been able to backstop a buyer for Bear Stearns the previous spring, the problems at Lehman were too grave. "[T]here was just a huge, $40 [billion], $50 billion hole that we had no way to fill and no money, no authorization, no way to do it, so we had to let it fail," Bernanke said.

Others argue policymakers could have found a more creative approach, had they wanted to. "In that kind of emergency, they could have found a way," say Douglas Elliott, a former investment banker and now a fellow in economic studies at the Brookings Institution think tank in Washington.

But would doing so have helped? In one limited sense, maybe. If Lehman had not gone bankrupt, its commercial paper would have still been good, there would have been no losses at money market funds and no panic, right? Not necessarily. Many economists, market participants, and policymakers argue that saving Lehman would only have postponed the panic briefly, if at all—and may well ultimately have worsened the crisis.

The Underlying Awareness

The fundamental problem was that there was an underlying awareness that many financial institutions, like Lehman, had used too much money from short-term lenders, such as money market funds, to make long-term loans that were going bad, such as those on real estate. If the short-term lenders hadn't discovered that Lehman might run short of money to repay them, they would have soon faced the reality at another financial institution and rushed to get their money back then. Or so the thinking goes.

Something like a run on the bank might have even started the next day. After all, American International Group (AIG) was also on the verge of failure. And just a day after Lehman's bankruptcy on Sept. 15, 2008, the insurer received $85 billion in government funds and guarantees. Given the company's integral role in the multitrillion-dollar derivatives market, its failure would have triggered many of the same reverberations as Lehman's—perhaps more—and policymakers knew it. "You would have still had a crisis when AIG was bailed out," says John Coffee, a Columbia University law professor specializing in the financial markets.

Moreover, other firms were looking shaky, too, as investors fretted that their assets were worth far less than the companies' books showed. Those doubts—illustrated by the dramatically widening credit-default swap spreads on companies such as Morgan Stanley (MS) and Goldman Sachs (GS)—could well have led to a run on those firms, which also relied heavily on the day-to-day confidence of short-term lenders. "That was really the fundamental feature of the crisis," says Phillip Swagel, who served as assistant Treasury secretary for economic policy last fall and now teaches at Georgetown University. "You had a financial system that did not have enough capital to take the losses that were there, to make good on all those bad loans. If you had bailed out the entire system, put a blanket guarantee on all creditors, that would have prevented the meltdown, but at great cost—both immediate cost and, I would say, future cost."

The TARP Angle

But bailing out Lehman—especially if followed by a bailout of AIG—could have made any further assistance to the financial sector that much more difficult. Public outrage at back-to-back, multibillion-dollar bailouts might have made it nearly impossible to pass the Troubled Asset Relief Program—the legislation signed into law in October giving the Treasury broad latitude to use as much as $700 billion to stabilize the financial system. Even amid the panic, Treasury Secretary Hank Paulson had trouble convincing Congress that TARP was necessary: It failed its first vote of the full House of Representatives.

"All of us at Treasury are convinced that if Lehman had been rescued, we either never would have gotten TARP authority, or we'd have been pursuing it later in the year," says former Treasury spokeswoman Michele Davis. "So later in the year, when [Citigroup (C)] stumbled, no capital to inject there. And when AIG needed capital in November, there would have been no TARP [money] to inject. And again when [Bank of America (BAC)] needed capital in January."

And to the extent that saving Lehman Brothers might have delayed the crisis, bailing it out could actually have worsened the outcome. By reassuring the markets that the government would step in to prevent the failure of major financial firms, the companies and their executives may have been encouraged to take bigger risks in an effort to dig themselves out of their financial holes. Then, when collapse finally came, the capital shortfalls could well have been worse.

Not everyone is convinced by this reasoning, of course. Elliott, the former investment banker at Brookings, says rescuing Lehman could have softened and slowed the bursting of the speculative bubble that had inflated asset prices.

A Softer Blow?

"The damage was so strong, and helped send the economy into such a tailspin, I have to believe we would have been better off" saving Lehman, Elliott says. "October was always going to be worse than September, no matter how we handled it, but we just fell off a cliff. I think we would have glided down instead of hitting so hard."

And one federal official, who has closely analyzed the financial crisis, concludes that sparing Lehman might well have prompted tougher love from government officials for other financial firms in distress and for the financial markets in general. If the Federal Reserve and Treasury had not been so frightened by the panic that Lehman's collapse triggered, the government might have forced shareholders and creditors of failing banks to take more losses. The officials might have also been slower to shore up the broad financial system with capital infusions, cheap loans, guarantees against losses, and purchases of mortgage-backed securities. Such a stance could have even helped prevent another crisis: Being tougher on the bailout could have enforced more discipline on big banks and general credit market lending. And, more discipline, in theory, would discourage the kind of reckless borrowing and lending in the future that caused this crisis in the first place.

Instead, what happened is that the banks and credit markets only got a short dose of discipline before the government started up its new bailout machinery. Now bankers, their shareholders and lenders, and the credit markets have seen how much the government will do to stop a panic. And, many are convinced the government will never allow another failure like Lehman. "People got the lesson that you can never let these fail," says one government official who asked not to be named. When it comes to heading off a period of crazy lending in the future, he says, "we might have made the problem worse." But with people and politicians more concerned about the economy today, that's a problem for another day.

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