Let's Put the Lehman Bailout Debate to Rest
An old meme in new clothing has been circulating recently: The Federal Reserve could have and should have saved Lehman Brothers. It had the resources, the legal authority and the obligation to do so; its failure to act let a modest financial fire become a full-blown credit crisis.
It is an interesting post-crisis theory from academia. But some of the claims are irrelevant, and almost all of them are wrong.
Larry Ball, chairman of the economics department at Johns Hopkins University and a researcher at the National Bureau of Economic Research, makes this argument in a new paper titled "The Fed and Lehman Brothers." There are three issues here worth addressing, and one that time and space doesn't allow for:
- Could the Fed have rescued Lehman?
- Was Lehman solvent?
- Was it capable of raising capital?
The issue I'm skipping for now (assuming the Fed could have rescued Lehman) is whether it should have done so. That's a separate question.
Let’s dispose of the first issue: That the Fed could have rescued Lehman Brothers, since a collapse would be an existential threat to the banking and financial systems, and withholding a bailout was likely to precipitate a much greater crisis. That’s not my belief, but it was the argument for a bailout in 2008, and ever since.
As subsequent events have shown, most especially with the Fed-led bailout of insurance giant American International Group, if there was a will, there most certainly was a way. Given all of the various bailouts of dubious legality, the Fed, Treasury and Congress most certainly could have devised a rescue plan for the 158-year old bank. But so what? The subprime meltdown was coming, and bailing out Lehman would have sent just as dire a signal about the health of the financial system as letting it collapse.
The second issue is two-fold: Was Lehman technically solvent and could this be determined in the weekend before the collapse with any degree of confidence? The answer to the former is probably not; the answer to the latter is definitely not.
As researchers William R. Cline and Joseph E. Gagnon at the Peterson Institute wrote, Lehman Brothers was “deeply insolvent.”
Our guess of Lehman’s true net worth at the time it filed for bankruptcy is somewhere between –$100 billion and –$200 billion . . . In the end, it is this negative net worth and the Fed ’s unwillingness to lend more than the collateral it received that made it impossible to find a buyer for Lehman.
Questions of Lehman’s true liquidity were evident even in early 2008. Even worse, “what little collateral Lehman had to pledge was of questionable quality and scattered across many affiliated entities.”
But the proof of Lehman’s insolvency is found in its notorious accounting deception, Repo 105. Each quarter, Chief Executive Officer Dick Fuld and his team of accountants at Lehman managed to move about $50 billion in liabilities off of Lehman’s books just in time for the quarterly earnings report. As the Wall Street Journal reported, “Because no U.S. law firm would bless the transaction, Lehman got an opinion letter from London-based law firm Linklaters.”
Hiding $50 billion dollars or more of liabilities each quarter is evidence of capital inadequacy or excessive leverage, if not outright insolvency. See chapter 11 on the bankruptcy report on Lehman Brothers -- it details the firm's many follies, leaving no doubt that it was bust.
Lehman’s accounting was especially opaque, even relative to other investment banks (and that’s saying something!), making it difficult for any suitor to throw Lehman a lifeline, especially on such short notice.
But there was one white knight who could have saved Lehman: Warren Buffett, chairman of Berkshire Hathaway. This resolves the last issue of whether the firm could have raised capital independently. Professor Ball observes:
The Search for a Strategic Partner Between March and September, Lehman executives sought a strategic partner that would take an equity stake in the firm or buy it entirely. The Valukas Report (Appendix 13) lists more than thirty prospects that Lehman approached, including investment banks around the world, private equity firms, sovereign wealth funds, and Warren Buffett and Carlos Slim. Yet, after the June 12 stock issue, none of Lehman’s efforts to raise capital was successful.
This isn't quite correct: Berkshire Hathaway offered Lehman Brothers capital on terms that were more generous than the deal it would eventually offer (and be accepted by) Goldman Sachs. As I wrote in "Bailout Nation":
According to Bloomberg, Berkshire Hathaway offered to buy preferred shares that would pay a dividend of 9 percent and could be converted to common at the then- market price of $40.30. Buffett’s money was costlier than other potential investors, but it came with the imprimatur of the world’s best-loved investor. That alone probably would have guaranteed Lehman’s survival.
Part of Buffett’s offer was that Lehman Brothers senior managers invest on the same terms alongside him with their own cash. Fuld spurned that proposal.
When Buffett offers you a few billion dollars -- and you foolishly reject it -- you can no longer make the claim that attempts to raise capital were unsuccessful.
It is very easy to succumb to hindsight. Just peruse some of the news headlines of the day, and you get a very different sense than the one Ball has assembled.
No, Lehman Brothers did not “precipitate” the financial crisis. The better metaphor is that Lehman was the first trailer in the park to be destroyed by the tornado. Whether it lived or died was not going to stop the financial forces that had been decades in the making and unleashed when the credit bubble popped.
I agree with Ann Rutledge, a principal with New York-based R&R Consulting, and co-author of two books on structured finance. She noted “It wasn’t a mistake to let Lehman fail, it was a mistake to let it live so long.”
Maybe now this exercise can be put to rest once and for all.
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