inside the meltdown

Letting Lehman Go Under

Sheila Bair Chair, Federal Deposit Insurance Corporation

... With the failure, we saw a lot of decreased confidence in all financial institutions, including banks, and we saw a lot of volatility in deposits. And that was creating an additional instability with some institutions. Some were weak and were not going to be able to survive the situation; others were stronger. ...

There were two cycles. Actually, after Freddie Mac [Federal Home Mortgage Corp.] had been closed, which was earlier in July, we'd seen steep deposit outflows in that situation and had been very concerned about it. And then, after the Lehman Brothers failure, we saw another extreme liquidity situation, which ultimately led to their primary regulator, the OTS -- Office of Thrift Supervision -- having to close them, and they were also sold to JPMorgan Chase. Fortunately for us, we were able to resolve it at a zero cost to the Deposit Insurance Fund [DIF]. But then later we had Wachovia, and again, this was a severe liquidity situation with them. ...

The FDIC, the reason we were created is to provide stability [so] people don't pull their deposits out. But there's still a lot of uninsured [money] out there, and that was being pulled out, especially with these business transaction accounts. Typically business transaction accounts will exceed, the payroll accounts will exceed the insured deposit limits. Also, counterparties were concerned about whether they were going to be able to roll their debt. That was a much larger institution, and it was more diversified. And at that point, that was actually the first time we decided to invoke our systemic risk exception with the Fed and the Treasury, which is an extraordinary measure, to provide some support on an open-bank basis to try to stabilize that situation.

But the Lehman Brothers bankruptcy, ... it was interesting that the confidence shocks were truly systemic, even though that was an investment bank. Everybody started pulling back, including the more sophisticated banks, didn't want to lend to each other. These were other institutions that surely had some sophistication, acumen to analyze the balance sheet of their counterparties to make some valuation of their strength. Everybody was just frozen in place. Nobody wanted to take a risk anymore. And we'd really been dealing with that situation. We continue to deal with that situation. ...

Should Lehman Brothers have been saved? ... Why wasn't it saved?

Hindsight is always 20/20. ... It's difficult to know when to pull the trigger and then how the resolution should occur. We're fortunate that we have a statutory process to use for resolution. Ordinarily, we follow least cost, and there's a very strict statutory regimen that shareholders and unsecured debt holders need to take losses before the FDIC takes losses, and that uninsured depositors take losses with us. Of course, insured depositors never take losses.

But there's a process in place for doing this. We have a receivership and resolution staff that are expert in how to close institutions, how to do that in an orderly way so people don't get scared or upset, and it's always better to try to sell it off to another institution to keep it running, as opposed to putting it into some type of a bridge bank [temporary] situation, which is what we had to do with Freddie Mac, or we're selling it off in pieces. We try to avoid that. …

So the Lehman Brothers bankruptcy did create a lot of disruptions in public confidence. On the other hand, I don't think we should go so far back in the other way now [and] just guarantee everybody. ... Somebody has to take the losses, whether it's the taxpayer, whether it's the Deposit Insurance Fund, whether it's investors and debt holders. ... I think a process going forward that does still ensure that some of the private investors do have to absorb some of the cost of these failed institutions is key. But I think we can do that in a way that mitigates the pain, that spreads it out to those who truly were assuming that type of risk, and doesn't cause these disruptions that we saw after Lehman.

... Was Lehman Brothers a symptom or a cause of the meltdown that followed?

Boy, that's a good question. Probably a little bit of both. Even if Lehman had been not allowed to fail, there still was a deteriorating situation. The economy is obviously having increasing problems. That was going to be feeding into public confidence in the system.

So it may have been more of a catalyst or accelerating event versus an actual cause. Then again, though, I think there are certain aspects of -- especially for some of the counterparty relationships with Lehman, ... maybe if those had been stabilized but others had been haircut, that could have been handled in a smoother way. But I think we're all learning as we go on here.

And again, for non-banks, [there] just is no process. So the Fed and the Treasury have pretty much had to use an ad hoc process, because there's nothing in the statute to provide guidance as to how to do it. ...

Adam Davidson NPR/Planet Money

I felt kind of good that they hadn't bailed them out. I remember for a moment feeling like, oh, good, yeah, let's not bail out everybody. We've got to let one or two of these collapse to show what this means.

Moral hazard.

Yeah. Capitalism requires failure. Capitalism is a lot about failure. You need to allow failure. And I learned a lot more than I did about the commercial paper market that week, and the interbank lending market that week. Really I don't think it was until Wednesday that we really saw, oh, goodness, the economy came close to dying.

I was joking with some friends that the economy was legally dead for a few hours Wednesday and Thursday before the plan to have a bailout plan was announced. And that was the famous day that Paulson and Bernanke have this off-the-record conversation with Congress, and say -- the reports we hear is they said things like -- Bernanke, the Great Depression scholar, saying, "We won't even discuss the Great Depression after this, because this is much worse than the Great Depression."

I remember that week just trying to get my head around what are we talking about, and calling people and saying: "Are we talking about, like, no money, no barter system? What are we talking about?" And people saying: "No, there would be money. It wouldn't be much in the way of lending and borrowing, and that's what our economy is built on." And, "How long will it take to sort itself out?" "We don't know. Nothing like that has ever happened before."

I keep thinking of, like, [until] you have a plumbing problem at home, you never think about your plumbing. ... That was the week where I really got a crash course in the commercial paper and interbank lending market. [Prior to that week] I think I could have defined them; I think I could have vaguely told you what they were. But when something like that breaks, that is the cessation of a crucial part of capitalism. And that was really stunning.

[When the government let Lehman fall, did they not anticipate those problems with commercial paper and interbank lending?] What did they miss ... ?

... It was irresponsible not to expect some de-leveraging, some housing-price fall. It was not necessarily irresponsible not to see this. What happened was as Lehman was in trouble, and I was calling around talking to people and saying, "What are the systemic risks?" ... They were saying, "Well, look, everyone has known Lehman is the next one up, the most risky one." So anybody who has any exposure to Lehman is lessening their exposure. They've spent the entire summer making sure that a Lehman collapse can't hurt them.

So I went to bed Sunday thinking, oh, OK, Lehman can collapse, and it really isn't that big a deal. And we are being told the Fed and others have been looking over the Lehman books very carefully. ...

The shock was that [mutual fund] the Reserve Fund had this big exposure to Lehman. And to this day I don't think anyone can quite understand how the oldest and one of the most respected conservative money market mutual funds would have that much exposure to Lehman. It does seem nuts. It seems irresponsible and nuts. ...

Martin Feldstein Economist, Harvard University

Again, not being an insider, I don't know everything there is to know. The Fed and the Treasury have said about Lehman that they did not then have the legal authority to take over Lehman. Unlike Bear Stearns, where they could find a private buyer, there was no private buyer for Lehman. ... And they did not have the TARP [Troubled Asset Relief Program] at the time, and so there was no way that they could save Lehman, they said.

Now, could they have? Could they have found, with the help of their clever lawyers, a way around it? I don't know. But it was certainly something that had very adverse consequences in global capital markets. ...

Barney Frank Chair, House Financial Services Committee (D-Mass.)

... Should they have let Lehman go?

In retrospect, no. In all fairness, I wasn't one of the ones saying that at the time, although, once again, I would say with regard to Bear Stearns or Lehman or AIG, Congress was never consulted. We were never asked our opinion. We were informed that this was happening.

It does now appear that the failure to [protect] the creditors of Lehman, ... that does appear to have had a negative effect. ...

But at the time, not even you knew how connected --

You had a conservative secretary of the Treasury and a conservative administration. There was right-wing criticism over Bear Stearns. I had the Republican members of the Committee on Financial Services wanting to tear into Paulson and Bernanke for what they did to Bear Stearns. I was sort of defending them against their own Republican colleagues.

Why were they after them? What was the argument?

It was the violation of the principles of free enterprise: Let the chips fall where they may; let the market deal with it. And I think that is what happened with Lehman. You had people saying, "Hey, look. This is the market. If you don't let some people go belly up, then you lose the discipline of the market." ...

And I think that they probably felt that politically they had to; they couldn't intervene. It is then the case that the consequences of Lehman have now neutered our position to further interventions. People said, "Oh, let them go belly up," and then it turned out dead bellies aren't as much fun to look at as maybe right-wing theology predicted. ...

Alan "Ace" Greenberg Former CEO, Bear Stearns

When the government decides, for whatever set of reasons, not to help them live --

That's been chronicled and chronicled, and the government has always said one thing; they've said, "We've tried to help them, but nobody wanted to buy them." Somebody wanted to buy Bear Stearns. There's a big difference.

Now, I don't think anyone expected the government to take over Bear Stearns, run it for a while and give it back to management. And I don't think that they expected that they'd do the same thing with Lehman. There were people who wanted to buy pieces of Lehman, but nobody wanted to buy Lehman, according to the government, because of their exposure and their investment in certain things that nobody could tell really what they were worth. So to say the government didn't try to help Lehman, from what I've read, is not true. They tried very hard to help Lehman, but they didn't have anybody that said they wanted to buy Lehman. So who were they going to help, themselves? Who was there to help?

What about Barclays? Didn't they want to buy Lehman?

No, no. They wanted to buy pieces of it. They ended up buying I think the European operation. And somebody else wanted to buy Neuberger Berman, and somebody else wanted to buy this. Nobody wanted to buy the whole thing because of what they felt the potential loss was in some of their so-called assets, from what I've read. Haven't discussed this with anybody.

Do you think they should have known -- I mean, the government is getting whacked pretty hard for not having anticipated the effect of Lehman going down.

I don't know what the effect of that is. I don't know.

Everybody says this was the fundamental mistake.

Do I think that? No, I don't at all.

Why?

Why? Our problems are people with houses -- people being foreclosed, people that can't pay their obligations. These people weren't stockholders of Lehman. They're trying to help people keep their houses. The worst thing I think you can have is a house that nobody lives in. After three weeks there will be nothing left; all the fixtures will be stolen. So these are the problems.

Now, Lehman, I'm sorry what happened. I'm sorry that somebody didn't step forward and say, "We'll buy it." But to say that it's a problem here is, I think, utterly ridiculous.

But what about this idea that they represented such a linchpin in the paper market and all of that stuff, that with them going, everything was so interconnected that it just all imploded? No?

No.

Why?

Do you know somebody who was imploded? Who do you know that was imploded? Who? I don't know anybody. Can't blame the people we read about last week on Lehman, can you? Can't blame [attorney Marc] Dreier or [broker Bernard] Madoff, or that goofy governor of Illinois [Rod Blagojevich] on Lehman. You think they caused them to implode? I don't know of anybody that imploded because of Lehman. If you own Lehman stock, of course you imploded. If you owned the bonds that didn't buy a credit default swap, you imploded. But that's it.

Paul Krugman The New York Times

What I can say is that, if I had been there, I would have been deathly afraid of letting Lehman fail. Actually, I wrote about it the next day, that it was "financial Russian roulette," that I was amazed that they were willing to do that. And my guess is that people at the Fed would have shared that view, that they would have looked at it the same way, saying this is like Bear Stearns, only much bigger. This is like LTCM [Long-Term Capital Management], only much bigger. The downside risk of letting this thing go is just huge. And so my guess, but that's based purely on extrapolation, is that the Fed view was probably, don't let this fail.

Why was Paulson prepared to let it fail? You can get some sense of that by looking at what conservative editorialists had to say on Monday before it became apparent just how big a mistake it had been. They were praising him to the skies: At last he's drawn a line in the sand; no more bailouts; private sector has to stand on its own; no more financial socialism. ...

What would the Fed have been looking at that would have worried them? ...

Part of its traditional role is lender of last resort, which you're always afraid of. The Fed was essentially created as a firebreak against banking crises. One bank fails, and that starts a run on the next bank, and that bank fails, and you know what happened in the 1930s, but also in fact was a regular feature of the U.S. economy.

Basically the panic of 1907, [investment banker and financier] J.P. Morgan stepped into the rescue. And people said: "Hey, there won't always be J.P. Morgan to do this. We probably should have an official institution that does it." And they had trouble with that role until the New Deal added a bunch of extra firebreaks. That is the Fed's central role and always has been. Fed and LTCM, 1998 -- the collapse of liquidity because you have a financial panic is what the Fed is there to stop.

The Fed had, by the time of Lehman, understood that there are a lot of things that aren't -- commercial banks aren't the Fed's traditional responsibility -- that can nonetheless have the same systemic effects as a bank failure. And in fact, when people ask me, "What can I read to understand the nature of this crisis?," I actually point to a [then-head of the New York Fed Timothy] Geithner speech from June 2008, before Lehman, about the parallel banking system and how it has become vulnerable to the modern equivalent of bank runs. And that's the source of our extreme fragility financially right now.

Presumably people at the Fed, presumably Geithner as well, were saying: "This is effectively maybe an investment bank, not a commercial bank. But it's got short-term debt and illiquid assets and CDS, credit default swaps, and a lot of counterparty risk. And if this thing goes under, [there] could be cascading effects through the system." That would be the view you'd expect them to have. You'd expect them to be very afraid of letting an institution like that fail.

posted february 17, 2009

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