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A Year After Lehman: Lessons Learned

Lehman Brothers, 2008; file photo

Editor’s note: All this week on the Business Desk, we’ll be featuring contributions from economists, financial journalists, and other experts on the origins and impact of the financial crisis.

Today, nearly a year after the collapse of Lehman Brothers set off one of the most volatile weeks in Wall Street history, we asked several experts to weigh in on lessons learned.

Barry Schwartz:

Policy makers, journalists, and social commentators responded to last year’s financial crisis with two types of suggestions about how to prevent it from happening again: better regulation and smarter incentives — sticks and carrots. Understandably so.

But some caution is in order. The financial industry has found clever ways to dodge all sorts of regulations in the past. And the “perverse” incentives that generated the most egregious behavior in the financial world last year were hailed only a few short years before as the “smart” alternative to what had gone before. I think something more is needed.

Instead of simply worrying about engineering “how” financial people do their work, with regulations and incentives, we would do well to pay attention to “what” work they do.

We certainly need better regulation and oversight. And we certainly need to eliminate incentives that actively push people to do the wrong things. This is as true of healthcare as it is of the financial industry. But beyond that, we need to identify and articulate a richer understanding of what it is that bankers (or doctors) are supposed to do.

“Supposed to do” in a moral sense, not just a legal sense. Failing that, we will come up with our new rules and incentives, fix the problem — temporarily — and be caught unawares when it resurfaces in a new form.

In December, president-elect Obama said of the bankers that “they must ask, not just ‘is it profitable,’ but ‘is it right.’” I think he was exactly correct about this, and no amount of tinkering with regulations or incentives will enable us to avoid that question. But to ask and answer the “is it right?” question is to have an idea of the proper work of a banker that goes beyond just making money.

Better regulation and smarter incentives will perhaps protect us from really bad bankers (and doctors and insurance companies and drug manufacturers) but it will never get us good ones.

Barry Schwartz is professor of social theory and social action at Swarthmore College and author of The Paradox of Choice: Why More Is Less.

Richard Sylla:

The biggest lesson for the business world arising from Lehman’s collapse a year ago is to be wary of consensus thinking or, in other words, never be confident that the unexpected can’t happen.

A valid inference from the orderly federal bailout of Bear Stearns in March 2008 was that a firm such as Lehman, which was twice the size of Bear Stearns and much more of an international player in finance, would certainly be bailed out in a similar and orderly way if it experienced problems like the ones Bear Stearns had. That was the consensus. But it didn’t happen. The federal financial authorities decided over a weekend to let Lehman fail. The consequence of that decision was that the expectations of financial institutions, investors, and businesses around the world were dashed. Panic set in, and credit markets froze up even more than they had during the first year of the crisis. A money market fund invested in Lehman paper broke the buck, setting off a run on other money market funds. Asset prices, both real (houses, commodities) and financial (stocks, bonds, commercial paper) tanked, and a yet barely identified recession suddenly became a lot worse.

After the fact of Lehman’s failure, the authorities claimed they had no choice, that there was nothing they could do. That claim seems lame given all the other innovative and unprecedented measures they then implemented —the bailout of AIG, TARP (the September and October ’08 versions of the ‘troubled assets relief program’), TALF (the ‘term asset-backed securities loan facility’), TLGP (the ‘temporary liquidity guarantee program’), and CPFF (the ‘commercial paper funding facility’). If Lehman had been handled like Bear Stearns, which is what most people expected, many of these costly innovations might have proved to be unnecessary.

Failure of one or more large banks or firms has been a feature of most of history’s numerous financial crises. A number of them have witnessed orderly bailouts or rescues of troubled institutions: Barings in 1890 England; Trust Company of America and the Moore & Schley brokerage in 1907 America; and Long-Term Capital Management in 1998.

The current crisis appears to be unique in a way. The authorities bailed out Bear Stearns (really, Bear’s creditors), creating the impression that no larger firm would be treated differently, and then they sat on their hands when Lehman, a much larger firm with similar problems, tottered on the brink of failure. The reasons for this flip-flop are still unclear. It will take time for governmental financial authorities to restore whatever confidence the business world may have placed in them.

Yes, the crisis might have been much worse without all the bold measures taken after Lehman failed. But it might have been much less severe if Bear Stearns had not been rescued and Lehman, assuming it needed saving, had been saved.

Richard Sylla is professor of the history of financial institutions and markets at NYU’s Stern School of Business.

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