Six years after Lehman, debating Fed independence and bank insolvency

The six-year anniversary of the month when Lehman Brothers failed, and brought down much of the financial sector with it, was a rough one for the Federal Reserve Bank of New York.

Stories in ProPublica and on NPR’s This American Life Friday revealed a New York Fed hobbled by so-called “regulatory capture” — long after the 2008 financial crisis. The institution the Fed was supposed to be regulating — in this case, Goldman Sachs — “captured” the Fed. Their regulators were uninterested in aggressively supervising the firm, and now a former bank examiner has secretly recorded audio from inside the Fed to prove it. That was last week.

By now, many readers have seen Tuesday’s New York Times Page 1 examination of “the bailout that never was.” In September 2008, the government concluded it could not bail out Lehman Brothers, which it considered insolvent — broke. That was a decision, that as the Times’ James Stewart and Peter Eavis write, “in cool hindsight, let problems at one bank snowball into a full-blown panic.”

These days, there’s little disagreement, former Fed Vice Chairman Alan Blinder tells the Times, that Lehman should have been saved. What’s still disputed in Washington and on Wall Street, and everywhere in between, is whether Lehman could have been saved. The news this week is that some people inside the New York Fed, unlike their boss at the time, Tim Geithner, thought the answer was yes.

Two teams of financial experts at the New York Fed came to that conclusion, but they never relayed the results of their research to Geithner. They’d been looking into just how broke Lehman really was, tasked with determining the value of the firm’s illiquid assets — the investments it couldn’t sell on the open market. Although the Fed teams didn’t arrive at an exact value, their analysis suggested that the Fed could save Lehman.

According to the six Fed officials who spoke anonymously to the Times though, it seems they never got that message out — or at least not effectively. Unable to speak to Geithner the weekend A.I.G. was crumbling, “the team members said, they delivered their findings orally to other New York Fed officials including Michael Silva, Mr. Geithner’s chief of staff.” They were told by the Fed’s general counsel “that there was ‘no time’ that weekend for a written analysis,” according to the Times.

(You’ll remember the name Silva from the other Fed-rocking story that broke this week. On Friday, the release of 46 hours of tapes secretly recorded by former bank examiner Carmen Segarra exposed a supervisory institution hesitant to hold Goldman Sachs accountable. Silva was Segarra’s boss, and he tried to convince her she couldn’t say Goldman was lacking a conflict of interest policy.)

In the days since September 2008, then-Fed Chair Ben Bernanke, then-Treasury Secretary Hank Paulson and Geithner have all argued that they did not have the legal authority to intervene to save an investment bank like Lehman. Bernanke made that argument to NewsHour’s Jim Lehrer at a televised town hall in 2009. “There 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. We had no choice.”

Princeton economist Alan Blinder is among Bernanke’s most enthusiastic supporters; he hired him at Princeton and the Lehman episode aside, gives Bernanke an A+ for his tenure at the head of the Fed. But “the Lehman episode,” Blinder told Paul Solman in January, “just sticks in my craw, not to save Lehman or put them to bed in a more gentle way.”

In our January Making Sen$e segment, which you can watch above, Blinder cast doubt on Bernanke’s legality argument.

ALAN BLINDER: Guess what? They had the legal authority to save the money market mutual funds by using something called the Exchange Stabilization Fund, which is supposed to be to support the dollar. Now, how did that work? But somehow the Treasury’s lawyers koshered that, when just a few days before nobody was koshering a saving of Lehman, so I count that as a mistake.

Blinder continued with this criticism on our Making Sen$e page:

Bernanke, I know, disputes this judgment on the grounds that the Fed lacked the legal authority to do what he thought best: to “save” Lehman with a big loan, much as it had done with Bear Stearns six months earlier. (Remember, the Lehman decision came before the Troubled Asset Relief Program [TARP] provided the Treasury with $700 billion to save the financial system.) Maybe so — if you construed the law narrowly and evaluated the quality of Lehman’s collateral with green eyeshades. But were those Bear Stearns assets, which JP Morgan Chase had refused to accept, really of such fabulous quality? And can’t you always find lawyers who will say yes, rather than no? After all, just days after the Lehman failure, the U.S. Treasury suddenly discovered $50 billion that it could use — legally, according to Treasury lawyers! — to save the money market mutual funds. No one sued Paulson.

As one of the anonymous Fed officials tells the New York Times, “We had lawyers joined at our hips. And they were very helpful at framing the issues. But they never said we couldn’t do it [save Lehman].” Yet another told reporters Stewart and Eavis, “It was a policy and political decision, not a legal decision.”

“But the government did let Lehman fail,” Paul Solman reported in 2009, “because it had to make an example of some firm? Because, according to some reports, Treasury Secretary Paulson didn’t like or trust [Lehman CEO] Dick Fuld? Whatever the reasons, the world economy froze almost immediately thereafter and still hasn’t really recovered.”

Over at Time Magazine, though, Michael Grunwald, who admittedly is biased, having helped Geithner with his memoir, “Stress Test,” argues that the Fed had no option to bail out Lehman — even though “they would have been thrilled to find a way” to do so. He cites a 2013 Peterson Institute for International Economics study, which the Times does not mention, concluding that Lehman was $100 billion to $200 billion “in the hole” in the fall of 2008.

Grunwald takes issue with the characterization that, as Blinder tells the Times, “the decision to allow [Lehman] to fail was the watershed decision.” Grunwald:

Even if the Fed had broken the law to lend into a run on an insolvent firm, and had somehow managed to stabilize Lehman rather than kiss its cash goodbye, it wouldn’t have defused the larger crisis. The government still lacked the authority to inject massive amounts of capital into the financial system — and a Congress that initially refused to grant that authority through the notorious TARP even after Lehman’s failure certainly wouldn’t have granted it before a failure of similar magnitude. Whatever. I guess some people find it comforting to believe the government could have snapped its fingers and ended the crisis early. It’s not a reality-based belief.

The Times suggests, though, that determining why Lehman was allowed to fail isn’t about who’s to blame; instead, this week’s news plays into a broader debate about the Fed’s role the next time they’re called upon to bolster the financial system.