The Fallout from Lehman

Let's go back in history and then take it chronologically now. So 2007-2008, you're the chief economic adviser. When did you guys know that, lo and behold, we might be holding a bag of stuff we don't want to hold, coming up soon? What were you debating? What were you talking about? And how slowly did the conversation you were having get more and more serious about a possible crisis?

I would say there are about two different eras through the campaign. The first thing I'll note is way ahead of me, way ahead of any of the advisers or any of the people on Wall Street, then-candidate Obama was well, well ahead of the curve. He had sent letters to Secretary [of the Treasury Hank] Paulson and to [Chairman of the Federal Reserve Ben] Bernanke, asking them to look at subprime mortgages, that there could be a brewing crisis.

In the summer of 2007 and going into the fall, the president goes and gives a speech at NASDAQ in which he says: "Number one, Wall Street is not an island. If the middle class can't pay their mortgages, you may think that is not going to reach you, but I assure you it will. We're all in the same economy. I'm going to be for a middle-class agenda, and you shouldn't be against it. You should be for it. And number two, it doesn't make you anti-business or anti-market to be for stronger rules of the road and a sound regulatory financial system."

No two points were ever more worthy, and no two points were ever more central to a financial crisis than that. That was the fall of 2007. After Bear Stearns in March of 2008, we're in the middle of an epic primary campaign between [then-Sen. Hillary] Clinton and Obama. Obama goes and gives a speech with [former Fed chair] Paul Volcker sitting right in the front row at Cooper Union in which he goes through in great detail, "Here is how we should re-establish rules of the road and regulation of financial system."

It's March of 2008. In the audience are primarily political journalists who are all looking at each other and saying, "Why is he talking about Fed oversight?" It was not on the radar screen of the political system. But it was on the mind of the president, because everywhere he was going, this was the natural culmination of the public is losing trust in the financial system. And when you lose public trust in the financial system, what tends to happen is everyone pulls their money out. And that is the essence of what the financial crisis was.

So I would say the president was definitely concerned about the potential for crisis all throughout 2008 and demonstrated that [by] giving speeches on the subject. By the summer of 2008, in running up into Lehman, through Robert Wolf, [Obama adviser and president and COO of UBS Investment Bank], through some other connections of people that he was talking to as well as talking to the economists, people were on pins and needles, because we knew if the credit system collapses, the country could be in for a real bad recession.

And then, after the events of Lehman, the doors blew off. Then at that point, we knew we had had a series of midnight-to-3:00 a.m. phone calls throughout the summer comprised of a lot of major-league names in finance and economics. Paul Volcker, he didn't have a cell phone, and finally they demanded that he get a cell phone, because there were so many times we were trying to reach him at midnight or whatever time that he had to do that.

By the fall of 2008, Secretary Paulson and the administration are calling then-candidate Obama, and they are saying: "Look, we think the world is close to coming to an end, and we really need your support. What do you want to do?" Both of the candidates I think were thrown into positions that are normally reserved only for people that are already the president, where they are being pressed to publicly get up and say: "What are you going to do? What do you want us to do?"

I think it is to President Obama's credit. It wasn't a secret that the TARP, that the financial rescue or any of that stuff was unpopular. That was easily understood from the second it was getting announced. The question really was, despite that being tremendously unpopular, maybe the most unpopular thing the government has ever done, do we still have to do it? And there were certainly political people advising him: "No. Well, look, why can't we demonize this?" But the president said: "It's too dangerous. We can't do that."

What did you find the reason was for why Paulson and Geithner decided that they would let Lehman fail?

Right after Lehman goes down, Ben Bernanke goes up to the Capitol Hill to testify about why the decision was made to let that happen. And what Chairman Bernanke says is that the judgment was that in the wake of the Bear collapse, they had sent clear signals that they wouldn't do that again, and the market therefore had time to adjust. So their judgment was the market could absorb the Lehman collapse. That's what Chairman Bernanke said right after the collapse.

But soon thereafter the story changed. And the story of policy-makers, whether it was Tim Geithner or Ben Bernanke or Hank Paulson, becomes that we didn't save Lehman because we didn't have the legal authority to do so. We looked at all the facts, and what we really found was, there was a decision to let Lehman go. And as it turned out, it was a decision that was a miscalculation in the sense they undersized the effect of letting Lehman go down.

We really found that they made it on the basis of political considerations. There was clearly concern about the backlash of another bailout. We determined that they made it on the basis that they couldn't find a buyer and had doubts about whether they really could, absent a buyer, save Lehman. And they made the decision because, in a sense, they did miscalculate the impact of Lehman. But our conclusion was that it really wasn't the lack of legal authority. It was a decision to let Lehman go for a variety of reasons, political, financial, their sense of the market.

I think what happened is, when they saw the reaction to Lehman's collapse and the looming and pending problems at AIG which were coming at the same time, they reversed course again and, of course, moved in to save AIG.

Let's go back to the Lehman moment and break it down a little bit more.

Sure.

The report is very good at defining exactly what happens when Lehman goes down. What are the consequences?

Well, the consequences of Lehman going down, I think it goes back to what we were talking about earlier, which is that there are two consequences. First of all, there are the direct consequences from Lehman going down, the direct consequences, which is they have 900,000 derivatives contracts with other parties; they have relationships with other institutions. But more than that, the policy-makers have sent inconsistent signals. They saved Bear; they didn't save Lehman. So the marketplace doesn't know what to expect.

And there's no doubt, in the wake of Lehman, there is real panic in the marketplace. But I will say this, that whether or not Lehman went down or not, the marketplace was so infected with toxic assets that whether or not Lehman itself goes down, this country still faces a dramatic, dramatic financial crisis.

Did this administration miss its opportunity when they had the leverage, they had the power to make bigger changes? Did they lose that opportunity? And if so, why? Was it simply fear that we were in such a crisis that they couldn't move too radically or else the whole thing could come down?

Well, I can't look into other people's decision making, but I do think that there was an extraordinary opportunity to remake the financial system in a dramatic way in the immediate wake of this crisis. I don't [think] the opportunity is fully lost because the country is still suffering greatly. I'd like to view it as dramatic change delayed, not forever lost as an opportunity. But clearly, in the wake of the crisis, when banks only survived through the kindness and the willingness of the American people to [for pay] trillions of dollars to support them, clearly in that context there is greater opportunity to change.

And make no mistake about it, no matter what you hear from revisionists today, almost every financial institution was on the precipice of collapse in the fall of 2008. There are those who now say, for example, at Goldman, "Oh, we would have probably made it anyway." If you listen to Ben Bernanke, he's pretty clear that of the 13 biggest financial institutions in the country, perhaps only one would have survived.

I think Secretary Geithner himself has admitted that every major financial institution was on the way to collapse. You know, it's interesting. In the week after Lehman, Morgan Stanley goes from having about $130 billion in liquidity, cash, in one week to about $55 billion. Goldman Sachs -- supposedly bold, strong investment bank -- goes from $120 billion cash on hand to $57 billion. All these institutions were about to collapse, and they never would have survived but for the trillions of dollars afforded them by the taxpayers.

Going back to Bear, when Geithner, who is really handling that one, sees the hole in Bear, how surprised is he, and how extraordinary [is it] that he was surprised?

Well, I think it's extraordinary that he should have been surprised, given how many assets they had in mortgages, in subprime and what's called Alt-A mortgages. And, you know, when things go at Bear, they go fast. They start the week of their collapse with about $18 billion in cash, which is less than the other institutions. But within five days it's gone, as essentially there is a run on that institution.

In a sense, runs happen very quickly. So when they start, they gather tremendous velocity. As I noted earlier and I will just repeat, right after Lehman, Morgan Stanley goes into meltdown. They go from $130 billion on hand to about 55 billion. Goldman Sachs within one week goes from 120 billion to 57 billion.

Some could argue, hey, when runs happen, they happen fast, so the policy-makers had to act quickly. But I think what's most troubling is the extent to which they didn't see the fundamental rotting in the system that had manifested itself for years. And it was clear, I think, and evident to many people in the marketplace by the end of 2006.

And remember, this didn't happen in a vacuum. By the end of 2006, many of the biggest subprime lenders in this country are beginning to go out of business. At the beginning of 2007 New Century blows up, so, you know, there is lead time here. Now, I think the real story of this financial crisis is probably not so much whether the bailout was the right thing to do or the wrong thing to do. The real question is, how did it come to be that this nation found itself with two stark, painful choices, one of which was to wade in and commit trillions of dollars to save the financial system, where we still end up losing millions of jobs, millions of people lose their homes, trillions of dollars of wealth is wiped away, and the other choice is to face the risk of total collapse? I mean, that's the real story. How did the policy-makers, our government leaders, the financial sector maneuver this country into that kind of corner?

They want to look at the master contracts for the derivatives. And you guys find e-mails that define what? What is the fear of asking for those contracts?

The fear is the mere asking [for] those contracts will set off panic and will set off panic that there is a view that Lehman is in trouble, which of course people in the marketplace know. And it is really quite telling, because what's striking about it is, here we are a month out from the deluge, the implosion, and we don't even have, as a country, in our regulators and our policy-makers the basic knowledge that they need about how our financial system operates.

You know, there had been a dramatic transformation of the financial system from the 1980s…

How prepared were our Treasury and the Fed -- [then-Treasury Secretary Hank] Paulson, [Chairman of the Federal Reserve Ben] Bernanke, [then-President of the Federal Reserve Bank of New York Tim] Geithner in New York -- before this crisis? What did you guys find?

Woefully unprepared. I think that was for me one of the biggest revelations of the year-and-a-half investigation that we undertook. What became clear as you look at the record is the extent to which the people who were charged with overseeing our financial system really didn't have a sense of the risks that were embedded in that system that could collapse our financial system and, ultimately, our economy.

And there's instance after instance where the folks who were in charge, who were charged with protecting the public, are caught completely by surprise. Of course, in 2007, in the spring and summer of 2007, Hank Paulson and Ben Bernanke reassure the public consistently that there is really no chance that the problems in the subprime market will spill over into the larger economy. And of course that turned out to be wholly wrong.

A good example is in July of 2007, when one of the first real signals of trouble to come happens, and that is the hedge funds that are run by Bear Stearns blow up. And then there is a meeting at the Fed about the implications of that. And what you read when you see what happened in that meeting is the view is that Bear Stearns is relatively unique, when, in fact, now we know that the holdings of major investment firms in these toxic subprime securities was pervasive.

You see that it's only in August of 2008 the Treasury claims that it fully understands the depth of the problems at Fannie Mae and Freddie Mac, literally weeks before the government decides to seize those entities. It is only a month before Lehman collapses that the New York Federal Reserve, the Federal Reserve Board of New York, decides that it had better look into the derivatives positions of Lehman Brothers, who had 900,000 derivatives contracts, and only one month before they said, "We'd better get a handle on this."

And of course then they're afraid to ask for the information from Lehman, lest they set off panic in the marketplace.