Book Review: The Fed And Lehman Brothers by Laurence Ball

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In a new book just out to this month, The Fed And Lehman Brothers, economist Laurence M. Ball re-examines the evidence of the choices facing the managers of the 2008 financial crisis. In particular he looks at a crucial choice – to let the storied Wall Street firm Lehman Brothers fail in bankruptcy rather than offer taxpayer support for a bailout.

His conclusion: the Federal Reserve, US Treasury, and New York Fed made a grave unforced error in allowing Lehman Brothers to declare a messy bankruptcy – still the largest US corporate bankruptcy of all time – in the process adding destructive force to the financial tsunami already enveloping the economy and financial markets in September 2008. And they disingenuously described the reasons for their decision.

The main managers of the 2008 financial crisis, Treasury Secretary Hank Paulson, New York Federal Reserve Bank President Tim Geithner, and Federal Reserve Chairman Ben Bernanke all claimed in official testimony and their subsequent memoirs that Lehman Brothers was “insolvent” at the time of the bankruptcy. One of the conditions of Fed lending is that it cannot lend money to insolvent institutions, or banks with insufficient collateral to pledge for a new loan.

It is undeniable that Lehman faced a liquidity crisis in September 2008 – the inability to pay back everyone it owed money to, if everyone wanted their money back right away. That’s a classic problem facing any bank in which depositors demand immediate return of their deposits. The dispute Ball addresses is whether Lehman had enough assets in the medium-to-long run that would have covered what it owed so that a fresh loan from the Fed could have averted bankruptcy.

In household terms, we can imagine a well-off person with a valuable house and car worth a million dollars, $25,000 cash in the bank, and who owes $750,000 in a combination of a personal loan, mortgage and car loan. If a lender suddenly demands a $100,000 personal loan be paid back immediately, we would say that person has a liquidity problem but is not insolvent. Given enough time, the person could likely solve the problem, through a sale of the car and house. Even easier than a fire sale of the car and house, a fresh loan against the home equity would ease the situation. Bankruptcy is far from inevitable.

In the case of Lehman, Ball argues, the Federal Reserve had created a program earlier in 2008 that could have provided that fresh loan.

Through reviewing pre-bankruptcy financial disclosures, reports of the bankruptcy managers, and independent analyses of firms that considered purchasing Lehman but declined, Ball details the amount of assets Lehman had the week before it declared bankruptcy.

Hank_PaulsonHe conservatively estimates the assets available to pledge as collateral for a new loan from the Fed totaled $118 billion. Lehman’s ultimate need for funds, again conservatively estimated, probably reached $84 billion. In that difference, in the amount of available assets above Lehman’s borrowing needs, Ball makes the case that this was a liquidity problem, not an insolvency problem.

$84 billion, of course, is quite a bit of money. But considering that the Fed committed $123 billion to AIG and $107 billion to Morgan Stanley that same month, it wasn’t out of the range of what the Fed was otherwise and ultimately willing to commit to dampen the financial tsunami.

The managers of the crisis have claimed, to this day, the opposite. They argue that Lehman was insolvent, and any new loan from the Fed would put taxpayer money at risk of loss.

This may all seem like ancient history, but it’s still relevant today. The Fed raised rates a few weeks ago and plans a few more rate hikes the year, unwinding policies in place since the crisis. Meanwhile, we’re still trying to figure out what the right lessons are from 2008. We still do not have an agreement on the correct solution to Too Big To Fail financial institutions when they get in trouble and face a loss of confidence, essentially a “run on the bank.”

ben_bernankeDo we essentially nationalize them, as we did to mortgage giants Fannie Mae and Freddie Mac? Do we take an 80 percent government ownership, then slowly sell the pieces back to the public markets as they recover, as we did with insurance giant AIG? Do we guaranty portions of their bad debt portfolios and force a shotgun marriage among investment banks, as we did when JP Morgan Chase bought Bear Stearns and Bank of America bought Merrill Lynch? Or do we convert them to commercial banks from one day the next, and inject $20 billion of capital to signal public support, as we did with Goldman Sachs and Morgan Stanley?
The managers of the crisis did all these different things, with wildly differing outcomes for firms, employees, executives, shareholders, bondholders, and taxpayers.

The managers tried everything. The messiest, least controlled, and most destructive was the Lehman bankruptcy. Ball’s big question – did it have to happen? – is a counterfactual exercise that informs future choices. He further concludes, despite all the testimony of the crisis managers, that Treasury Secretary Paulson essentially made the call to let Lehman fail.
Paulson’s concern was to avoid the label “Mr. Bailout” in 2008, so he wanted to signal with the bankruptcy that sometimes firms did fail and that the government wouldn’t always be there. Ironically the bankruptcy was so disruptive that Paulson and the rest had to double-down, triple-down, and then quadruple-down on further bailouts. Clearly they did not anticipate the depth of the mess of Lehman’s bankruptcy filing.

The_Fed_And_Lehman_brothersHaving said that, it doesn’t mean I think that Paulson, Geithner and Bernanke blew it in the management of the 2008 crisis. My overwhelming thought, ten years later, is how well they responded to unprecedented and unpredictable events. We are incredibly fortunate those particularly competent people held those positions at that particularly crucial time. They made one big mistake with Lehman, and they kind of fudged their reasons for it, but overall managed throughout the fog-of-war of the 2008 crisis admirably.

 

A version of this post ran in the San Antonio Express News and Houston Chronicle.

Please see related posts:

Book Review: Too Big To Fail by Andrew Ross Sorkin

Book Review: Diary Of A Very Bad Year by Anonymous Hedge Fund Manager

 

 

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Book Review: Too Big To Fail

You may, like me, be curious about what happened during the Great Credit Crunch.  You may, like me, have the feeling we reached a financial precipice, peeking over the edge into the abyss.  But before falling in we blacked out and woke up in the hospital, a thick IV needle in the arm, tired and confused but otherwise basically OK, thinking, “But, but, but, wha, what happened back there?”

Andrew Ross Sorkin wants to answer this question for us in Too Big to Fail, his bestselling account of the eight most dramatic months of the Great Credit Crunch.  It begins in March 2008 with the demise of Bear Stearns, peaks the week of September 15 2008 (Lehman declared bankruptcy, Bank of America agreed to purchase Merrill Lynch, and AIG got its first $85 Billion bailout by the Federal Reserve) and ends in October 2008 with the mandatory TARP investments by the US Treasury in nine systemically important – aka Too Big To Fail – banks.

Sorkin covered the crisis for The New York times via his Dealbook column, and has a lot to offer us as that front-line journalist, under nearly war-time conditions of high stakes and daily – even hourly -changing conditions.  For sheer personal access to the leading protagonists, as well as the rendering of real-time conversations, Too Big To Fail is a helpful first brush at history.  No doubt the movie attracted even more attention than the book, because, well, most people would rather watch a movie than read.

For all the attention and acclaim he received for his A-list account of the Great Credit Crunch, however, Sorkin has two big problems.  The first is a minor stylistic issue, the second a fundamental difficulty.

Look, Sorkin had a problem in writing this book; namely, how to make concrete action out of events that took place primarily on the financial ledgers of governments and banks.  These ledgers do not exactly provide riveting visuals, and I definitely get the feeling Sorkin planned to sell the movie rights before he finished Chapter One.  So visuals were key to his plan.  As a way to create cinematic action Sorkin highlights every swift swipe of the Blackberry from Hank Paulson’s pocket, every frenzied snatch for the phone while riding in a Town Car zooming away from the Federal Reserve.  There’s a lot of gasping and ‘Oh my God!’ horrified looks as bank executives read the latest risk report on their phones from their loyal lieutenants.  Paulson’s phone in particular plays a fetishistic role in the book, constantly moving from his ear to his pocket and back.  It’s just a quirk of style on the one hand (movie rights must be sold!) but it is nevertheless distracting and silly.  Sorkin tries to show the high stakes danger facing Paulson and his deputy Neil Kashkari, but instead merely brings to the reader’s mind Crockett & Tubbs shouting into their oversized car phones, buzzing the Day-Glo storefronts of Miami in 1985.

The more fundamental problem with Too Big To Fail stems directly from Sorkin’s strength as a New York Times journalist – his access to financial executives and government officials.  They needed him to tell their story, and he needs them to write his story, but their pact of mutual benefit results in a narrative with no bad guys.  In Sorkin’s story, every Dick Fuld, every Tim Geithner, every Lloyd Blankfein and every Jamie Dimon is just a high powered guy with a Blackberry doing his darndest to survive this financial firestorm.  They gave extraordinary access to Sorkin, they will give extraordinary access to Sorkin in the future, and there’s really no point in painting any of them in a negative light, now is there?

Hank Paulson made this book happen through repeated interviews with Sorkin, in his attempt to get his (Paulson’s) version of the crisis on the record first.  As a result, the one exception to Sorkin’s rule of mutual benefit is Chris Flowers, who clearly got so under Hank Paulson’s skin (their historic antagonism goes back to the ‘90s when both were at Goldman) Sorkin shows him as the backstabbing, untrustworthy thief that he probably is.  In this case, Sorkin risks an unflattering portrayal (and really, the shocking thing is that ONLY Flowers is shown in this light) because he needs to present Paulson’s version of the truth.  Reading Too Big to Fail I kept thinking that the Wall Street I know has got a lot more unsavory characters than just Chris Flowers.

I do not mean to imply that I prefer a book bashing the heads of Wall Street firms.  There are plenty of those, and frankly they’re even less helpful than Sorkin’s book.  What we do need, however, is some analysis that might make Sorkin’s sources uncomfortable.  We need a chronicler of the Great Credit Crunch to contextualize what happened, to explain the forces at work that put us in this situation in March 2008 in the first place.  Less necessary is Sorkin’s entire book – which can be summed up as: ‘There were a bunch of aggressive but basically good guys working late nights and weekends to save their bacon and that of their firms, and it was really scary but kind of exciting to be there with them.’

If you read the news as obsessively as I did during that period, you know the basic facts, and Sorkin tells us a lot more basic facts of who said what to whom, and when, and what late model Blackberry they used.  But now we’re lying groggy in the ICU with that thick IV muttering, “OK, I know WHAT happened, but WHY?”

Please also see related post, All Bankers-Anonymous Book Reviews in one place.

 

 

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