Prof. Laurence Ball’s paper has been making news. The US officials let Lehman go in really adverse times. They have told us the i-bank could not be saved as it did not have any collateral. Though, few doubted this narrative.
In this shorter post, he explains that this narrative is wrong. Lehman could have been saved and it was just a political decision to let it go. They also underestimated the costs of the blowup:
In a recent monograph, I seek to set the record straight on why the Fed did not rescue Lehman Brothers (Ball 2016). To that end, I examine in detail the voluminous record on the firm’s bankruptcy, much of it from investigations by the Financial Crisis Inquiry Commission and the Examiner for the bankruptcy court. Both of these authorities had subpoena power, and they interviewed hundreds of people and gathered documents and emails from Fed officials and Lehman executives.
I conclude that officials’ explanation for the non-rescue of Lehman is incorrect, in two senses.
First, a perceived lack of legal authority was not the reason for the Fed’s inaction; and
Second, the Fed did in fact have the authority to rescue Lehman.
I base these broad conclusions on several findings, given below.
- First, before the bankruptcy, Fed staff extensively analysed Lehman’s liquidity risk and how the Fed might assist the firm. In the record of these discussions, there is little concern about the adequacy of Lehman’s collateral, and nobody suggests that legal issues might preclude a Fed loan.
- Second, arguments about legal authority made by policymakers since the bankruptcy are unpersuasive. These arguments involve flawed economic reasoning, such as confusion between the concepts of illiquidity and insolvency. They also include factual claims that are not supported by evidence. The Financial Crisis Inquiry Commission repeatedly asked Ben Bernanke for details about Lehman’s collateral problem, but Bernanke was unresponsive.
Further, from a de novo examination of Lehman’s finances, it is clear that the firm had ample collateral for a loan to meet its liquidity needs. In particular, I estimate that Lehman could have survived with $88 billion of overnight lending from the Fed’s Primary Dealer Credit Facility (PDCF), and the firm had at least $131 billion of assets that were acceptable as PDCF collateral.
Also, Fed officials did not stand by passively as Lehman failed, but rather took action to ensure that the firm filed for bankruptcy. Specifically, the Fed denied access to the PDCF to Lehman’s broker-dealer subsidiary in London, forcing that part of the firm into default. (A week later, the Fed granted PDCF access to the London broker-dealers of Morgan Stanley and Goldman Sachs.)
Finally, the Fed took on more risk in rescuing Bear Stearns and AIG than it would have if it rescued Lehman. In the case of AIG, the collateral accepted by the Fed included equity in privately-held insurance companies, which is hard to value. The collateral might have been worth less than the $85 billion that AIG borrowed.
Liquidity support from the Fed would have bought time for Lehman to seek a long-term resolution of its crisis. We will never know what the outcome would have been, but one possibility is that Lehman would have been acquired by the British bank Barclays. Barclays and Lehman made a tentative acquisition deal before the bankruptcy, but the deal was held up at the last minute by problems with British regulators. With time, these problems might have been resolved and the Barclays deal completed.
Alternatively, Lehman might have survived as an independent firm. This outcome would have been likely if Lehman succeeded with a plan to spin off some of its assets to a real estate investment trust. At worst, Lehman would have proven unviable and eventually been forced to wind down its business. An orderly wind down, however, would have avoided much of the damage to the financial system from Lehman’s abrupt bankruptcy filing.
All these events continue to tell you how all such centralised actions create trouble no matter what is done. If Lehman was saved, there would be criticisms that an investment bank was bailed out furthering too big to fail. If it was allowed to fail, there will be all kinds of conspiracy theories.
This Lehman-Fed episode will continue to interest scholars in future as well..It is a deep mystery…