Lehman Had to Die So Global Finance Could Live By JOE NOCERA

September 12, 2009
Talking Business
Lehman Had to Die So Global Finance Could Live By JOE NOCERA

What if they’d saved Lehman Brothers?

What if, a year ago this weekend, the government and the banking industry had somehow found a way to keep Lehman from filing for bankruptcy? How might that have changed the course of the financial crisis?

We know, of course, what did happen; it is seared in our memory. On Monday, Sept. 15, 2008, when the news broke that, despite nonstop efforts that weekend, there would be no last-minute reprieve for Lehman, à la Bear Stearns, all hell broke loose.

The stock market tanked, dropping more than 500 points that day. The Reserve Primary Fund, a money market fund that held Lehman bonds, “broke the buck.” Shortly afterward, the American International Group nearly collapsed, and had to be bailed out with an extraordinary $85 billion loan from the government. Morgan Stanley was rumored to be next. Banks all over Europe were teetering. There were even fears about the stability of mighty Goldman Sachs. On Wall Street — indeed, in financial capitals all over the Western world — the panic was palpable.

Ever since that weekend, most people, including me, have viewed the decision by Henry Paulson Jr., the Treasury secretary at the time, and Ben Bernanke, the Federal Reserve chairman, to allow Lehman to go bust as the single biggest mistake of the crisis. Never mind that the two men have insisted ever since that they had no other option; surely, they could have created some options if they’d wanted to. Or so goes the conventional wisdom.

Christine Lagarde, France’s finance minister, for instance, called the decision “horrendous” and a “genuine mistake.” According to David Wessel, author of a book about the crisis, “In Fed We Trust,” the head of the European Central Bank, Jean-Claude Trichet, has said the same thing in private. He quotes one of Mr. Trichet’s aides as saying, “It never occurred to us that the Americans would let Lehman fail.” In speeches and articles, in books and television appearances, commentators of every political stripe have pointed to the Lehman bankruptcy as the event that turned the subprime crisis into a full-blown financial collapse.

As we approach this anniversary, though, I’ve begun to question that conventional wisdom. Yes, the fall of Lehman Brothers set off a contagion of panic. And I’m still convinced that Mr. Paulson and Mr. Bernanke could have found a way to save Lehman had they been so inclined (more on that in a moment). But I’ve become convinced that, if Lehman had been saved, the collapse would have occurred anyway.

John H. Makin, a visiting scholar at the American Enterprise Institute, wrote recently, “If the Lehman Brothers’ failure had not triggered the panic phase of the cycle, some other institutional failure would have done so.” I’ll go a step further: it is quite likely that the financial crisis would have been even worse had Lehman been rescued. Although nobody realized it at the time, Lehman Brothers had to die for the rest of Wall Street to live.

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A week ago, a Reuters reporter traveled to Richard Fuld’s vacation home in Ketchum, Idaho, to see if the former Lehman chief executive would say anything about the anniversary. (When Mr. Fuld walked outside to meet her, he said, “You don’t have a gun; that’s good,” according to the reporter.)

Standing in his driveway, leading, as ever, with his chin, Mr. Fuld talked about the “pummeling” he had taken for presiding over the bankruptcy. “They’re looking for someone to dump on right now and that’s me,” he said. “The facts are out there. Nobody wants to hear it, especially not from me,” he added.

Mr. Fuld’s bitter remarks reflect the way many former Lehman executives feel, even now, about the fact that their firm was the only one to go under during the crisis. After all, they say, Lehman’s mistakes — too much leverage, an overreliance on shaky real estate assets, playing down the risks on its balance sheet — were the same mistakes just about every firm made. Bear Stearns made those mistakes — and was rescued. Citigroup made those mistakes — and was rescued.

What’s more, they say, in the months and weeks leading up to the September crisis, the firm, realizing that it might need a Plan B, proposed that it be allowed to become a bank holding company. It also asked for access to the Fed’s discount window, which is reserved for troubled banks. (What Lehman didn’t do, however, despite the repeated urging of Mr. Paulson, was find a partner with deep pockets or raise additional capital.) These are the “facts” Mr. Fuld was referring to when he spoke the Reuters reporter.

But Timothy Geithner, then New York Fed president, now Treasury secretary, didn’t like the idea of letting an investment bank become a bank holding company — so he said no. Immediately after the Lehman default, however, that is exactly what he allowed Morgan Stanley and Goldman Sachs to do, which helped stabilize both firms.

Of course, politics played a role, too. Congress had no stomach for another bailout on the heels of the takeover of Fannie Mae and Freddie Mac just a week before Lehman weekend. In his book, Mr. Wessel, the economics editor of The Wall Street Journal, quotes Mr. Paulson as saying in a conference call, “I’m being called Mr. Bailout. I can’t do it again.”

Although Mr. Paulson would later say that he had no legal authority to save Lehman Brothers, it seems pretty clear from Mr. Wessel’s account that he wasn’t really looking for any authority. He wanted to send a message. That Monday morning, in announcing the Lehman default, Mr. Paulson told the media: “I never once considered that it was appropriate to put taxpayers’ money on the line” to save Lehman Brothers.

For all of these reasons and more, former Lehman executives tend to feel that the process that led to the firm’s bankruptcy was profoundly unfair. I’ve heard the word “tragic” more than once. And I agree with them: it was unfair — and, certainly for the people who lost their jobs, even tragic. Lehman Brothers was simply in the wrong place at the wrong time. But for the sake of the financial system, it was also the luckiest thing that could have happened.

In the months between Bear Stearns and Lehman Brothers, Mr. Paulson and Mr. Bernanke had approached Congressional leaders about the need to pass legislation that would give them a handful of additional tools to help them deal with a larger crisis, should one ensue. But they quickly realized there was simply no political will to get anything done. After Lehman, however, Mr. Paulson and Mr. Bernanke were able to persuade Congress to pass a bill that gave the Treasury Department $700 billion in potential bailout money — which Mr. Paulson then used to shore up the system, and help ease the crisis. Even then, it wasn’t easy; it took two tries in the House to pass the legislation. Without the crisis prompted by the Lehman default, it would have been impossible to pass a bill like that.

That is one reason the Lehman default turned out to be a good thing. Here’s another: If Lehman had been sold to Bank of America, as originally planned, some other firm — no doubt bigger, and posing more danger to the global financial system — would have failed instead. By then, there was simply too much panic in the air. A crisis of some sort was inevitable.

Mr. Paulson, recall, wanted Wall Street to come up with its own solution for saving Lehman. But as the chief executives sat around the big conference table at the New York Fed all weekend, they kept worrying about who would be next. They talked openly about whether Merrill Lynch could last much longer. (Mr. Paulson bluntly told John Thain, Merrill’s chief executive, that he needed to find a buyer, which is why Bank of America turned its attention to Merrill and away from Lehman.) And there were rumblings that A.I.G. was in trouble. Why were they so reluctant to pitch in to save Lehman? They were worried that they might be next.

In truth, a Merrill or A.I.G. default would have created something akin to a financial nuclear bomb — much worse than Lehman’s filing for bankruptcy. Merrill was a much bigger firm, with deep roots on Main Street thanks to its “thundering herd.” A.I.G. was the world’s largest insurance company, whose credit-default swaps were propping up half of Europe’s banks. (By buying A.I.G.’s swaps, European banks could evade their capital requirements.) Lehman, by contrast, was a smaller firm, with practically no ties to Main Street. The risks it posed to the system were real — but smaller.

Almost everyone I’ve ever spoken to in Hank Paulson’s old Treasury Department agrees that without the immediate panic caused by the Lehman default, the government would never have agreed to make the loans needed to save A.I.G., a company it knew very little about. In effect, the Lehman bankruptcy caused the government to panic, which in turn caused it to save the firm it really had to save to prevent catastrophe. In retrospect, if you had to choose one firm to throw under the bus to save everyone else, you would choose Lehman.

It would be nice to be able to say that officials at Treasury and the Federal Reserve understood this at the time. But of course they didn’t. Throughout history, people have stumbled their way through crises, not fully understanding the potential consequences of their actions, hoping the choices they make turn out to be the right ones.

Mr. Bernanke is a well-known student of the Great Depression, which guided many of his actions during the crisis. Mr. Paulson showed immense tenacity once the crisis struck. History, I now believe, will praise their efforts in subduing the collapse. But the Lehman default?

You know the old saying: Sometimes, it’s better to be lucky than good. A year ago this weekend, it turns out, was one of those times.