38: The Fed Made a Massive Mistake Letting Lehman Go

If I'm going to be completely honest, I haven't read the entire thing, but I know that it's making quite some waves in the world of law and economics and banking because it has a provocative thesis about how Lehman was let to fail and whether the official story really matches what happened. Right. So it was penned by Lawrence Ball. He's a professor of economics over at Johns Hopkins University.

He's also research associate at the National Bureau of Economic Research and a visiting scholar at the I m F. He is going to be our guest for today, but just before we start, you know, let's talk about the paper a bit, because, yes, you're right, the thesis here is that the FED essentially had a choice when it came to letting Lehman Brothers go back in two thousand and eight, and that when it decided to let Lehman Brothers go, that ended up being a massive mistake for

the financial system, which is provocative because you'll remember that people like Ben Bernanky were quite adamant at the time that they did not have an option here. They had to let the bank fail. That's right. The basic argument at the time that the FED said was our our hands were tied. There are clear laws about when we can lend to a bank that's in distress. Lehman wasn't solvent and so forth, and they've stuck to that line after several years, even though we know what a huge

disruption the collapse of Lehman cause. So it's a big deal if you know, you go back and say, actually, they could have they could have potentially build them up. And there's one other short thing I want to say about this paper before we begin. It is two hundred eighteen pages long. It doesn't have an abstract, you know, the summary that normally comes with these kinds of academic papers.

And it's also kind of unusual in that when you think about academic research, especially in finance and economics, there's usually a lot of mathematical formula regression analyses things like that. This one is different because it kind of relies on a lot of information that's already out there, things like the Lehman Brothers bankruptcy examine or report of the government inquiry into the financial crisis, things like that. It doesn't read like your usual academia, right. It's almost more of

a piece of investigative journalism, isn't it. Yeah, exactly. So I'm really excited to have Lawrence on the show. Let's bring him in now, Hi, Lawrence, thanks for joining us today. Hello, thank you for joining us, Lawrence. Oh, you're welcome. I'm happy to talk, all right. So let's start at the beginning. What prompted you to choose this particular topic for research, given that you know, it's now almost a decade from Lehman Brothers collapse, and a lot of people would be

happy just forgetting that it ever happened. Well, first of all, I started it four years ago, so it's four years less uh far in the past when I started. And there's a basic motivation. Like most macro economists, I was interested in what caused a great recession? And the answer is the financial crisis? What was the big event and the financial crisis Leman Brothers? So why did Lehman Brothers fail? And like a lot of people, I had some doubts about the story that we couldn't save them, even though

we couldn't save everybody else. So I just started looking into that. And you mentioned the Bankruptcy Examiners report and the Financial Crisis and Greek Commission report. There's quite a bit of easily accessible information from these investigations. A lot of people give opinions about the crisis without knowing that's actually there are actually a lot of facts out there that you can look up. So you mentioned that you

were skeptical of the original story that was told. Um, you know, give us yours to sink summary of that story and what tipped you off earlier on or early on that um you know, may not fully explain what happened. Well,

the story is fairly simple. The the law Section three in the Federal Reserve Act says could only land if there is satisfactory security, which is generally interpreted to be enough collateral so that the fat is protected even if the loan does not take back and the position the Fed officials is that that condition was not met, that the amount of collateral that Lehman had was much less than the amount of money they would have needed to

borrow to survive, So they didn't have satisfactory security. So it wasn't legal in that sense, their hands were tied. And I guess what made me wonder is just having read a fear amount about it that they that was never backed up with any numbers or any analysis. It was just given on authority that these other firms had plenty of collateral and Lehman had not nearly enough collateral. So I just started to look to look into that. So how did you actually go about calculating how much

collateral Lehman would have had? Because I mean, Joe and I both know having covered markets in finance for a long time, that valuing a bank's balance sheet, particularly in September two thousand and eight, when a lot of this stuff was very liquid, is incredibly difficult and relies on a whole bunch of subjective assumptions. Right, It's hard in

normal times, let alone in a period of extreme acute crisis. Well, in terms of valuing assets, I used the best available, but I think it's probably the best available evidence, which is analyzes done at the time by Barclays and by Bank of America, which we're both considering acquiring Lehman and so looked over its balance sheet very carefully and um and then also by the constortium of Wall Street firms that was famously gathered at the New York FED to

analyze the situation. They all looked very carefully at the balance sheet and came up with different numbers about how much Leman overvalued their assets, and the numbers were remarkably consistent and in the range of fifteen the thirty billion dollars of overvaluating, which puts them on the borderline of

solvency and insolvency. So one interesting in these papers you actually come up with the number for the amount of assets that would have been acceptable as collateral for FED liquidity, and you put it at a hundred and thirty one billion worth of assets, which means that Lehman probably could have stayed in business if it had received a loan of something like eight billion. Walk us through how you

how you made that calculation? Okay, So, so that calculation the hundred and thirty one billion came primarily from looking at financial statement, which is again all the original documents are on the websites of both the Financial Requests Inquiry Commission and Bankruptcy Examiner. A financial statement of Lehman, which I believe was intended for their quarterly report for the third quarter, which never got issued because they declared bankruptcy.

And actually that the hundred thirty one billion dollars were assets that were specifically eligible to be collateral that the fends lending facility and the primary deal or credit facility, and those were actually not the same that the assets with the questionable evaluations were things like private equity and real estate projects. There's a lot of subjectivity. One billion dollars were primarily securities where valuation was reasonably straightforward based

on market prices. So I got that from the essentially uh Lehman's financial statement that they were preparing, and then I estimated that they would need billion dollars of support. That is pretty speculative, but it's based on a mixture of what had happened in the last week, how many WE purchase agreements they had lost and so on, and various in colonel forecasts at what was going to happen

the next week. Also the Federal Reserve did there's no evidence of the FAT booked very carefully at the issue. Over the last weekend in the summer. They did stress tests what would happen if there was a run on Lehman, and they had numbers for, well, what if a bunch of the prime brokerage customers flee, how much catually lose, how much casually lose if there's this kind of collateral call, and so on. So I relied on that. Also in your research, you pointed out that there were some a

couple of voices at the FAT. I believe we said, actually Lehman probably would be solvent, they do have enough collateral to merit a bailout, but that they weren't really listened to what happened there. So that is something that I don't know firsthand. That there was a very interesting article in two thousand and fourteen by James stewar Or in another New York Times reporter, which was based on

anonymous sources from the New York Fed. And again there, if you want to be careful about it, there are actually two distinct issues, one about how much collateral they had per a loan, and the second about their asset over evaluation and solvency, which are related but different questions, And the way this New York Times article was reported, the New York Fed people were looking at the over evaluation and solvency issue and seemed to have can't counter

roughly the same conclusion that I did of that it was a close call whether they're net worth was a little bit positive or a little bit negative. The New York Times article also reports that this that this analysis

never made it to senior policymakers. So one of the more striking things I thought in the paper was you actually look at other bank bailouts undertaken by the FED and the US front, including you know, Bear Sterns earlier in two thousand and eight, and then later on Morgan Stanley and Goldman Sachs also got some liquidity access from the FED, and you point out that those operations were actually done on far more favorable terms than what we're

potentially being asked of Lehman Brothers. At the same time, Yes, absolutely so. In my reading of the evidence, Lehman Brothers just needed overnight, well collateralized lending through the FED lending facilities. But I guess what Morgan Stanley and Goldman Sachs received in large quantities was what also needed and that and that was quite safe. Again, it was lending one day at a time with big haircuts on the collateral. The loans to the I G and too Maiden Lane, which

brought the bear stret certains assets were risk here. I mean a I G is quite striking. The collateral or the a I G loan consisted largely of stock equity ownerships and a I G S insurance subsidiary, and Fed River officials have said things like that was good collateral. It guaranteyed every penny of the money we lent. But I've never seen evaluation of that. And they're actually in again looking at the publicly available documents. There's some fragment here.

There's some fragmentary evidence in the form of power point presentations of the New York Fed which seemed to call in the question how healthy these insurance companies are and how much they're really worth. As I say, it's fragmentary, but they've they're they've never given an account. Actually, another side story is that I repressed some documents about the I G loan under the Feet of Information Act, and the FED declined to provide them, and I them in

federal court and I lost. So uh so we said, we don't have very much information about how valuable so a i g. Was lent eighty five billion dollars and whether the collateral was worth more or less than eighty five billion dollars. We have very little idea. So why didn't the FED bailout Leman? I mean you say they theoretically or for your research, they had the numbers could have backed it up. What ultimately was the reason? Yeah,

why didn't they do it? That? Well? So I think based on my research is easier to say why they did not do it, what's not the reason and what is the reason. So my main point is that was not an absence the legal authority. They had the legal authority. And also in the extent of real time record, there was no discussion that do we have legal authority or don't we have legal authority? What way? What they were discussing, and this is not an original point with me, was

politics of the matter. So, in particular, Henry Paulson, who seemed to have been in charge of the decision making, has been quoted by many people are saying, I can't do it again, needing a bailout. I can't be mr bailout again. In the record of emails between government officials over that weekend, there are things like, we can't do this, the press will kill us if we if we do

this so again. This is not an original point with me, but the the idea that there was political pressure against bailouts is consistent with the evidence that I've seen, along with not fully appreciating how damaging the bankruptcy would be. I think nobody was an unprecedented event and they were worried about it, but there was hope that maybe they could contain the damage and it wouldn't be so bad.

Do you think that was an objectively wrong judgment that should have been known at the time, or that something okay in retrospect. Clearly the Lehman failure was economically damaging, but it wasn't necessarily obvious that it was going to

be so bad. That's a good question. I would say it was not necessarily obvious because it was an unprecedented event, but there was the fact that markets had already seen the Bear Stearn's problem and seeing problems that Lehman and UM and the FED was taking various measures to trying to contain the damage, increasing their lending to other investment banks, and several other things. So I I can imagine in

real time arguing it either way. So I don't think it was obvious at the time that it was going to be as disastrous as it actually was. Actually, just for example, some specific things that happened the whole episode with the Reserve primary fund breaking in the box and that leading to the run on a market funds and the breakdown of the commercial paper market. That was very damaging and that was a big surprise to everybody. So this paper has been four years in the making, it's

been out for um, I guess a little over a week. Now, what reaction have you gotten. Have you received angry phone calls from Ben Burnanki or Hank Paulson that sort of thing. Uh? No, Ben Brankian Hank Paulson have not shared their thoughts at any about the paper with me. To be honest, the reaction that received is similar to reactions I've received other papers critical of the Federal Reserve that people I know with the Federal Reserve don't like it, and most other

people do like it. It's interesting vote on the left wing of the political spectrum and the right wing of the political spectrum, there's a lot of suspicion of the Federal Reserve. And actually, much as I'd like to say that my people have read my paper carefully and it's persuasive,

obviously people's actions are based on their preconception. So I think a lot of people who were skeptical the FAD have have appreciated that people who work for the FAD or are very close to the fans felt like you mentioned some people at the FED and how they've reacted

to the paper. I think when I was discussing this with some of my contacts who used to work at the New York FED in particular, one of the main criticisms they had was that you rely on sort of third party sources journalistic research, some of which full disclosure was mine back in two thousand and ten. About the

Maiden Lane portfolio. My former New York FED contacts, they say things like that Maiden Lane analysis could have benefited from a regression analysis that would have actually revealed that the FED was buying very low grade collateral inflated prices. So, if anything, the paper could have been more forceful had it done some of the more traditional things that you find in macroeconomic papers. Okay, well that's interesting. So there

are a couple of points there. I mean, I think both my paper and you're reporting on me in lane, if I may say so, I mean uses direct evidence about facts, and you actually had data on which securities exactly we're in the portfolio and what their ratings were, and that's just data. So I think, actually, um, again, there's lots of primary material out there that was gathered by the Financial Crisis Inquiry Commission, and I grew for the examiner of both of whom had subpoena power, and

I think that's what I rely on mostly. I mean, as far as the point about regression analysis, I guess the simple answer to that is that one can add up numbers about what assets they have and add up numbers about what liquidity drains they would have had based on information about those things, and I'm not sure that

high power statistics would add very much. Is there any particular lesson for policy makers now from your research, or is this something that was kind of hyper specific to an event and important for the historical record but may not necessarily be applicable in situations going forward. I would say that there are some lessons. I think for any any historical episode of this magnitude that understanding what happened is almost sure to have some lessons. In this case,

a lessons at a couple of different levels. I think the fact that, or the my view that there could have been a better resolution of the crisis is important. What one reason is that, as I'm sure you know that dot Frank Act limits effectibility to rescue financial institutions, and it's actually, again, this would be complex, but but it's possible that what they could have done for Lee men actually there there would actually be legal barriers in

the future. So I think it's relevant us. It's relevant for that. It's also in terms of Fed governance or politics. The Federal Reserve talks a lot about how they are independent of politics, and in this episode that doesn't completely ring true because of Kenry Paulson, the Treasury Secretary's role and dictating policy. The Federal Reserve officials also talk a lot about the principle of transparency about their policy actions and the reasons for their policy actions, and I don't

think they were very transparent in this episode. Alright, So tell us what you're working on now or are you taking a break after penning this two d page report, which is quite hefty. Well, when we're you know now is largely did different things that I put off by

they're going put off because of this project. I do mainly spend my professional life doing more traditional research, So I run regressions to estimate the philips current relationship between insolation and unemployment and things like that, like a regular macroeconomist. So I'm going back to that for a while. I don't I'm not sure what if anything, I might do related to the financial crisis in the future, you know, on on this question real quickly about sort of macroeconomics.

I know it's always tough to talk about counterfectuals, but when I think of like that period, I see the Layman collapses sort of being a catalyzing force for some of the actions taken by both Congress and the Fed to start to turn the economy around. And so we had this massive collapse, but then we got TARP, and then we got you know a few months later, we got QUEI one and so forth. Had Layman been saved?

Do you have any sort of vision of what the economic trajectory would have been would have been shallower, but a longer uh declined down something like that. Like, what is the sort of in your view alternate history scenario had they billed out Layman? Good question question, What would a kind of factual history like in in this in an alternate history novel if you were writing it, and and in that history they had bailed out Layman, how

do you see things having played out? Because there was obviously still deep problems with all the bad mortgages that a Layman um a Layman rescue wouldn't have changed that. So how do you see the next several quarters and years playing out had they not let Lehman fail? So with with the obvious qualiplication that nobody knows, my guests would be. I think my guess would be it might be the latest. It might be like the collapse of the tech bubble, or like the savings and loan crisis

of the nineteen eighties. I mean, it was a real problem in financial markets and people lost money in it, who would have had a dampening effect on the economy. But I think the scale the financial collapse and the scale of the Great Recession UM could have probably been avoided. All right, Lawrence Paul, we're going to leave it there. Thank you so much for joining us today. Than thank you very much. All right, Joe. So, I think that was a really good summary of what would otherwise probably

take a good hour or so to read. What do you think? Oh? I thought I thought that was a fascinating conversation. I like anything that involves multiple years of meticulous research until one event to really shed light on something that, you know, it's probably just sort of hazy in people's mind. It's probably hazier in my mind than yours, because you have you did, you did reporting that got cited in the research. No. I love any work like

this type of thing. Yeah, and I'm surprised that this paper has you know, it's been making some waves up but I'm surprised it's not getting more attention because it really synthesizes basically all the criticisms UM you could level at the FED or at US Treasury over that time era. And I think it's important to bring it up again now, specifically the point about how officials might have misjudged the impact of a Lehman Brothers collapse, because nowadays, as you know, Joe,

we're facing so many more unknowns, right. Lehman Brothers collapse was a complete unknown back in two thousand eight, and now it seems like we're facing a throwing laundry list of unknown macroeconomic risks that no one really knows how

they'll play out either. Yeah, I tend to, you know, when I think back about the decisions made in summer of two thousand and eight and early two thousand nine, I sort of, you know, there was this sort of fog of war type feeling where you're right in the middle of it and you don't know what decisions are going to prove correct, and you don't know what's going to um have been a mistake. But it really is worth examining in detail, even if it's several years later,

the exact choices that were made. And I think he was spot on that any sort of his proper historical record of this stuff does potentially have, um have lessons for the things that we face today. Right, There's nothing better than financial crisis hindsight, isn't that in your Twitter bio? Yeah, I'm quoting myself. All right, let's go all right, Well, on that note, I'm Joe Wisenthal, there has been another episode of Odd LODs. You can find me on Twitter

at the Stalwart and I'm Tracy Alloway. I'm on Twitter at Tracy Alloway. Thanks are listening. M