The Fed vs. the FDIC on Lehman’s Failure
As we all know, the 2008 financial crisis began in earnest when Lehman Brothers filed for bankruptcy. It has always been a question why Lehman was allowed to fail when Bear Stearns—a smaller firm—was rescued with $30 billion of Federal Reserve financial support to JP Morgan Chase. Questions were even more pointed when the Fed rescued AIG only days after it let Lehman descend into bankruptcy. Now the U.S. Federal Deposit Insurance Corporation (FDIC) has shed its own light on the issue. In a report last week, the FDIC claimed that the losses would have been far smaller than initially estimated if Lehman Brothers had received government financial support to avert its bankruptcy and eventually been wound down or sold.
The trigger for the financial crisis, in other words, appears to have been the market’s loss of confidence in a solvent firm.
After the calamitous market reaction to Lehman’s failure in September 2008, the Treasury Department and the Fed initially argued that the Fed did not have the legal authority to rescue Lehman. This turned out to be a bit of obfuscation when a Fed lawyer testified to the Financial Crisis Inquiry Commission that it was only necessary for the Fed’s Board of Governors to have adopted an appropriate resolution. In his testimony to the FCIC, Fed Chairman Ben Bernanke did not dispute this fact, but said it would not have been responsible to rescue Lehman because it was so far under water that the Fed would simply have been throwing good money after bad. “There was not nearly enough collateral to provide enough liquidity to meet the run [on Lehman]. The company would fail anyway, and the Federal Reserve would be left holding this very illiquid collateral, a very large amount of it.” In other words, the Fed did not save Lehman the way it saved Bear because Lehman simply did not have enough available collateral to protect the Fed against losses if it attempted, with liquidity support, to stop the run.
In its new report, however, the FDIC claims that if it had been able to use the resolution powers later granted under the Dodd-Frank Act, losses to Lehman’s creditors would have been limited to three cents on the dollar—far less than the losses Bernanke had suggested. Given the uncertainties associated with the facts of the Lehman case and the FDIC’s own inexperience with resolving nonbank financial institutions, one should take this estimate with a large grain of salt.
The FDIC’s contention that Lehman’s creditors would have lost only three cents on the dollar again calls into question the U.S. government’s decision to let Lehman fail.
Still, if it is anywhere close to reality, the FDIC’s contention that Lehman’s creditors would have lost only three cents on the dollar again calls into question the U.S. government’s decision to let Lehman fail. Clearly, after Bear Stearns’s rescue, the financial markets were assuming that the United States would rescue all larger firms. This was confirmed by Anton Valukas’s report as an examiner for the U.S. bankruptcy court. Most market participants, he reported, including Lehman, could not imagine why the Fed would rescue Bear Stearns and not Lehman. When Lehman was allowed to fail, market participants realized that they did not know who would survive and who would not. A massive panic ensued as financial institutions hoarded cash.
Indeed, in the Valukas and FDIC accounts, Lehman does not look like the basket case Bernanke portrayed. According to the Valukas report, Lehman had raised at least $10 billion dollars in additional capital in April and June 2008, and the FDIC noted that in September 2008—the month Lehman filed for bankruptcy—the firm had equity and subordinated debt of $35 billion. It also had $50 to $70 billion in impaired assets of questionable value, most of which had been identified by the diligence examinations of various suitors. Assuming a loss ratio of 60 to 80 percent on these assets, the FDIC estimated that Lehman in liquidation would have lost about $5 billion.
When Lehman was allowed to fail, market participants realized that they did not know who would survive and who would not. A massive panic ensued as financial institutions hoarded cash.
The difference between the FDIC and the Fed about the financial condition of Lehman before its failure is no small matter. It not only puts in doubt the Fed’s account of its decision-making, but it also raises significant questions about the nature of the financial crisis. If Lehman’s creditors would have lost only 3 percent in a liquidation, the firm might actually have been solvent as a going concern. As difficult as it is to imagine, the trigger for the financial crisis, in other words, could have been the market’s loss of confidence in a solvent firm.
The financial crisis was triggered by the meltdown of the U.S. housing bubble, which in turn caused the collapse of the market for mortgage-backed securities. With that market gone, mark-to-market accounting required the write-down of asset values on the balance sheets of financial institutions around the world. In many cases, these losses turned out to be temporary accounting losses. U.S. banks today are adding back into their earnings the heavy provisions that they had made for losses on mortgage-backed securities. Was the financial crisis, then, a recognition of real losses and weaknesses in the financial system—as initially portrayed—or only a world-class panic induced by investor uncertainty about the scope of housing losses, made worse by a series of major policy-maker errors?
Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute. He was a member of the Financial Crisis Inquiry Commission.
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