The Fed And Lehman Brothers
Laurence Ball
Johns Hopkins University
July 2016
The Fed And Lehman Brothers – Introduction
On Monday, September 15, 2008, at 1:45 AM, Lehman Brothers Holdings Inc. filed a bankruptcy petition in the United States Bankruptcy Court for the Southern District of New York. This action was the most dramatic event of the financial crisis of 2007-2009, and many economists believe it greatly worsened the crisis and the Great Recession that followed.
Why did Lehman Brothers fail? At one level, the answer is clear. Lehman suffered large losses on real estate investments in 2007-2008, which threatened its solvency. Other financial institutions lost confidence in Lehman, precipitating a liquidity crisis: the firm could not roll over short-term funding that supported illiquid assets. Lehman declared bankruptcy in the early hours of September 15 because it did not have enough cash to open for business that morning.
Yet one part of the story is less clear. Lehman was the only large financial institution to file for bankruptcy during the financial crisis. Others, such as Bear Stearns and AIG, also experienced liquidity crises and surely would have gone bankrupt if not for emergency loans from the Federal Reserve. Why didn’t the Fed make another loan to rescue Lehman?
This question is controversial among students of the financial crisis. Some say that Fed officials bowed to political opposition to a “bailout” of Lehman. Others say that policymakers were concerned about moral hazard: they feared that rescuing Lehman would encourage excessive risktaking by other firms. Yet another factor, according to many, is that policymakers underestimated the damage that Lehman’s bankruptcy would do to the financial system and economy.
Yet Fed officials insist that none of these views is correct. The people in charge in 2008, from Ben Bernanke on down, have said repeatedly that they wanted to save Lehman, but could not do so because they lacked the legal authority. When the Fed lends to a financial institution, the Federal Reserve Act requires “satisfactory” collateral to protect the Fed if the borrower defaults. In Lehman’s case, according to Bernanke (Jackson Hole, 2009):
[T]he company’s available collateral fell well short of the amount needed to secure a Federal Reserve loan of sufficient size to meet its funding needs. As the Federal Reserve cannot make an unsecured loan… the firm’s failure was, unfortunately, unavoidable.
According to Bernanke (FCIC testimony, 2010):
[T]he only way we could have saved Lehman would have been by breaking the law, and I’m not sure I’m willing to accept those consequences for the Federal Reserve and for our systems of laws. I just don’t think that would be appropriate.
In his 2015 memoirs (p. 288), Bernanke reiterates that Lehman did not have “sufficient collateral to back a loan of the size needed to prevent its collapse.”
This paper seeks to set the record straight on why the Fed did not rescue Lehman Brothers. I conclude that the explanation offered by Fed officials is incorrect, in two senses: a perceived lack of legal authority was not the reason for the Fed’s inaction; and the Fed did in fact have the authority to rescue Lehman. I base these broad conclusions on the following findings:
- There is a substantial record of policymakers’ deliberations before the bankruptcy, and it contains no evidence that they examined the adequacy of Lehman’s collateral, or that legal barriers deterred them from assisting the firm.
- Arguments about legal authority made by policymakers since the bankruptcy are unpersuasive. These arguments involve flawed interpretations of economic and legal concepts, and factual claims that do not appear to be accurate.
- 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. Such a loan could have prevented a disorderly bankruptcy, with negligible risk to the Fed.
- More specifically, Lehman probably could have survived by borrowing from the Fed’s Primary Dealer Credit Facility on the terms offered to other investment banks. Fed officials prevented this outcome by restricting Lehman’s access to the PDCF.
We will never know what Lehman Brothers’ long-term fate would have been if the Fed rescued it from its liquidity crisis. Lehman might have survived indefinitely as an independent firm; it might have been acquired by another institution; or eventually it might have been forced to wind down its business. Any of these outcomes, however, would likely have been less disruptive to the financial system than the bankruptcy that actually occurred.
If legal constraints do not explain the non-rescue of Lehman, then what does? The available evidence supports the theories that political considerations were important, and that policymakers did not fully anticipate the damage from the bankruptcy. The record also shows that the decision to let Lehman fail was made primarily by Treasury Secretary Henry Paulson. Fed officials deferred to Paulson even though they had sole authority to make the decision under the Federal Reserve Act.
See full PDF below.
