Lehman Lessons

Posted on September 17, 2009 by David Laidlaw 

September 15, 2008 Lehman Brothers filed for bankruptcy triggering a financial meltdown.  Looking back, many wonder why Lehman was not saved.  AIG was given an $85 billion government bailout and Merrill Lynch was force fed to Bank of America soon after Lehman filed.  Then Treasury Secretary Henry Paulson maintains he did not have the authority to save the company and the public did not want another bailout (Fannie Mae and Freddie Mac were bailed out a couple weeks prior).  Federal Reserve Chairman Ben Bernanke denied Lehman status as a bank holding company and therefore denied access to its discount window, i.e. access to cheap money.  Goldman Sachs and other financial institutions were given access a few weeks later.

The bottom line is the government could have done something to save Lehman.  At the very least, Paulson could have strong-armed another bank into buying Lehman as he seemingly did when JP Morgan bought Bear Stearns.  I believe Paulson, Bernanke and others wanted to send a message that the government would not swoop in to save every bank.  And since Lehman was not a bank holding company with consumer deposits, its collapse would not cause panic on Main Street.  We’ll let this bank collapse to teach everyone a lesson and hopefully Mains Street will not notice.

This is a good idea in theory.  If banks have a fear of failure, they will dial down leverage and hopefully avert future financial crisis.  Of course, actions speak louder than words.  The government has proved more than willing to help since Lehman collapsed.  Citigroup was given more bailout money in November 2008.  Accounting rules were changed so banks did not have to mark their assets to market, and therefore provide an accurate picture of their balance sheet.  The most troubling trend is the acceptance that certain banks pose “systemic risk.”  Basically the government has acknowledged that it will not let certain banks fail—this creates a nice winner take all market for banks.  Get big enough and the government will bail you out.  This means certain banks can take on more leverage than their less important peers, and in turn drive those smaller peers out of business and become even bigger.

The lesson from Lehman seems to be if you’re going to fail, make sure you’re big enough so your failure causes widespread pain.  I don’t believe this was the intent and it should be reversed—the current situation puts too much taxpayer money at risk.  The solution may be simple—re-institute the Glass-Steagall Act of 1933 which prohibited a bank holding company from owning other financial companies, thus keeping them from posing systemic risk.  The act was repealed in 1999 and has been reversed to the point that financial institutions such as Goldman are instructed to convert to bank holding companies.  The simple beauty of the Act was that it kept risk taking banks such as Lehman separate from bank holdings companies.  This meant those taking risks did not hold consumer deposits, limiting much of the damage to Wall Street when they failed.