Biggest Mistake of the Financial Crisis: Lehman Bros. Bankruptcy

Writing the first draft of history is hard.

Getting history right is even harder.

The first draft of the history of the financial crisis says that allowing Lehman Brothers to file for bankruptcy protection one year ago today was the right decision. The final version is likely to conclude otherwise.


Lehman Brothers was not Hank Paulson's problem. Lehman Brothers was Dick Fuld's problem.

And, when Fuld couldn't find a buyer, he had no choice but to file for bankruptcy protection early on Monday, September 15.

What Paulson and the others had not foreseen, perhaps because they had endured too many sleepless nights in the past week, was the cascading effect that a Lehman bankruptcy would have – on U.S. as well as international markets – as scared investors made a run for their assets, leaving a multitude of banks and companies with insufficient funds and causing widespread secondary effects on housing markets, jobs and the overall economy.

When markets opened, the unthinkable happened. Crisis erupted. The Dow fell 504 points. The overnight lending rate in London nearly doubled. The cost of insurance against credit default soared, triggering collateral calls for thousands of hedge funds, banks and insurance companies.

A day later panic erupted as insurance giant AIG, with its $1 trillion in assets, teetered on the edge of bankruptcy. Although just hours earlier, Paulson had had enough with federal bailouts, he decided that AIG, overleveraged, undercapitalized and with $400 billion in credit default swaps outstanding, was too interconnected to fail. The Fed authorized a multibillion dollar bailout of AIG.

That same day, Sept. 16, the Reserve Primary Fund, the oldest money market fund in the country, learned that its nearly $800 million of Lehman debt was worthless. Money market funds had become a mainstay of businesses and individuals, not only because they paid better interest than CDs. They were meant to maintain a par value of $1, meaning that almost no one would ever lose money. But the Reserve Fund had already lost $27 billion of its $62 billion assets that week; with the write-down of its Lehman debt, the Fund was forced to "break the buck" and reduced its share value to 97 cents, marking only the second time in history that a money-market fund had been unable to maintain its share value at par.

That event triggered a crisis of confidence that sent shudders through the ordinary investment community -- those who viewed their money market funds as safe as cash and who had never dreamed that their funds could lose money.

Prime Reserve Fund holders tried to do what any rational investor would do -- get their money back. But, they couldn't because the Fund had frozen withdrawals.

Suddenly, anything seemed possible as turmoil spread throughout the industry. Investors rushed to their brokers and withdrew some 4 percent of the industry's $3.5 trillion assets in just two days.
To stop this run, Paulson announced on September 19 that the Treasury Department would support all money market mutual funds in exchange for a fee. Yet, the unfolding crisis didn't even slow down.

Starting with the September 15 Lehman bankruptcy and continuing beyond the September 19 rescue of the mutual fund industry, the U.S. government did whatever was necessary to bail out the financial industry. It spent $85 billion to keep AIG out of bankruptcy; allowed Goldman Sachs and Morgan Stanley to convert from investment banks into more traditional commercial bank holding companies, operating under far stricter Government supervision; encouraged Bank of America to purchase Merrill Lynch, and stood ready to support the entire mutual fund industry. Realizing that the crisis had crossed global lines, the U.S. added hundreds of billions to its swap lines to aid the European Central Bank and foreign central banks.

At the end of September, with hat in hand, Paulson crawled up to Congress nearly begging for a $700 billion bailout fund. Congress initially balked -- and this action sent the Dow further down -- before approving on Oct. 3 an amended bill known as the Emergency Economic Stabilization Act of 2008.
The stock market showed what it thought of this Act -- it fell 18 percent the following week.
The crisis continued to spread internationally. Iceland essentially lost its banking sector. The United Kingdom essentially forced HBOS, the U.K.'s largest mortgage lender, into the Lloyds TSB Group and nationalized Bradford & Bingley, another big mortgage lender. Governments in Belgium, France, the Netherlands, Spain and Switzerland, took similar actions to save their own over-leveraged and undercapitalized banks. The Lehman bankruptcy nearly wiped out Norway's government pension fund.

Little has been written from the inside about the Treasury's decision to allow Lehman to file for bankruptcy. One of the first drafts, however, comes from then Assistant Secretary for Economic Policy, Phillip Swagel. In his paper prepared for the Brookings Institution titled "The Financial Crisis: An Inside View," Swagel says, "The decision not to save Lehman Brothers is perhaps the most hotly debated decision of the crisis." He also suggests that the Treasury and the Fed could have taken actions that would have provided time for a "more orderly dissolution of the firm." Swagel acknowledges that "Everyone got hurt from the resulting crash."

So, where do we stand a year later?

The unemployment rate is at 9.7 percent, sharply up from the 6.1 percent rate a year ago. More than 6 million jobs have been lost this year, although the rate of loss is slowing, with fewer than a quarter of a million jobs lost last month compared with the more than 600,000 lost in April.

The Dow is more than 1600 points lower than it was on September 15, 2008.

The economy is still losing ground, although at a slower rate than the 6.4 percent annual decline in the first quarter of the year.

The bailout and stimulus plans have severely weakened the fiscal picture. The Congressional Budget Office estimates that the Federal budget deficit will exceed the unheard amount of $1.6 trillion this year. These deficits will accumulate to more than $7 trillion over ten years.

Although taxpayers may end up paying just a fraction of this amount, the federal government has committed more than $12 trillion to prevent the Great Recession from becoming another Great Depression.

Not everyone is worse off now than a year ago.

Goldman Sachs has repaid its $10 billion government loan. Its shares now sell for more than $170 each, a giant leap up from its $47 a share last fall. And, while it no longer has the cachet of being an investment bank, it is on pace to pay upwards of $12 billion in bonuses this year. With diminished competition due to the elimination of Bear Stearns and Lehman Brothers, the company earned a record $3.44 billion in the second quarter.

Was Lehman's bankruptcy the biggest mistake of the financial crisis?

It's hard to know for certain what would have happened if the government had saved Lehman because there are no "do overs" in real life.

However, we can look at what happened when another investment bank was rescued rather than allowed to fail. On March 16, 2008 the Federal government essentially financed JP Morgan's purchase of Bear Stearns by agreeing to backstop some of its loans. And, in so doing, Bear's debt portfolio did not become worthless and its creditors were not forced to unwind their positions at distress prices.

Five months after that rescue, the economy was in recession, but it was not in a crisis. In fact, the economy had looked so good in August 2008, that many experts could not believe that it turned so bad just a month later.

Many factors explain that August's relative calm. One is that the financial markets were not absorbing the fallout from the sudden collapse of a globally interconnected bank. This fact suggests that, as much as the government dislikes bailing out irresponsible risk-taking banks, sometimes it is better to take these steps rather than face a full-blown crisis.

The housing market already had been showing clear signs of weakness in the summer. But, the disorderly dissolution of Lehman very likely played a major role in transforming the housing crisis into a full-blown financial crisis.

Let's hope the government has learned from its mistake.