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Five years after the tumultuous week in which Lehman Brothers failed, A.I.G. was rescued by the Federal Reserve from failure, and the Troubled Asset Relief Program was proposed, it is still often asked whether Lehman could have been saved by the federal government rather than filing for bankruptcy early on the morning of Monday, Sept. 15, 2008. After all, policy makers had intervened to prevent the bankruptcy of A.I.G. just two days later and saved Bear Stearns back in March 2008. Surely, the question inevitably goes, the same could have been done for Lehman, and thus (by some lines of reasoning) the worst part of the financial crisis and ensuing recession averted.
I was a senior official at the Treasury during this period as the assistant secretary for economic policy — chief economist for Treasury Secretary Henry M. Paulson Jr. I did not work on the Lehman or A.I.G. transactions, but have written at length about the crisis and will write further in this season of anniversary. But it is worthwhile addressing this question by itself, one that has been raised recently in a column in The New York Times.
Lehman failed before TARP was passed or even proposed to the Congress. This meant that the Treasury Department had no legal authority to put government money into the firm or provide a guarantee for its obligations. This changed with the passage of the Emergency Economic Stabilization Bill on Oct. 3, 2008, which provided $700 billion in TARP financing to be used to purchase troubled assets (used in the end mostly to purchase preferred shares in banks).
The Treasury did have the exchange stabilization fund, which was then a roughly $50 billion pot of money meant to be used to stabilize the value of the United States dollar. The failure of Lehman, while something that Secretary Paulson and others had worked around the clock to avoid, was not seen at the Treasury as an event that by itself threatened the stability of the dollar.
The exchange stabilization fund was used later in the week as the financial backing behind a Treasury guarantee for money market mutual funds, which faced panicked withdrawals in the wake of problems at the Reserve Primary Fund. But this use followed broader difficulties, as short-term credit markets were severely strained by the fallout from the money market mutual debacle, as American corporations that relied on sales of short-term commercial paper to the funds had to scramble for other sources of cash for their day-to-day needs.
The money market problems could not reasonably have been anticipated; indeed, in retrospect it seems reckless for a money market fund that portrayed itself as safe to have taken on the risk of a sizable exposure to Lehman securities. Even the usage of the exchange stabilization fund to prop up money market funds, while essential to end the run on short-term credit markets, was seen as tenuous by Congress, which forbade a repeat of it in the subsequent Dodd-Frank financial reform legislation.
In sum, the Treasury did not have the ability to put government money into Lehman and did not have the authority to guarantee its operations for a private acquirer such as Barclays, the British bank that was contemplating purchasing Lehman.
At the time that Lehman failed, the Federal Reserve under its Section 13(3) emergency powers could lend money to any firm in the case of “unusual and exigent circumstances.” This authority was narrowed by the Dodd-Frank legislation to restrict loans to classes of firms rather than individual ones and to require the approval of the Treasury secretary along with a vote of the Fed’s governing board, but even in 2008 a requirement for the Fed to act was that any credit had to be secured by collateral. The Fed could not legally make a loan on which it expected to take a loss.
As the New York Fed general counsel, Thomas Baxter, explained in 2010 testimony to the Federal Crisis Inquiry Commission, the Federal Reserve did not believe that Lehman possessed the necessary collateral against which the Fed could provide the financing necessary to avert a bankruptcy filing. Indeed, Lehman was widely viewed by market participants as insolvent, requiring other industry participants to come up with tens of billions of dollars even to make possible the acquisition considered by Barclays.
This transaction in the end did not take place, in part because the potential acquirer sought for the Fed or Treasury to shoulder the risks of any losses from Lehman’s assets until Barclays shareholders had approved the transaction. The Treasury could not do this (before TARP), while for the Fed such a guarantee would have exposed it to the full scope of losses embedded at Lehman — again, a nonstarter given the legal requirement that the Fed’s financial exposure be collateralized.
The reluctance of the Federal Reserve to lend to Lehman contrasts with its actions regarding Bear Stearns and A.I.G. The difference is that in the other two cases, the Fed saw itself as lending against reasonable collateral.
In the case of the Fed’s loans that facilitated the acquisition of Bear Stearns by JPMorgan Chase, $29 billion of Fed money was at risk against a collection of Bear Stearns assets thought to be worth $30 billion. JPMorgan would absorb the first $1 billion if the value of those assets declined, providing a cushion ahead of the Fed (that is, ahead of taxpayers). Those assets were good in the end, with the Fed fully repaid with interest.
In the case of A.I.G., the Fed’s loans were collateralized by the entire assets of the firm, based on the observation that A.I.G. had potentially huge losses at its unit that sold credit default swaps but the rest of the firm was a successful insurer. The latter parts — the rest of the company — provided the collateral for the Fed’s initial loans, and eventually TARP funds were substituted for the Fed resources to provide the company with a better capital base rather than Fed loans. To be sure, it was hard to know in September 2008 that the value of the company would offset the potential losses in A.I.G.’s financial products division, but this turned out to be the case, with both the Treasury and the Fed turning considerable profits on their investments in A.I.G.
Such a successful outcome was simply less imaginable with Lehman than with either Bear Stearns or A.I.G. To all eyes, the problem at Lehman was one of solvency while the issue in the other two cases was liquidity. The Fed’s actions on Bear and A.I.G. were thus appropriate in its role as a lender of last resort and the same with its caution at Lehman. Indeed, after Lehman had filed for bankruptcy, the Fed did extend loans to allow the firm’s broker-deal subsidiary to function, but in bankruptcy these loans could be fully collateralized by assets within the brokerage subsidiary and not encumbered by obligations in other parts of the larger firm.
These legalities are of little consolation to former Lehman employees whose lives were upended, or to the millions of people who suffered immense financial losses. In a 2009 analysis written for the Pew Charitable Trusts, I calculated the cost of the financial crisis as $5,800 per American family in 2008 and 2009 alone. Others have subsequently used a similar methodology and calculated the overall economic losses as ranging into the trillions of dollars.
Imagine if the Federal Reserve itself had discarded the legalities and simply extended credit or a guarantee to Lehman to avert its bankruptcy, even while believing that the firm did not have adequate collateral to safeguard the Fed’s loans. In this case, the subsequent losses would have fallen directly on taxpayers, whose exposure would have been open-ended up to the full amount of potential losses in the firm’s assets. Such an exposure to losses is appropriately beyond the legal authority of the Federal Reserve and instead requires an act of Congress.
The orderly liquidation authority in Title II of the Dodd-Frank legislation provides legal authority in certain circumstances for the federal government to put taxpayer funds into a failing firm to keep it afloat as part of a plan to resolve the company (that is, to wind down or sell off the failing firm to other private investors). Importantly, the Dodd-Frank law requires that any losses involved in propping up a failing company must be absorbed by private investors, including the shareholders of the firm, the lenders to it, and ultimately other financial firms rather than taxpayers.
It is quite likely that this authority would have been used had it been available when Lehman failed in September 2008. After all, government officials went to great lengths to arrange for private financing of Lehman, an effort that failed when Barclays, the last potential buyer of the firm, was unable to proceed with the acquisition ahead of the bankruptcy. With the new Dodd-Frank power, the federal government could have provided the financing that Barclays was looking for while it sought shareholder approval, on the condition that any losses suffered by Lehman during this period of uncertainty ultimately would be borne by other financial firms and not taxpayers.
This orderly resolution authority has not yet been used, and it is not clear if it will be successful — indeed, a report from a project on financial regulatory reform of which I am co-director at the Bipartisan Policy Center provides dozens of recommendations to policy makers on how the Federal Deposit Insurance Corporation should exercise its new authority. Still, there is the possibility that the new authority in Dodd-Frank will provide the tools that were not available to policy makers five years ago when Lehman failed.
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