IT WAS announced from Washington recently that Tim Geithner, a former president of the Federal Reserve Bank of New York and US treasury secretary, is to write a book on how to fight global financial crises. The announcement was timed to coincide with the fifth anniversary of the Lehman Brothers collapse.
Policy aficionados will swiftly turn to the chapter in which Geithner will write on his central role when Lehman Brothers collapsed. It will be fascinating to see if he still maintains that stronger government action should have been taken to save Lehman.
One should expect some revisionism, too, as he interrogates the roles of his fellow dramatis personae, Treasury Secretary Hank Paulson and Federal Reserve chairman Ben Bernanke. There are, however, some unlearnt lessons and contextual history that are already known.
The collapse of Lehman was the most dramatic moment in the worst financial crisis since the Great Depression. On September 15 2008, after suffering huge losses in the subprime market, Lehman was felled by the weight of $60bn in toxic debt. The fourth-largest investment bank by asset size — with more than $600bn in assets and 25,000 employees — filed for bankruptcy.
Opinion among South African policy makers, like elsewhere, remains divided whether the financial crisis could have been averted if the Fed and Treasury had intervened to save Lehman. However, this debate obfuscates two foundational questions. Was the collapse of Lehman the cause of the subsequent worldwide financial distress? Or was it merely the weakest link in an overextended and underregulated financial system?
If it was the cause, there would be a solid case that the Fed and Treasury should have intervened to save it. But if the failure was a function of the structural weaknesses of the global financial system, the case becomes harder to establish.
The evidence leans towards the latter. And SA’s Reserve Bank should be alarmed that the structural weaknesses that marked the period have still not been rectified. In a speech to the Brookings Institute a year after the crisis, Bernanke recalled that "the failure of Lehman Brothers and the near failure of the American International Group (AIG) were dramatic but hardly isolated events".
In other words, the financial system in mid-September 2008 was more vulnerable than almost every policy maker and market player realised at that time. The financial system would still have spiralled out of control if Lehman had been bailed out — the recession had already been under way for eight months.
Three other events were also as significant as the Lehman bankruptcy: the AIG collapse on September 16; the struggle to get the Troubled Asset Relief Plan (Tarp) plan passed by the Republican-dominated Congress over the following weeks; and the run on the Reserve Primary Fund (the large money-market mutual fund) on the same day. Today’s amnesiac Republicans forget Tarp was former president George Bush’s intervention, not President Barack Obama’s.
One puzzle is why the US government let Lehman fail when it propped up Bear Stearns with $29bn in return for JPMorgan Chase acquiring it for next to nothing? The answer is that there was no equivalent finance house to buy Lehman. The Fed lacked the authority to take on Lehman’s bad assets.
Bernanke’s testimony to Congress on April 20 2010 shows that while the government knew that the failure of Lehman would shake the financial system, it lay outside of the Fed’s legal mandate to save it.
If Bernanke’s testimony was correct, then it becomes an extraneous question whether the Fed should have intervened.
In the absence of a bail-out, the only alternative would have been to broker a purchase of Lehman. Enter Geithner, who advocated hiving off a section of Lehman into another entity, which the consortium of banks would have wound down over time, leaving only the "good" bank. Barclays Bank in London held discussions about buying Lehman, but British bank regulators were sceptical. Ironically, Barclays did end up buying some of the valuable parts of Lehman a week after it declared bankruptcy.
These events prompt a related political question, which Geithner should try to answer in his forthcoming book: why should taxpayers bear the cost and risks that financial houses and bonus-greedy executives are not prepared to bear themselves?
Part of the explanation must lie in the principle of collective action. While it would have been in the best interests of the financial houses to co-operate, there were also incentives to defect on the agreement and free-ride on the costs borne by the other houses. The Bush government could have played an active role by forcing collective action and preventing defectors.
This cuts to the heart of the morality of bailing out an institution that displays scant regard for the need to reform.
Both the Treasury and the Fed were concerned about raising "moral hazard" incentives for financial institutions to take on excessive risk. With Lehman’s vulnerability clear, the company, the officials reasoning went, was a natural "experiment" to provide a lesson to market players that they should take measures to protect themselves. It later transpired that Lehman was, indeed, still acting deceitfully by hiding the true extent of its leverage through shady accounting, even after the financial crisis gathered pace.
This bolsters the Fed’s view that, by allowing Lehman to fail, it sent a warning light to other highly leveraged financial houses that they needed to reform.
Here it is also relevant to note that neither Lehman, nor the Bush administration, prepared for bankruptcy in an orderly manner.
Paulson failed to brief his European counterparts about the impending bankruptcy so they could prepare for the dramatic aftershock. Then there was the absence of a mechanism for dealing with the failure of a large complex financial institution.
From the counterfactual perspective, would bailing out Lehman have been politically feasible anyway?
Or was Lehman’s failure the price to pay to convince a sceptical US electorate of the necessity of subsequent intervention?
The failure of Lehman symbolised — for most people — a crisis of confidence in the financial system. The tough question is not whether the crisis would have been averted, but whether it would have been less acute if Lehman had been bailed out.
Yet bailing out Lehman could only have further undermined the credibility of the battered financial system.
The key lesson for SA’s public policy makers today is to remember that every economic project, as the unfolding euro crisis so dramatically demonstrates, has a political fuse. The multiple policy failures in 2008 were as much a product of failed political leadership as they were of poor economic management. It is unlikely that the notoriously do-nothing Congress would have passed the limited Dodd-Frank reforms if the crisis had not been so severe.
Lehman had to fall in order to summon the political will to make the piecemeal changes to the financial system.
The festering problem is that the reforms remain half-baked. And that should concern us all in SA.
• This is drawn from an extended paper on the role of central banks in the financial crisis by Cayzer as a Master of Public Administration candidate at the Harvard Kennedy School in 2011.