The recent publication of former Federal Reserve Chairman Ben Bernanke’s book on the financial crisis, “The Courage to Act,” has once again raised the issue of why the large Wall Street investment bank, Lehman Brothers, was allowed to fail. In his book, Bernanke implies that the he and Hank Paulson, then the secretary of the Treasury, really had no choice. Lehman was so deeply underwater that a rescue would have been futile. It did not have enough collateral to support a Fed advance and would have left the Fed in a position of lending into a run.

This statement, which Bernanke also made to the Financial Crisis Inquiry Commission, was called into question by a Sept. 29, 2014, article in the New York Times in which Peter Eavis and James B. Stewart reported that unnamed economists at the New York Fed had analyzed Lehman’s financial condition before that fateful weekend in September 2008, and concluded that, “Lehman might, in fact, be a candidate for rescue.” In other words, these economists believed that Lehman had sufficient collateral for a loan from the Fed, but they were never asked for their views.

paulson-geithnerThe reason for this, which is covered in my book on the financial crisis (“Hidden in Plain Sight: What Caused the World’s Worst Financial Crisis and Why It Could Happen Again”) is that four days before the Lehman bankruptcy Paulson had told Bernanke and then-New York Fed President Tim Geithner that he would not support the use of government funds to rescue Lehman.

In his book, “Stress Test,” Geithner describes a conference call with Paulson on the evening of Sept. 11 — only four days before Lehman filed for bankruptcy. In that call, which also included Bernanke and SEC chair Chris Cox, Paulson said that “he didn’t want to be known as “Mr. Bailout,” that he could not support another Bear Stearns solution.” Indeed, Bernanke himself reported the same conversation, in an interview that appears in David Wessel’s book, “In Fed We Trust.”

Under these circumstances, Bernanke and the Fed could not have participated in a Bear-like rescue of Lehman; the support of the Treasury was politically essential. So the bankruptcy of Lehman was allowed to occur, even though Bernanke told the Financial Crisis Inquiry Commission that he was certain there would be a “catastrophe” if Lehman were allowed to fail. The likely real reason — Paulson’s unwillingness to be known as “Mr. Bailout” — was never disclosed.

But this was only one of the many government blunders leading up to and flowing Lehman’s bankruptcy; together they resulted in the U.S. financial crisis, Congress’s approval of $800 billion for the unnecessary Troubled Asset Relief Program (TARP), and the enactment by Congress of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd- Frank) in July 2010. It is Dodd-Frank’s heavy regulation of the U.S. financial system that has caused the historically slow economic recovery in the United States and the political controversies about middle class stagnation, the decline in participation rate in the U.S. work force, and the concerns about inequality that have ensued.

From the summer of 2007 through early 2008, the financial news was uniformly frightening for investors and creditors. Formerly healthy firms that held large portfolios of mortgages or private mortgage backed securities (PMBS) were illiquid or insolvent and were declaring bankruptcy. On Aug. 9, 2007, BNP Paribas, a major French bank, suspended redemptions from funds it was managing because it could no longer be sure of the value of the PMBS assets that the funds were holding. This event shook the markets and caused a sharp rise in indicators of investor unease.

Still, Bernanke and Paulson continued to assure the markets that the problem of subprime mortgages was “contained” and the then current troubles only temporary. In substantial part, their position was the result of the fact that neither they nor anyone else outside the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac knew that the GSEs had not disclosed the full extent of their exposure to subprime loans.

At this time, and still today, the GSEs were the dominant players in the U.S. housing finance system. They set the underwriting standards that others followed, and for many years they had been acquiring vast numbers of subprime and other weak and risky mortgages in order to comply with government “affordable housing” quotas. These, by 2008, required that 56 percent of all mortgages they acquired be made to borrowers at or below the median income where these borrowers lived. This caused a significant nationwide decline in mortgage underwriting standards, so that by 2008 more than half of all mortgages in the U.S. — 31 million loans — were subprime or otherwise low quality, and the two-thirds of these mortgages were on the books of Fannie and Freddie.

It is a remarkable and shocking fact that neither the secretary of the Treasury nor the chairman of the Federal Reserve Board ever sought — as the mortgage markets began to meltdown — to understand why this mortgage collapse was occurring. The information would have been readily available from the Federal Housing Finance Agency (FHFA), the regulator of Fannie and Freddie. Indeed, in early September 2008, Paulson concluded that both Fannie and Freddie were insolvent and placed them in a conservatorship run by the FHFA — all without knowing why these two government-backed firms had become insolvent or connecting the dots between the “mortgage meltdown” that had been underway for a year and the unprecedented number of defaults that were occurring among mortgages on the books of Fannie and Freddie.

But these were far from the only blunders. In March 2008, Bear Stearns, the smallest of the five major Wall Street investment banks, was unable to fund its operations; because of its investments in mortgages and PMBS, it had lost the confidence of the market and the firm was bleeding cash. Paulson and Bernanke were faced with the choice of whether to let Bear Stearns fail or to take extraordinary steps to rescue it. They chose the latter. Bear Stearns was sold to the giant bank JPMorgan Chase with the Federal Reserve providing $29 billion in financial support as an inducement to the acquiring bank. This was a fateful move, and set up the conditions that eventually led to the market liquidity panic that we know as the financial crisis.

Although the Bear rescue temporarily calmed the markets, it created substantial moral hazard. Market participants now believed that the government had established a policy of rescuing large failing financial institutions. This perception substantially affected subsequent decisions. Firms with weak cash or capital positions did not take the opportunity to raise as much new equity as their parlous condition required; with the government likely to rescue their creditors, there was little reason to further dilute their shareholders in order to foster creditor confidence.

Firms that might have been willing to accept acquisition offers from stronger buyers thought they could drive harder bargains, and interested buyers backed away. Potential acquirers for Lehman, noting the $29 billion support that JPMorgan Chase received from the Federal Reserve, were probably unwilling to buy a firm even larger than Bear with no financial support or risk-sharing from the U.S. government. Yet, Paulson was telling anyone who would listen that there would be no government risk-sharing. (Until the phone conversation with Geithner and Bernanke mentioned above, neither of them believed Paulson would back away from rescuing Lehman, and Paulson himself says in his memoir, On the Brink, that his position was a bluff; he was trying to stir up private support for Lehman by denying that the government would step in).

Paulson and Bernanke seemed not to recognize how the rescue of Bear had created moral hazard and changed the way the market would normally behave. They apparently thought that during the relatively calm period after the Bear Stearns rescue financial firms were taking adequate steps to prepare themselves for future challenges — improving their liquidity positions and selling shares to shore up their capital. But little of this was happening. It was far more rational to believe that the mortgage problem was “contained” and conditions would soon improve than it would be to dilute a firm’s shareholders by raising significantly more equity when the stock market was in the tank.

Thus, the key government decision makers had very different perceptions of reality than market participants. Despite the fact that both Paulson and Bernanke had extensive financial experience (Paulson in particular had been a chair of Goldman Sachs), neither seemed to understand that their strategy was both discouraging actions by weakened firms that would improve their capital or liquidity positions and making a buyer for Lehman more difficult to find.

Thus, when Lehman Brothers filed for bankruptcy on Sept. 15, chaos ensued. Market participants, investors, and creditors who had assumed that the government would not allow any large financial institution to fail now had to re-evaluate all their counterparties. This outcome was not conducive to calm reflection. Uncertainty about the financial condition of many firms caused investors and creditors to seek cash. In turn, financial institutions, including the biggest banks, afraid of rumors that they were not able to meet the withdrawal requests of creditors and depositors, hoarded cash, not willing to lend to one another even overnight. This caused a virtual collapse of liquidity, and induced Paulson and Bernanke to press the unnecessary TARP idea on Congress, and sent the market into a panic that we now know as the financial crisis.

Yet — and this is the final irony — no large firm failed as a result of Lehman’s bankruptcy, showing that if Bear had not been rescued the market would not have fallen apart as we have so often been told. The financial crisis was the result of a toxic combination of government housing policies and government blunders — more evidence, if any were needed that the government should be kept on the sidelines whenever possible.

Peter J. Wallison is the Arthur F. Burns Fellow in financial policy studies at the American Enterprise Institute. His latest book is Hidden in Plain Sight: What Caused the World’s Worst Financial Crisis and Why It Could happen Again (Encounter Books, 2015)

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Peter J. Wallison

Peter J. Wallison, a codirector of AEI’s program on financial policy studies, researches banking, insurance, and securities regulation. As general counsel of the U.S. Treasury Department, he had a significant role in the development of the Reagan administration’s proposals for the deregulation of the financial services industry. He also served as White House counsel to President Ronald Reagan and is the author of Ronald Reagan: The Power of Conviction and the Success of His Presidency (Westview Press, 2002). His other books include Competitive Equity: A Better Way to Organize Mutual Funds (2007); Privatizing Fannie Mae, Freddie Mac, and the Federal Home Loan Banks (2004); The GAAP Gap: Corporate Disclosure in the Internet Age (2000); and Optional Federal Chartering and Regulation of Insurance Companies (2000). He also writes for AEI’s Financial Services Outlook series. 

Peter J. Wallison
Arthur F. Burns Fellow in Financial Policy Studies
American Enterprise Institute
Washington D.C.

T: +1 (202) 862 5864
E: pwallison@aei.org
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