Even after five years, there has been little acknowledgement of how the Lehman bankruptcy could have been avoided on September 15, 2008. A deal to spin off Lehman's bad assets to a Maiden Lane special purpose vehicle had been forged by Wall Street firms willing to lend the funds to make it possible. However, the sale of Lehman's good assets to Barclays Bank failed for lack of a temporary Fed guarantee of Lehman’s trading book. It may go done as the biggest mistake in the history of the Fed.
By Robert Stowe England
The Federal Reserve could have prevented the bankruptcy of Lehman Brothers in September 2008 by briefly guaranteeing the trades on Lehman’s good assets. The Fed guarantee was needed for only about 30 to 60 days to allow time for a vote by Barclay’s board of directors on Barclay management’s decision to acquire Lehman’s good assets.
By Saturday, September 13, a deal had been put together under direction of Treasury Secretary Hank Paulson and New York Fed President Timothy Geithner to break Lehman into a good bank and bad bank – and to sell the good assets to Barclays. The U.K. bank had agreed to buy Lehman’s good assets if Lehman disposed of what was then thought to be $40 billion to $50 billion in bad assets.
Paulson had already been successful in bringing together major Wall Street firms to back a deal to dispose of Lehman’s bad assets, so the disposition of the good assets in a sale to Barclays was all that needed to be done to complete the rescue.
The heads of the major Wall Street firms, meeting at the New York Fed Friday night, September 12, worked all night to hammer out an agreement to lend a newly-created special purpose vehicle $37 billion to buy the Lehman’s bad assets, hoping to eventually to recoup their loan principal when the troubled assets were later sold off. A who’s who of banking were present: Jamie Dimon from JPMorgan Chase, John Mack from Morgan Stanley, Lloyd Blankfein from Gold man Sachs, Vikram Pandit from Citigroup, John Thain from Merrill Lynch, Brady Dougan from Credit Suisse, and Robert Kelly from the Bank of New York Mellon.
The special purpose vehicle would be similar to the Maiden Lane vehicle set up to acquire the bad assets of Bear Stearns in March 2008, making it possible for JPMorgan Chase to acquire the failing investment bank. The Federal Reserve Bank of New York, which is adjacent to Maiden Lane in the financial district, loaned the first Maiden Lane LLC the funds to buy the troubled assets of Bear Stearns. (Maiden Lane II and III were set up after the Lehman Brothers to dispose of bad assets from AIG.)
After the multi-bank rescue agreement was reached, however, a parallel effort underway among some of the bank chiefs to value the assets of Lehman reported that they thought the value of Lehman’s bad assets was only $27 billion. This meant the banks would be $10 billion short, assuming valuations never recovered. Yet, after some bickering amongst themselves and prodding by Treasury, the banks held firm in their willingness to do the deal. Barclays agreed to contribute some of its shares to the new entity to reduce the potential shortfall.
On Sunday, September 14, at 8 am, Barclays chief executive officer John Varley and Diamond told Paulson, Geithner, and Securities and Exchange Commission Chairman Christopher Cox that the Financial Services Authority had declined to approve the deal. Geithner and FSA chairman Collum McCarthy, who said he had not rejected the deal outright but was wary of guaranteeing the trade during the time it would take for Barclays shareholders to vote on the deal. The FCIC reports that the New York Fed, meaning Geithner, had required that the Lehman’s obligations be guaranteed from the time of the sale until the transaction closed.[i] Geithner insisted that Barclays guarantee the trades, which had required of JPMorgan Chase during the time between its agreeing to purchase Bear Stearns and the closing of the transaction.
According to the FSA, “Barclays would have had to provide a (possibly unlimited) guarantee for an undefined period of time, covering prior and future exposures and liabilities of Lehman that would continue to apply including in respect of all transactions entered into prior to the purchase, even in the event the transaction failed.”[ii]
Geithner asked McCarthy for a waiver on the shareholder vote so that the board could immediately accept the deal. McCarthy said that the waiver could only be granted by Chancellor of the Exchequer Alistair Darling. At 10 am Paulson called Darling to break the logjam with information that Wall Street bankers would buy lend the funds to buy the bad assets. Darling refused to grant a waiver. Paulson told Lehman’s outside council: “We have the consortium – the British government won’t do it. Darling said the he did not want to spread the U.S. cancer to the U.K.”
Here is where things are muddy about why the Fed would not guarantee the trades. Paulson told the FCIC that a Fed guarantee was out of the question since the shareholders could reject the acquisition and the Fed would be in possession of an insolvent bank.[iii] Paulson was worried that a run on Lehman would continue during the time shareholders were voting, and the Fed would have to provide liquidity for Lehman, as repo lenders and other parties withdrew funds from the bank. Lehman’s general counsel Thomas Baxter told the FCIC that Barclays knew full well they would have to guarantee the trades because of the JPMorgan Chase/Bear Stearns precedent. Baxter said he believed that the U.K. regulators refused to go along with waiving the shareholder vote because the U.K. government was uncomfortable with the deal.
Did anyone tell Barclays and the U.K. regulators that the Fed could not guarantee the trades? Was the option actually considered to make the deal possible? Without the Fed as a guarantor and with no other guarantor in sight, the deal to sell Lehman's good assets fell through and, with it, the agreement by the consortium of Wall Street banks to buy the bad assets.
It would appear that the guarantee option was not palatable because Paulson and Bernanke were worried that it would not be sufficient to stop the ongoing run on Lehman Brothers, as nervous markets waited for a shareholder vote. If the U.K. authorities had decided to waive the shareholder vote, then there would have been no waiting period for financial markets. So, Baxter’s hunch seems persuasive. The U.K. government was too worried about contagion to waive the shareholder vote. Paulson appears to have been worried that if the liquidity squeeze continued at Lehman after the Fed guarantee its trades and the Fed ended up owning Lehman Brothers, it could have had serious market fallout for Washington’s ability to manage the financial crisis.
It seems there was a bad case of jitters in both London and Washington. The jitters are more defensible on the part of the United Kingdom since the atmosphere of crisis had so far been contained to the United States. For U.S. authorities, however, the failure to act – to have the Fed guarantee Lehman’s trades in the good bank – revealed that the authorities had not come even close to understanding the fallout that would follow.
Since it is difficult to know how an alternative history would play out, it’s hard to know with certainty whether both the U.K. and U.S. financial regulators by their inaction and inflexibility actually made the situation worse than it turned out to be. However, it’s also hard to imagine that if the Fed had guaranteed Lehman’s trades, and the U.K. authorities accelerated the shareholder voting process down to a week to 10 days, that it could have turned out worse than it did. Even if the Fed ended up owning Lehman, as Paulson feared, would it have been worse than what actually happened?
When Lehman declared bankruptcy on September 15, 2008, it froze up financial markets around the globe and threatened to collapse global finance and plunge the world into a depression as regulators struggled to find ways to unfreeze the markets.
Since September 2008, neither Paulson nor Bernanke have indicated whether or not they seriously vetted the idea having the Fed guarantee Lehman's trades and were prepared for the refusal of U.K. authorities to allow Barclays to guarantee the trades. Or, conversely, that they sufficiently considered the worst-case scenarios that would occur if Lehman failed. In fact, we know very little about the details of any of the options that were under consideration by Paulson and Bernanke in the waning days and hours of Lehman have surfaced. Paulson in his book, On The Brink, reported that he and Bernanke in daily one-on-one meetings at Treasury discussed possible options for rescuing Lehman. Paulson said the options were few but never identified any of them. Nor was any information on the options being considered by Paulson and Bernanke revealed in the work of the Financial Crisis Inquiry Commission, including its conclusions about what caused the crisis.
If Bernanke and Paulson had already considered the potential use of the Fed guarantee option before the 11th hour and rejected it, we do not know. We do know that the Fed’s chief counsel Scott Alvarez had prepared a list of options for consideration by Bernanke and Paulson, but we do not know what they were. If the two had discussed and had already rejected a Fed guarantee on legal grounds before the Lehman crisis erupted into public view, it might explain why it was not seriously considered at the last minute, when it was so desperately needed.
Curiously, in spite of the facts on the record, the perception emerged at the time of the crisis that the Lehman deal failed for the lack of a loan guarantee by the Fed to buy Lehman’s bad assets and not by the lack of a guarantee of Lehman’s trades to help facilitate Lehman’s good assets. This view that the failure of the Fed to guarantee a loan to buy the bad assets was based in part on statements made by Bernanke that the Fed could not make loans without sufficient collateral – this marking the difference between the Fed’s role in Bear Stearns, where it actually did lend money, and the Lehman case, where it was not necessary for the Fed to lend money to acquire the bad assets. Fed loans could have come into play if the run on Lehman had continued after a deal had been struck to sale the good bank to Barclays and have Wall Street firms lend money to buy the bad assets.
The Financial Crisis Inquiry Commission in its conclusions found the regulators shouldered a good deal of blame for the crisis – but stopped short of pinpointing specific actions that were at fault.
Bernanke indicated in subsequent testimony that he did not think the Fed had legal authority to engage in unsecured guarantees, meaning they could not guarantee assets if the collateral was insufficient to cover the Fed’s exposure. In April 2010, in testimony before the House Financial Services Committee, he stated: “At the time, neither the Federal Reserve nor any other agency had the authority to provide capital or an unsecured guarantee, and thus no means of preventing Lehman’s failure existed.”
The irony is that after the devastating fallout from Lehman’s failure, the Fed did guarantee assets in a number of efforts to unfreeze the markets and prevent the failure of more large banks. In its biggest gambit, the Fed took part in an effort with Treasury and the FDIC to ring-fence or guarantee most of an enormous $306 billion Citigroup portfolio of troubled mortgage assets that threatened to bring down the bank. Under the agreement, Citigroup would take the first $29 billion in losses, while Treasury was on the hook for $5 billion from TARP funds and the FDIC for $10 billion. The Fed was on the hook as guarantor of last resort for the remaining $272 billion. Importantly, the value of those assets at the time of the guarantee were unlikely sufficient to cover the Fed’s exposure.
Carnegie-Mellon University professor of economics Allan Meltzer, author of an acclaimed history of the Federal Reserve System, did not hold back in his rebuke of the Fed’s treatment of Lehman. “After 30 years of bailing out almost all large financial firms, the Fed made the horrendous mistake of changing its policy in the midst of a recession,” he wrote a year after the crisis. “Allowing Lehman to fail without warning is one of the worst blunders in Federal Reserve history.”
Mr. England is author of Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance, published by Praeger and available at Amazon.com