The Fed Could Have Saved Lehman Brothers With a Temporary Guarantee of Lehman's Good Assets
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
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