By Yusuke Horiguchi
October 7, 2014
1. In a systemic financial crisis, strong forces of contagion--a virulent form of negative externality--put even the solidest financial firms with no faults of their own at serious risk, because of other firms' plight. This is a notorious example of market failure, providing a justification for public intervention aimed at preventing the financial system's collapse, typically involving taxpayer money. This is a standard economic analysis, widely accepted, at least at this level of generality, and with a straightforward prescription on the general direction of policy to be followed when coping with severe system-wide financial stresses. It needs emphasis, however, that the prescription is applicable only to systemic crisis situations.
2. The situation of September 2008 and the ensuing few months was none other than that of an epochal systemic crisis. It in fact was the epitome of "unusual and exigent circumstances", in which the Fed was authorized to exercise extraordinary lending power under Section 13-3 of the Federal Reserve Act (in particular pre Dodd-Frank). What was needed then was not just one but a series of decisive public interventions, with the Fed playing a critical role using its Section 13-3 power. Not bailing out a big financial firm in trouble in such a situation could cost taxpayers much more dearly than the direct cost of bailout, as witnessed in the wake of Lehman's collapse, an event which should have been prevented.
3. Why did the Lehman rescue efforts fail? It does not take a rocket scientist to figure out that then Treasury Secretary Paulson's dogged adherence to his policy of no public money for a Lehman rescue made an already very difficult task of preventing Lehman's collapse an almost impossible one, as documented amply in Ross Sorkin's Too Big To Fail, and former Treasury Secretary Geithner's Stress Test. What caused Paulson's absolute aversion to another use of public money was the political flak he had been getting, especially following the bailouts several days earlier of Fannie and Freddie. He could not stomach any more politicians' damning refrain "here goes Paulson again with his checkbook". As pointed out in those books, had Paulson chosen to take a higher road and indicate, at a strategic moment, his potential readiness to be less inflexible, at the end of the day, perhaps contingent on certain conditions, the process and the outcome of rescue efforts could well have been different.
4. Paulson found a convenient defense for his position in an analytical assessment circulating at the Treasury and the Fed with considerable top-levels support, that financial firms were ready to cope with a Lehman failure given their preparation over the six months since the Bear Stearns event. This analysis, however, was a cavalier one, to say the least, ignoring altogether a fallacy of composition typical in a panic whereby individual firms' rational behavior to run from risks collectively acts almost like a death sentence for the financial system already on its knees. A sloppy analysis should be accorded no place as a basis for a strong policy position like that of Paulson's, especially in a moment of truth.
5. Strangely, post Lehman's bankruptcy, Paulson's public statements on why Lehman was not bailed out cast aside his policy of no public money for Lehman. Paulson instead contended, like then Fed chairman Bernanke, that, given the lack of adequate collateral on the part of Lehman, they had no legal authority to lend to Lehman, even under Section 13-3, an amount sufficient for it to weather the storm and survive. Aside from a question why Paulson had to be so vehemently opposed to something that, according to him, they were not even legally authorized to do, a set of "circumstantial evidences" points to rather shaky grounds on which this contention stood.
6. To begin with, contrary to their public statements, the real legal authority issue in Lehman's case was not whether the Fed had legal authority to lend to Lehman under Section 13-3 but rather whether the Fed had legal authority to proffer a guarantee for Lehman's trading obligations during the interim between the time of Barclays (a UK bank, the only potential buyer of Lehman in the final stage) and Lehman signing an acquisition agreement and the time of the deal's closure. On Sunday September 14, with a consortium of major banks having already agreed, to meet Barclays' demand, to put up $33 billion to fund a special vehicle to purchase Lehman's toxic assets--a la Maiden Lane the NY Fed created for Bear Stearns rescue--the last hurdle blocking Barclays top executives' signing of an agreement in New York that day to acquire Lehman was the absence of a Barclays shareholders' yes vote on proffering trading obligations guarantee.
7. With the UK authorities refusing then to waive the country's requirement of a shareholders' vote on this, the only way viewed as potentially available for the merger deal to get signed that day was for the Fed, instead of Barclays, to proffer such a guarantee to Lehman, until the time of Barclays shareholders' yes vote. And that was what was deemed legally impossible for the Fed to do, as articulated by NY Fed general counsel Baxter in his statement to the Financial Crisis Inquiry Commission. So, Paulson and Bernanke were right in claiming that they did not have legal authority, but the legal authority in question was not one related to lending to Lehman in the alleged absence of adequate collateral but one related to proffering a temporary guarantee for Lehman's trading obligations. This distinction is critical. The Fed's lack of legal authority in this very specific and narrow matter cannot be considered as the last word on a broader issue of whether a legal way to use public money to rescue Lehman could not have been found.
8. A key issue in that broader context is whether Lehman had adequate collateral for a Fed loan under Section 13-3. The assertion of Paulson and Bernanke notwithstanding, a strong support for a positive answer to this question is found in the bank consortium's unambiguous decision to provide $33 billion to fund a special vehicle to buy Lehman's toxic assets. According to the Sorkin's book, the way the consortium valued those assets for deciding how much to provide was merciless, with 25-50% writedowns from Lehman's own downbeat estimates being common across those assets. A reliable basis for assessing the suitability of those assets as collateral for the Fed's potential loan operation for a Lehman rescue is found in NY Fed lending for Bear Stearns rescue. In that bailout, the collateral for the NY Fed's $29 billion loan to Maiden Lane was valued using, as is, Bear Stearns marks as of March 14. It would be a mystery if the Fed indeed had no legal authority to lend for a Lehman rescue based on the far more stringently valued collateral.
9. These considerations indicate that a way could have been found to get around the aforementioned specific legal obstacle and let Barclays sign the purchase deal. For example, given the consortium's commitment to provide $33 billion, a plausible scenario for Lehman rescue would have been for the consortium, instead of the Fed, to proffer the needed guarantee, using that money as a means to boost the guarantee's credibility, and for the Fed in tandem to fund a special vehicle to purchase Lehman's toxic assets, as it did for Bear Stearns. Would the consortium have demanded that the guarantee be secured by collateral? Not likely, in the light of the total lack of any "fusses" on the part of JP Morgan Chase in proffering the required guarantee to Bear Stearns, in sharp contrast to its adamant refusal to proceed with the acquisition deal in the absence of the Fed's commitment in effect to covering the great bulk of possible losses associated with Bear's toxic assets. Had the consortium asked for collateral, it very likely would have found adequate collateral among Lehman's non-toxic assets valued then at more than $500 billion.
10. As a final point on the legal issues, it should be emphasized that the Fed's lack of legal authority to proffer a guarantee as such should not have been taken as precluding a search for an instrument available within the Fed's legal power that performs a function equivalent to a straightforward guarantee for Lehman's trading obligations. To leave no room for doubt that Lehman's commitment in trade deals be honored, all that the Fed would have had to do was to make a non-recourse loan to Lehman in the amount of any trading transaction that Lehman did not have resources to consummate, taking the assets acquired from the counterparty to the deal as primary collateral. The Fed had the authority to make such a loan (and could have prevented a bankruptcy) but did not use it. Another possible channel through which to provide public financial support for a Lehman rescue was thus left unexplored.
11. The absence of official financial support to underpin the Lehman rescue plan being developed in New York made the UK authorities highly skeptical of the plan's workability, causing them to refuse to go along with the US authorities' prodding to give Barclays the green light for its acquisition of Lehman. The sketch provided by Paulson of the deal in the works, notable for no official skin in the game, clearly indicated to the UK authorities that Barclays would be taking on more risk than it could manage. What they looked for, in order to be supportive, was an assurance that the deal was sufficiently watertight to cope with any worst-case scenario. In their view, such assurance was possible, in the midst of the raging systemic crisis, only with an unequivocal financial backing of the US authorities for the deal. While the UK authorities' strong disinclination to go along, including its refusal to waive the requirement of a shareholders' vote on proffering of the guarantee, was taken by the US side as the final nail into the coffin of the deal, it should have been crystal clear from the very outset that there was absolutely no way for the UK government-or any other government for that matter-to endorse the deal as envisaged, in effect bankrolling a US investment bank when the US authorities would not.
12. By way of concluding, a mention has to be made of a concern about the moral hazard affecting big financial firms, a concern almost certain to have been underlying all those individual reasons for the failure of the Lehman rescue efforts. Despite its powerful influence in politics, substantively moral hazard affecting such firms is merely an untested extrapolation of a concept relevant for individuals' behavior to organizations'. To begin with, an official bailout of such firms is for the system's stability and never for any individual stakeholder. In cases where a firm on the brink gets bought into a healthier firm, it loses its own identity, and its stakeholders typically lose big time. Even in the bailouts of AIG and Citi in which their identities were preserved, the losses incurred by their shareholders as well as top executives and highly paid staff, typically with substantial holdings of shares of their respective companies, were enormous. Given that, an idea that individual stakeholders behave recklessly just because of the knowledge that their firm would be bailed out in time of crisis is absurd. So, then, is the notion of the moral hazard affecting large financial firms.
13. Moral hazard was not a driver of large financial firms' pre-crisis reckless behavior; greed and other basic frailties of many key individual stakeholders were. Despite its little substance, the concern about moral hazard has intensified in the aftermath of the repeated bailouts of unprecedented scales. This is visible in certain recent regulatory changes, including in particular Dodd-Frank's elimination of the Fed's power to lend to individual nonbanks and of the broader FDIC guarantee authority. Making the collapse of systemic firms during a crisis less preventable while lessening the authorities' ability to keep the panic from spreading can prove a devastating combination. In contrast to significant regulatory reform achieved on crisis prevention side, retrogression is the clear trend for the crisis management apparatus charged with the imperative of preserving systemic stability, driven by moral hazard concern and anti-bailout sentiment. Last time, the authorities failed to make full use of available instruments; next time of a category-5 hurricane, they will find themselves short of instruments. This has to change without delay.