Who pulled the plug on Lehman Brothers?

We must thank Professor Laurence Ball at the Johns Hopkins University for filling a very important information hole on the demise of Lehman Brothers. He has done a wonderful service although, for reasons beyond your control, there are unanswered questions. The decision was taken by Hank Paulson, the then Treasury Secretary, although he had no locus standi to take that call.

Several questions cropped up in my head on reading his 218-page long paper published last year on the bankruptcy of Lehman Brothers:

(1) Is there no consequence for Bernanke not responding to the FCIC request for information on Lehman Collateral and his refusal to provide the information?

(2) When Prof. Ball made the FoIA request for details on the collateral from AIG against which the Federal Reserve lent, it was already 2012. By then, the collateral had been liquidated. Why was it still not feasible for the Federal Reserve to comply with Prof. Ball’s Freedom of Information Act (FoIA) request? It would not have jeopardised price discovery of AIG collateral since they had been liquidated, by then. Pity that the courts too did not agree with him.

(3) I can understand, to a degree, why Hank Paulson did not want to commit public money after the backlash he received for Bear Stearns bailout. But, did it involve taxpayer money? Lending against collateral is the job of a central bank and it is a call that it should take.

To be sure, I agree that if the collateral were of dubious value, then eventually the burden becomes fiscal. But, that is a judgement that the Federal Reserve had to make and the risk of that judgement is part of the job.

In other words, no taxpayer funded bailout should not have meant that Lehman Brothers should be barred from the Fed Primary Dealer Credit Facility (PDCF).

[I learnt from Professor Ball’s interview (see below) that, after Dodd-Frank, the Treasury Secretary has to authorise Fed lending to a stricken institution.]

(4) Why has Hank Paulson not been questioned/tried/fined/ imprisoned for overstepping his authority vs. the Federal Reserve, not to mention yelling at Cox of SEC?

(5) Why has there been no follow-up action to the Financial Crisis Inquiry Commission (FCIC) report in terms of holding public officials accountable for their decisions? The Federal Reserve had dodged information requests from FCIC on the extent of collateral available from Lehman Brothers, on the Fed’s assessment, etc., They were not given that information. Is there no consequence for that?

(6) There is some escape avenue for Paulson because he had tried to arrange a private sector solution. He had spoken to Dick Fuld on fifty occasions between July and September. The paper mentions that. He spoke to Alastair Darling to waive the Financial Services Authority (FSA) insistence on Barclays’ shareholder approval, etc.

But, he could have easily allowed the Fed to fund Lehman for sixty days for Barclays to obtain shareholder approval and let the firm fail, after that, if it did not materialise. That could have also given the system to prepare better?

(7) In an interview for the ‘Promarket’ blog at the Stigler Center at the University of Chicago Booth School of Business, Prof. Laurence Ball specifically rules out ulterior motives for the then Treasury Secretary:

Q: In the aftermath of the crisis, there were rumblings that the reason Lehman was allowed to fail while other institutions were bailed out had something to do with the fact that the government was filled with former competitors of Lehman, and they were the ones calling the shots.

A: I read that. I don’t think that’s really true. There were also stories about Henry Paulson who had been in charge of Goldman Sachs and supposedly didn’t like Richard Fuld, who was head of Lehman Brothers—that may be true, I don’t know, but I think it’s pretty clear that Henry Paulson did not want Lehman Brothers to fail and did not think this was a good thing or tried to get back at his rival on Wall Street. Paulson knew that at best he was taking a very big risk, and he did work very hard to try to arrange for some kind of private sector rescue of Lehman. The last big hope being the Barclays acquisition that didn’t work out, and he was very unhappy. In the end he did everything he could to prevent Lehman’s bankruptcy, whether he liked or didn’t like Richard Fuld. Except he wasn’t willing that the Fed put in money because of the political consequences of that. [Link]

(8) It is funny to see the slant of the interview from the ‘pro-market’ blog. They were trying to argue that the whole crisis was probably much ado about nothing because, had Lehman Brothers been bailed out, it might not have become so serious as it did and therefore what was the fuss really about?!

Never mind that there was a global real estate crisis, bank failures in a few countries in Europe, etc. The interviewers for the blog were trying to argue that the Federal Reserve made a miscalculation and did not rescue Lehman Brothers. They did not want to acknowledge that investment banks were leveraged 40:1 or that Countrywide engaged in predatory lending and that subprime mortgages had grown too much too quickly and that they were securitised multiple times over. None of these constituted a problem. This kind of market fundamentalism is actually repulsive and distasteful.

There is one explanation in their favour. Possibly, they were merely being provocative. That cannot be ruled out.

Those who do not wish to read the 218-page long paper might wish to read this short NYT Deal book article and this 18-page summary paper by Prof. Ball himself.

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