The Lehman Brothers lesson, five years later

By Robert J. Samuelson

The New York Times had a fascinating story the other day, which again raises a crucial historical question about the financial crisis: Did Lehman Brothers have to go bankrupt in September 2008? Lehman’s failure turned what had been a series of serious problems at financial institutions (Bear Stearns, Fannie Mae and Freddie Mac) into a full-blown panic. But did Lehman have to crash?

The answer from the then top-policy makers — Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke and head of the New York Federal Reserve Bank, Timothy Geithner — has been that they lacked the legal authority to rescue Lehman. Under the law, they said, the Fed couldn’t lend to a financial institution with a negative net worth: its liabilities (what it owed) exceeding its assets (what it owned). This was the case with Lehman Brothers, they have contended.

At a congressional hearing in mid-November 2008, Paulson said: “There was no authority, there was no law that would have let us save Lehman Brothers.”

Now comes the Times, in a story written by James B. Stewart and Peter Eavis, claiming that some analysts at the New York Fed had concluded that “the government had the authority to throw Lehman Brothers a lifeline, even if the bank was nearly broke.” The analysts’ preliminary conclusion was that Lehman had a modest, positive net worth.

“It was a policy and political decision, not a legal decision,” the Times quotes one analyst as saying of the refusal to bail out Lehman. But for reasons the story never makes clear, the analysts’ conclusions didn’t work their way up the chain of command to Paulson, Bernanke and Geithner, who said in interviews with the Times that they did not know about the analysis.

The real motive for not aiding Lehman was a desire not to be seen as favoring Wall Street, the story suggests. Paulson — the ex-head of Goldman Sachs — “had endured months of criticism for bailing out Bear Stearns in March 2008.” In a September statement to Congress, Bernanke did not mention the legal obstacles to aiding Lehman, the Times said. Only in early October did the legal rationale surface, it reported.

Even now, Lehman’s financial condition at bankruptcy is controversial. When it filed, Lehman listed assets of $626 billion and liabilities of $560 billion for a net worth of $66 billion, according to a study by economists William Cline and Joseph Gagnon of the Peterson Institute. If true, Lehman would have been comfortably solvent. But Cline and Gagnon say the firm’s assets were probably overstated and its liabilities understated. They estimated that Lehman had a negative net worth of at least $100 billion at bankruptcy. The fact that no other financial institution wanted to buy Lehman also suggests a negative net worth.

Regardless, Lehman’s collapse triggered a financial frenzy. No one knew which institutions, if any, the government might protect. Without a safety net, lenders pulled money from institutions that — like Lehman — might fail. Investors sold bonds whose values were in doubt.

Aside from its historical significance, the Lehman story has practical implications. The law that Paulson, Bernanke and Geithner say prevented aid to Lehman Brothers was section 13(3) of the Federal Reserve Act. It gave the Fed expansive power to lend “in unusual and exigent circumstances” as long as borrowers had a positive net worth. Though it wasn’t invoked for Lehman, 13(3) allowed the Fed to make hundreds of billions of dollars of loans that muffled the financial crisis.

The trouble is that, in the Dodd-Frank financial law, Congress has handcuffed 13(3) with a host of technical restrictions. They reflect an understandable reaction to unpopular financial rescues. This may make us feel better now, but it threatens havoc in any future crisis. For Lehman’s real lesson is that letting crucial financial institutions fail can backfire on us all.