Making Sense of Lehman Through Bernanke

I confess to being slightly obsessed with the schizophrenic zig-zagging by the U.S. authorities that arguably made the credit crisis much, much worse. The feds underwrote the bailout of Bear Stearns, then let Lehman Brothers become the biggest bankruptcy in U.S. history, and the very next day rescued American International Group, and leaving the world of finance bewildered and confused. After reading the latest memoir on the period, I'm still not convinced the principal actors in the drama are being entirely frank about what happened behind the scenes of the real Lehman moment.

My pain is easy to name: The overseers of finance were able to produce a $30 billion loan to persuade JPMorgan to absorb Bear Stearns. They finagled $85 billion more when AIG was heading for the cliff. But in between those two unprecedented bailouts, they say there was no possible way -- no possible way -- to avert Lehman's bankruptcy in September 2008. I find myself unwilling to suspend my disbelief and accept that narrative.

My excuse for revisiting the affair is the arrival this week of former Federal Reserve Chairman Ben Bernanke's "The Courage to Act: A Memoir of a Crisis and Its Aftermath." I was hoping to discover the justification for the flip-flop; instead, I find myself as disappointed as I was last year by Tim Geithner's book "Stress Test." (Ignore for now that I reckon letting Bear Stearns go broke in the first place might have been a sufficiently cathartic event to lessen at least some of the carnage that occurred.)

It isn't that Bernanke obfuscates; he deals with the issue head on in rejecting the accusation that Lehman was deliberately allowed to fail:

I do not want the notion that Lehman's failure could have been avoided, and that its failure was consequently a policy choice, to become the received wisdom, for the simple reason that it is not true. We believed that Lehman's failure would be extraordinarily disruptive. We did everything we could think of to avoid it. The same logic led us to rescue AIG where (unlike for Lehman) our makeshift tools proved adequate.

Bernanke's argument for why Lehman died while AIG survived can be summarized like this:

1. Only the government had access to sufficient cash to bail out Lehman.
2. The government wasn't willing to provide that cash.
3. So Lehman was unsalvageable.

Expanding the Fed's balance sheet quickly enough to rescue Lehman would have been difficult, but not impossible. Post-Lehman, the Fed was able to create an almost unlimited supply of money. Bernanke says the Fed didn't have the resources to backstop Lehman either by buying its trashed assets (as it later effectively did with the Troubled Asset Relief Program) or underwriting its takeover by a competitor (as it had already done with Bear). But check out what Bernanke says was the case in 2008 versus what the balance sheet did afterwards:

Geithner, who headed the New York Fed at the time all this was happening, also stressed in his book that there wasn't a deliberate decision to let Lehman go to the wall:

The world naturally assumed we had consciously decided to teach Wall Street a lesson. We hadn't chosen to draw a line. We had been powerless, not fearless. We had tried but failed to prevent a catastrophic default.

Both central bankers make the case that AIG had bags full of collateral, something Lehman lacked. Both also stress that the sheer size of AIG (as well as the speed of its demise) gave it the potential to trigger an economic depression, never mind recession. So the Fed held its nose and wrote a check for AIG, as Bernanke explains:

There was some circularity here: If the loan to AIG helped stabilize financial markets, then AIG's companies and assets would likely retain enough value to help repay the loan over time. But if financial conditions went from bad to worse, driving the economy deeper into recession, then the value of AIG's assets would suffer as well. And, in that case, all bets on being repaid would be off.

But everything Bernanke lists as the potential consequence of not stuffing AIG full of taxpayer cash -- doubts about the solvency of its financial peers, chaos in derivatives, commercial-paper losses trashing money-market funds -- had already happened after Lehman, and were equally predictable. And AIG's assets were at least as toxic and as hard to value as Lehman's; more so, maybe, since the Fed was including real assets such as AIG's insurance and airplane businesses, not just the securities it owned.  

Moreover, the counterfactual is whether AIG would still have gone into a tailspin if Lehman hadn't gone bust. Rescuing Lehman -- however hard and expensive and controversial -- might have restored confidence and cauterized the cash bleed; instead, the hemorrhaging got worse.

The argument that government money wasn't available to plug the holes in Lehman is also problematic. It's obvious Treasury Secretary Henry Paulson wanted a market-led solution that would see Lehman become a ward of one of its healthier peers. And it's equally obvious that a blank check from the government would diminish the chances of the private sector financing such a solution. "Tactical considerations were an important motivation" in Paulson ruling out government assistance, Bernanke says.

But it's hard to shake the suspicion that what started as brinksmanship and a bluff morphed into something more dangerous. Given how inventive the authorities have been in the "making it up as we go along" approach to post-crisis policy, could Paulson, Bernanke and Geithner really not have found some way to keep Lehman on life support? In Paulson's own memoir, "On The Brink," he says that Geithner challenged his stance:

Tim expressed concern about my public stand on government aid; he said that if we ended up having to help a Lehman buyer, I would lose credibility. But I was willing to say `no government assistance' to help us get a deal. If we had to reverse ourselves over the weekend, so be it.

So the contingency of the Treasury reversing its opposition to using public money to keep Lehman afloat was, it seems, at least a possibility. And yet Lehman was still allowed to fail. And, incredibly, it seems Bernanke and Paulson conspired to, well, be economical with the truth when they testified to Congress about Lehman's dissolution:

Paulson and I were deliberately quite vague when discussing whether we could have saved Lehman… we had agreed in advance to be vague because we were intensely concerned that acknowledging our inability to save Lehman would have hurt market confidence… our caginess about the reasons for Lehman's failure created confusion about the criteria for any future rescue.

You might argue this is all ancient history. In a post-crisis world where regulators are trying to force financial institutions to address the too-big-to-fail problem, though, it's important that the authorities review their actions, too. That's the only way to have a coherent playbook in place for when disaster strikes again. But the nagging, uncomfortable truth is that I still don't feel like I know why Lehman was allowed to fail. 

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To contact the author of this story:
Mark Gilbert at magilbert@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net