Larry Ball on the Lehman Brothers Collapse and Its Role in the Great Recession

A lot can be learned from the Lehman Brothers collapse and its fallout can still be seen ten years later.

Larry Ball is a professor and department chair of economics at johns Hopkins University. He is published widely in the field of macroeconomics and joins the Macro Musings podcast to discuss his new book, “The Fed and Lehman Brothers: Setting the Record Straight on a Financial Disaster” and its implications for potential future crises.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected]

David Beckworth: Larry, welcome to the show.

Larry Ball: Thank you. I'm happy to be here.

Beckworth: Oh, it's a real treat to have you on. With all my guests, I always begin our conversation by asking, how did you become an economist and particularly a macroeconomist?

Ball: Well, in high school I was interested in the social studies and math and in college I figured out that economics is kind of the combination of the two. So, that's how I became an economist. And then in graduate school, at the risk of dating myself, it was the early eighties and there was lots of excitement in macroeconomics about the new classical revolution, whether Keynesian economics had or had not been debunked. And that's what everybody was talking about. So, I joined in to that.

Beckworth: Okay. When you've been a very productive scholar in the field of macroeconomics, there's a lot we could talk about, a lot of interesting research you've done. Maybe we'll have you back on the show for another conversation, but today we want to focus on your new book. It's just out and it's called The Fed and Lehman Brothers: Setting the Record Straight on a Financial Disaster. And we're going to work our way through it in detail, but why don't you begin by giving the listeners kind of the overview, a summary of what the book's about.

Ball: The book is about the role of the Federal Reserve and the Lehman Brothers' failure, asking the question of why Lehman Brothers' fate was so different from the fate of Bear Stearns and AIG and other firms, which were at the brink of bankruptcy, but were rescued by loans from the Fed. Why wasn't Lehman also rescued by a loan from the Fed? And the main conclusion of the book is in a sense a negative one, which is that the reason they were not rescued is not the reason that's been given repeatedly by Federal Reserve officials at the time. What Ben Bernanke and Tim Geithner and on down the line say is that, legally, in order for the Federal Reserve to lend to a financial institution, there has to be satisfactory collateral and the Lehman did not have enough collateral to back the loan that it needed. And therefore any rescue of Lehman would have broken the law and the Fed didn't want to break the law.

Ball: And long story short, what I find in the book is that, that story about collateral and legal authority is not accurate in two related but distinct senses. First of all, in terms of Fed decision making, they were not focusing on issues of collateral illegality. They were discussing various economic and political effects of whether Lehman would fail. And secondly, if one does actually do the exercise of looking carefully at Lehman's financial condition, it's clear that Lehman did have enough collateral to borrow the money and needed to keep going and to find some resolution of its crisis, which was better than suddenly declaring bankruptcy.

Beckworth: Yeah, those are pretty stark findings and there are questions that people have asked all along, but you provide the evidence, you've done a lot of research to get this. And you also note that other big investment banks were treated differently than the Lehman. I mean, soon after Lehman collapses, Goldman Sachs, Morgan Stanley, they tap into the Fed and were able to borrow excessive large amounts. And you asked the question, why did Lehman not get the same treatment as these other big banks?

Ball: Yes, Morgan Stanley and Goldman Sachs after Lehman failed, received exactly the kind of assistance that Lehman needed that would have rescued Lehman, which was large loans from the Feds' Primary Dealer Credit Facility. Some other firms like AIG received in a sense much more help than Lehman needed. In my estimate, the Fed actually took on quite a bit of risk in lending to AIG and because they actually, its collateral was questionable whereas lending to Lehman would have more clearly been safe.

Beckworth: Yeah. We'll get into this more detail later, but it is worth noting up front that the amounts lent to Goldman Sachs and Morgan Stanley were more than what would have been needed for Lehman. In fact in Goldman Sachs, you have a nice list in your book, the big five investment banks before the crisis, Goldman Sachs was the largest than Morgan Stanley. Both a little over a trillion dollars in assets, Merrill Lynch also, but a trillion, Lehman comes in at 691 billion and Bear Stearns at 395. So, it's the little guys that go out first. Merrill Lynch's eventually acquired as well and Goldman Sachs and Morgan Stanley are the only ones left standing and they become bank holding companies, but it is striking that the Fed went above and beyond what would have been needed for Lehman with Goldman Sachs and Morgan Stanley and they took on more risk with AIG.

Beckworth: You also mentioned Bear Stearns is riskier than Lehman at the time, so a lot of inconsistencies is the story. It's very sobering read and quite friendly. He doesn't leave one very inspired about the future, but we'll come back to that in a minute. Let's begin by kind of over what happened in 2008. You have a chapter that kind of nicely lays out what's happening. You began by talking about these investment banks and how they got into the business of housing finance. They were highly leveraged, highly relied on short term borrowing through the repo and also commercial paper, but what's happening in 2008? What chain of events kind of lead us up to the fall of the year when Lehman's in distress?

Ball: Well the important point is that all of the big investment banks you gave the list had similar experiences to greater or lesser, mostly greater degrees. And hindsight obviously is wonderful, in hindsight it's clear that they engaged in risky real estate investments and did so with very little equity. So, that once they started losing money on real estate, people started to question their solvency as their thin equity cushions started to disappear. And then at the same time they were very open at risk for essentially bank runs because they rely on very short term, often overnight funding. And once confidence in the investment bank started to fall it was very quick for the repo counter parties primarily who are providing their funding to cut the funding off. Again, very much in the manner of a classic bank run. And again, that happened really at all five of the big five investment banks. And then there's a story about how the ultimate outcome was different for different ones of the five.

Beckworth: Yeah. You mentioned Lehman was not a saint. It definitely got its hands in the cookie jar and expended its balance sheet. You mentioned from 2005 to 2007 its assets grew from 410 billion to 691 billion that it had when the crisis begins. So, it definitely was involved. But it was like the other banks, as you mentioned in the question is why were they treated differently? You also mentioned that 2007 was actually a good year for Lehman and even the first quarter of 2008 earnings was lower but came in higher than expected. So, things weren't looking down going in 2008. It wasn't preordained I guess that Lehman was going to collapse but in the end of the year they did. And you start off-

Ball: In 2007, Fortune Magazine had a list of the most admired securities firms and Lehman was number one. So, certainly it seemed far from preordained and they would be the one getting in trouble.

Beckworth: Right. Even Bear Stearns that you mentioned, it's not clear why the run on Bear Stearns occurred when it did. I even recall Jim Cramer on Mad Money. Of course, he's infamous for this now, but he told people to buy Bear Stearns' stock not too long before it went under. So, to some extent these firms collapsed at a time that's not easy to explain in terms of the fundamentals. Nonetheless, let's start the year off with Bear Stearns because that's the first kind of shock to Lehman. And that's March, 2008. So, tell us about how Bear Stearns unfolds its crisis and how that plays into Lehman's situation?

Ball: Well, the basic story is that Bear Stearns among the big investment banks was specially heavily invested in real estate. It actually posted a quarterly loss in the first quarter of 2008, so it was slightly ahead of the curve in starting to lose money. And so, there was a lot of talk about Bear Stearns is in trouble and again, it really is like a bank run that as soon as people start questioning, "Is Bear Stearns going to survive?" Then the fear that it won't survive becomes self fulfilling because people don't want to lend to a firm that might not survive.

Ball: And so, it's short term lending was suddenly cut off, and it's not surprising in a way that people might've been saying, "You should buy Bear Stearns," because as people lost confidence, the stock price went way, way, way down and relative to fundamentals that might look like a bargain to buy Bear Stearns if only it could have had enough liquidity to survive. Then once Bear Stearns almost failed or almost taken over by JP Morgan Chase with the assistance of the Fed, then people started talking about which is the next firm to get in trouble. And Bayer was the fifth biggest investment bank. Lehman was the fourth biggest investment bank who was also very heavily in real estate. So, there was a lot of discussion about which will be the next investment bank to get in trouble and a lot of speculation that the answer might be Lehman. And again, that became self-fulfilling.

Beckworth: Okay. Both of these experiences Bear Stearns run and the Lehman run, they do speak to this idea that there's a fine line between a liquidity crisis and a solvency crisis, right? That it may start out with the solid fundamentals, but big enough bank run can turn a bank insolvent even if fundamentally it was okay before.

Ball: Absolutely. Yes. Again, it really in a way is a textbook illustration of a bank run, which doesn't have to happen, wouldn't happen except for self fulfilling expectations and a loss of confidence.

Beckworth: Okay. All right. So, Bear Stearns is the first shock of the year. Then we have a confidence blow in June. You mentioned there's a second quarter loss, 2.8 billion. There's rating downgrades. There's also some liquidity strains because JP Morgan starts... Which is the bank that clears Lehman's repo contracts starts to many more collateral. Even by September when Lehman does collapse, it still had $23 billion in liquidity at the beginning of the week. Now, during this time, you also mentioned Lehman took several steps to save itself. You mentioned it raised capital and tried to get rid of some of its liquid assets. And then you mentioned the episode where the Korean Development Bank tries to invest in it. What happened in that episode? Why didn't the Korean Development Bank agreement come to fruition?

Ball: Well, I'm not certain about that, but I think... So, first of all, Lehman did. Once Bear Stearns failed, Lehman realized that might be the next in line. And they had quite sharp shift in strategy from building up the real estate holdings to trying to reduce their real estate holdings, trying to increase their capital, trying to increase their liquidity and also to try to find... Well, they talked about both acquisitions of the firm or institutions like the Korean Development Bank that would provide some capital. Actually the bankruptcy examiner for the bankruptcy court, which I draw on a lot documents over 50 different sets of negotiations I had with different possible strategic partners and none of them came to fruition.

Ball: So, a common viewpoint which makes sense to me, although I haven't evaluated closely is that Lehman was somewhat over optimistic about its prospects or valued itself more than other people did. So, that I think a number of possible deals foundered on the problem that the price of Lehman wanted to acquire it or to get a stake in it was higher than what other people were willing to pay. Now, of course that, at the very end, that changed. Getting a little ahead of the story, they were about to sell the whole firm to Barclays for essentially nothing when they actually knew the alternative was bankruptcy within a few hours. Again, with special respect problem may be fair to say that Lehman should have tried taking a less strong bargaining position in some of the negotiations for investments by other firms.

Beckworth: Yes. You mentioned in the book that Hank Paulson put the blame on Dick Fuld, the CEO at the time. And I understand from some other books I've read that Hank Paulson and Dick Fuld weren't the best of friends. They had some competitive energy from the days when Hank Paulson was on Wall Street. So, to what extent do you think Paulson was right? Did Dick Fuld... Was he the reason that Lehman was reluctant to lower its sales price?

Ball: I honestly don't know. I mean, I've read the same things. I think it sounds plausible that Lehman's... I don't know faults specifically, but Lehman's executives were a little slow to catch onto the realities that they were really in trouble and needed to cut a deal.

Beckworth:Okay. You then mentioned there's a September panic, September 9th to the 13th, and this is when things really began to unfold and really sets the stage for the bankruptcy of Lehman. You mentioned a couple of things that led to it. One is the announcement that the Korean Development Bank arrangement was not going to happen. And then the second thing was the big losses in the third quarter. And so, what happens? Liquidity falls from 23 billion on Tuesday, September 9th to 1.4 billion on Friday, September 12th, that last week. So, it's game over at that point. And then we go into this final weekend and tell us about this weekend. Gets a lot of interesting things are happening there and interesting personalities are involved. So, walk us through that last week in Lehman's existence?

Ball: Well, certainly very dramatic. There were meetings for the whole weekend at the Federal Reserve Bank of New York in which secretary Paulson participated and Tim Geithner then the president of the New York Fed and these policy makers essentially called the CEOs of all the biggest Wall Street firms down to the New York Fed for the weekend and said, "We have to work out some way to rescue Lehman." And as of Saturday night of that weekend, September 13th, it actually appeared that there was a rather complex deal in which Barclays Bank would acquire Lehman, but only after Lehman had spun off some of its risky real estate assets, which were going to be financed by a consortium of the big Wall Street firms which would each contribute a certain amount of money.

Ball: In any case, I think people went to bed on September 13th thinking that there was going to be the solution. And then on Sunday, September 14th, there was the dramatic news that British bank regulators because which had to approve the deal because Barclays was a British bank that they had raised objections. And so, sometime around the middle of the day, Sunday, September 14th, all of a sudden it was clear that the Barclays deal had fallen through and Lehman had no cash, that if it opened its doors on Monday morning people would show up and say, "Where's our $3 billion?" And they didn't have any money.

Ball: So, it really was game over at that point unless.... Although one of the central ideas of the book is that even at that late date, the Fed could have stepped in and provided emergency lending to give them enough cash to keep operating, to figure out a better solution. Harvey Miller who was Lehman's lead bankruptcy attorney made a clip about this being by far the largest corporate bankruptcy in the US in any industry, and also the one with the smallest number of hours devoted to preparing a bankruptcy petition. So, literally leaving went from thinking it was going to survive at noon time on Sunday to a situation in which they had less than 12 hours to file a bankruptcy petition, which accounts for how chaotic the bankruptcy was.

Beckworth: Yeah, your book really doesn't need job of laying out all the details. A lot of things I didn't recognize or realize about this case, I'm going to list a few of them. First off, Lehman wanted to have something similar to what Bear Stearns had. So, Bear Stearns, the Fed worked through JP Morgan. It created this off balance sheet item made in lane, which bought up the bad assets from Bear Stearns. And initially Lehman was looking for something like that and then Fed said no. So, that's the first kind of deviation from the Bear Stearns approach. And they turned to that consortium that you mentioned, they had Wall Street bankers going to back up and buy some of the bad assets.

Beckworth: So, that's the first interesting deviation where they changed course. The second interesting observation from this experience to me is the reason why Barclays said no and Barclays really didn't say no. They said no in the sense that they had to wait, right? They had to get all of the shareholders to vote on this transaction because Barclays would have to guarantee all of the assets, kind of like JP Morgan had guaranteed all Bear Stearns assets. So, they just needed time to get it done. And that couldn't happen by Monday. And as you point out in the book, it's ironic, the Fed could have provided a bridge loan. The Primary Dealer Credit Facility would have been an easy way for them to provide a bridge loan to get to that point. And they didn't. And ironically, as you also mentioned, they use that same facility to give a subsidiary of Lehman a bridge loan that's broker-dealer part for some time. We'll come back to that. The other-

Ball: It wasn't Barclays that said, no, it was Barclays' regulator, the financial services that's already in the UK. Britain's financial services authority vetoed the deal because it would have required Barclays to provide financing for Lehman in between the period when the deal was signed and when it was approved by shareholders and that wasn't allowed under British law unless there was a separate shareholders' vote to allow that bridge financing. And it seems to me fairly obvious that the solution could have been that the Fed would provide the bridge financing through the Primary Dealer Credit Facility. And as you mentioned, the Fed decided to do that for Lehman's broker-dealer subsidiary in New York, Lehman Brothers Incorporated but did not do it for other units of Lehman, which is why the Lehman Holding Company had to declare bankruptcy.

Beckworth: Right. And again, comparing it to Goldman Sachs, Morgan Stanley, it did extend loans to them, but just didn't to Lehman. So, lots of questions are raised by this experience. Finally, other interesting point I'll raise about this particular weekend is that the Fed itself advised bankruptcy once everyone realized that Barclays was not going to be able to buy Lehman's. It advised bankruptcy and you argue in the book, it actually really incentivized push Lehman in that direction through some obvious mechanisms, not allowing it to borrow from the Primary Dealer Credit Facility. So, the Fed really pushed it in the direction of bankruptcy. Now, let's quickly talk about what happened after Lehman's. What was the consequence of all of this and what did the Fed do?

Ball: Well, so there's some controversy about this. There are some people who say that Lehman was more a symptom than a cause and there would have been a financial crisis anyway because of fundamental problems with the economy. I mean, that's a big issue. I tend to be on the side, which is probably the majority side of thinking that the leave and failure was really the pivotal event or the whole financial crisis when we went from strains and financial markets to disaster in financial markets and from the prospect of a mild recession to the prospect of a deep recession. And I think there's a rich not fully understood story of all the ways in which Lehman affected the economy.

Ball: Many people have argued, I think persuasively that part of it was just confidence or a panic in the whole financial system. People thinking if Lehman's going to fail, anybody can fail. Again, Lehman was the 2007 most admired securities firm. There were also more concrete links between Lehman and the crisis. One of the most important being the run on money market mutual funds, which was sparked when one money market fund reserve primary fund lost money on Lehman commercial paper and that caused it to break the buck in the lingo to reprice it's $1 share as it less than $1. And that led to a panic about money market funds and withdrawal of money for money market funds, which then meant money market funds were not buying as much commercial paper from corporations and that caused problems.

Beckworth: Yeah. I want to briefly ask here about the Fed's stance on monetary policy during 2008 because they had a FMC meeting about that same time and they decided not to lower the federal funds rate. It was at 2%. It had been at 2% since April I believe, so there'd been pretty long run there with the Fed was apparently worried about inflation, not apparently, but was worried about inflation. If you read the transcripts, the minutes, speeches, they were very worried.

Beckworth: Some of them were worried about inflation and they did not want to lower the federal funds rate even as they were providing these financial assistance to the financial firms. But I want to get your thoughts on that. To what extent did the Fed fail in not providing more monetary policy commendation throughout 2008? I've looked at some of the records. If you look at, for example, the Fed fund futures contracts, it's rising all through the first part of the year and I think it's tied to the Feds talk about inflation concerns. What is your take? To what extent was this crisis worsened by the Fed kind of sitting down on his hands in terms of monetary policy?

Ball: I'm not sure honestly that, that was a major issue and they did lower the federal funds rate pretty rapidly. And even for most of 2008 economy was not doing too badly and they were still lowering the federal funds rate. I guess in hindsight, given the big recession that followed, if they had eased even more aggressively in terms of lowering their federal funds rate that would have been even better. I think the really big mistake though was the failure to rescue Lehman. Maybe if there had not been that huge shock to the system, I'm not sure that a whole lot of additional monetary easing would have been needed.

Beckworth: Yeah. I was thinking about this beforehand. I've been critical the Fed in 2008. But the point you just mentioned about if Lehman had not collapsed, now would we have seen the need to bail out Goldman Sachs, Morgan Stanley, AIG? Would we have seen QE1? And there's a lot of interesting counterfactuals one could consider, but it does seem Lehman was probably very pivotal. So, it's neat to kind of wonder what could have been had Lehman not fallen?

Ball: Yeah. I mean, just really one specific example along those lines, AIG was essentially a few days behind Lehman in running out of cash. And so, at the same time Lehman was right on the brink. The Fed was working at what are we going to do about AIG? Which maybe has a week's worth of cash left. There was actually a tentative deal by a group of private sector firms led by Goldman Sachs. And I forget the other big institution that organized a consortium of banks to make $75 billion loan to AIG. And it actually looked, you have to date these things in terms of hours. It was so fast moving. As of the morning of Tuesday, September 16th, that looked as though perhaps there would be this private sector rescue of AIG, but then that fell through and people were speculative.

Ball: It makes sense that one reason that the private sector became scared about giving money to AIG was all the panic and the follow of the Lehman failure. So I think, again, it's very hard to do counterfactual history, but possibly if Lehman had been rescued by the Fed, AIG could have been rescued by the private sector and generally there could have been a lot less. Well, one of the ironies of the whole thing is that some people oppose the leave and rescue because that's too much Fed intervention in the financial system. But once Lehman failed, that led to enormous intervention of the financial system by the Fed and the treasury buying stock and banks because people didn't want to have a 1930s all over again.

Beckworth: Yeah. If you're going to take a classical libertarian perspective when you're this far in, it's kind of hard to find an easy solution. I mean you have to pick your poison and go with it. And maybe saving Lehman would have been the preferred poison to take at that time. But we'll get to this in a minute. But Hank Paulson apparently did not want to choose that poison. So, we got what we did, but soon after this occurs, we have the Fed intervening as you mentioned with these other banks and with AIG also it begins its commercial paper, money market, mutual fund facilities, and then the government does tarp soon after that. Now, let's briefly talk about what the Fed is legally able to do. Section 13(3) of the Federal Reserve Act has three criteria, and this is the 2008 version I should say, because it's changed because of Dodd-Frank. But the 2008 version of section 13(3), what were the conditions that permitted the Federal Reserve to intervene and how was it seen? How was it interpreted?

Ball: So, there were three conditions that were required for the Fed to lend money civically to a non-depository institution. It's more routine for the Fed to make discount loans to commercial banks. But say for an investment bank or an insurance company, they had three conditions had to be met. One, the Board of Governors or the Fed to have had to find that there were unusual and exigent circumstances. Was just sort of a funny phrase, whatever that means most people would agree situations were unusual and exigent. The second condition is that the borrowers had to be unable to get credit elsewhere. So, the Fed is only allowed to step in as a last resort if firms cannot borrow elsewhere. And that condition also was clearly satisfied for the firms the Fed rescued.

Ball: And for Lehman, the fact that Lehman could not get credited anywhere else and also could not get credit from the Fed was what led to its bankruptcy. The controversial part of the law is the third criterion which is, that there has to be satisfactory security for a loan. And the term satisfactory security obviously is a little bit vague and has never been clearly defined by court or by the legislative history of the Federal Reserve Act or by Fed officials. But long story short, when people like Scott Alvarez, the General Counsel of the Board of Governors of the Federal Reserve were pressed to explain what a satisfactory security mean, he would say things like, "Well, it means you're pretty sure you'll get paid back." Ben Bernanke also in some speeches said, "We need to have a reasonable assurance that we'll get 100% return on our loan."

Ball: And again, what's a reasonable assurance or means what it means to be pretty sure will get paid back is not quite clear. But that seems to be the criteria. And the central point really of my book is that Lehman Brothers clearly met that hurdle, that the Fed could have lent the money to keep them in operation and it could have been over-collateralized lending and there would have been very little risk of substantial losses to the Fed. So, that's the essential place where my story deviates from what Fed officials have said. They say that Lehman did not have adequate collateral for a loan. And so, if the Fed did lend, it would have taken on substantial risks of losses. And that was against the law.

Beckworth: Yeah. You argue in the book that Lehman was both solvent and had sufficient collateral to meet this condition. You note that if you use mark-to-market accounting, it was borderline solvent. And if you would look at it's more fundamental values, it was clearly solvent. So, the Fed could have lent to them. And then you mentioned with collateral that they had plenty of cushion and that you suggest 84 billion may have been a good number for them to borrow and they would have had plenty of collateral that exceeded that amount. So, you do a very good job making the case and documenting and looking closely at the balance sheets. One of the things you raised though in the book is that the Fed claimed otherwise and suggested, or at least hinted that there was some analysis backing up their claims, but this analysis has never been found or submitted. I believe the Financial Crisis Inquiry Commission asked for this additional documentation and never was delivered. Any more thoughts on that? Is it ever been found or any more discussion on why it was never delivered?

Ball: No. So, first of all, I think the distinction between insolvency and collateral is important. I think the question of is, was Lehman solvent? That is somewhat debatable. I would say yes, they were solvent by a little bit. But I also emphasize in the book that solvency was not at the time a condition for the Fed to lend. It was just did Lehman have enough collateral to put up for a loan so the Fed would not be taking any risk? And as I discussed at length in the book, that's a weaker criteria and then being solvent. So, even though they probably were solvent, I would say that, that wasn't even necessary. But you're right. The one thing I hope to do with my book is to publicize some of the great work done by the Financial Crisis Inquiry Commission.

Ball: They held hearings and the two main Fed officials who testified at these hearings were Ben Bernanke and then Thomas Baxter who was the general counsel of the New York Fed. And those hearings, this did not make the final report of the Financial Crisis Inquiry Commission, but there are readily available transcripts. And that's the one point at which I've seen any people really push Fed officials on the issue of collateral. So, if you read the transcripts Bernanke and also Baxter say, "Well, we couldn't lend them money because they didn't have enough collateral." And then commissioners say, "Well, how do you know they didn't have enough collateral?" And Bernanke and Baxter said, "Well, people at the New York Fed analyzed it."

Ball: And then the commissioner said, "Well, who analyzed it? What was their analysis? How much collateral did they have?" And they just didn't get an answer. So, if you read these transcripts, they're these long circular discussions in which the Financial Crisis Inquiry Commission tries to pin down chairman Bernanke and general counselor Baxter on where's this analysis of collateral and don't get an answer. And then there were follow up letters that were said to Bernanke and Baxter, which very pointedly repeat the question and the question is still not answered. So, there just isn't any evidence that any analysis really was done.

Ball: The other thing to say along with that is there is from the investigation of the Financial Crisis Inquiry Commission and the bankruptcy examiner for the court, there's a tremendous amount of evidence about what was discussed over that last weekend because those two investigations had subpoena power and they got many, many emails that people at the Fed were sending back and forth to each other. And there were lots of discussions and those emails about the economic consequences, the political consequences of letting Lehman fail, different plans for saving it. And there was essentially no discussion about collateral or is this legal? So, I think the only natural conclusion is that there wasn't really much or any analysis of the collateral issue. That was an idea which was brought up after the fact, essentially as an excuse for why the Fed didn't act.

Beckworth: Yeah. That was one of the surprising points of your book is the lack of evidence that this was a concern. The collateral concern was being discussed beforehand. So, Lehman files for bankruptcy. You mentioned also that the Fed insured Lehman's bankruptcy. It refused to let Lehman tap into the Primary Dealer Credit Facility. Talk about Lehman's subsidiary. It's broker-dealer that was allowed to tap in and get funding. What's going on there?

Ball: Yeah. So, the details get a little bit complex, but Lehman had... So, Lehman Brothers Holdings was a holding company of lots of subsidiaries. The two subsidiaries that had a lot of repurchase agreements that didn't get rolled over and which ran out of cash were Lehman's broker-dealer in New York and Lehman's broker-dealer in London. So LBI, Lehman Brothers Incorporated and LBIE, Lehman Brothers International Europe, which was the broker-dealer in London. So, they both ran out of cash. The Fed decided to lend money to the New York broker-dealer to keep it going for a while to try to find some orderly way to wind down its operations. It refused to lend to the London broker-dealer.

Ball: It also made some arbitrary restrictions on what the New York broker-dealer could do with any money it borrowed to make sure it didn't give the cash to the London broker-dealer. So, there a lot of details that I go through in the book. But essentially the Fed's goal was to... I think the media was waiting for a big announcement of either the Fed bails out Lehman or the Fed lets Lehman fail. And Lehman in that case meant the holding company. So, I think that the Fed decided that the headline or the paper had to read, Fed Does not Bail out Lehman. So, the holding company had to file for bankruptcy.

Ball: At the same time they wanted to keep the New York broker-dealer in operation. So, there was these complex rules about the New York broker-dealer being able to borrow and keep on operating but not transfer any funds to other parts of the company. It was actually the part of the company that ended up being the center of the bankruptcy was the London broker-dealer. It ran out of cash and it was going to default on its obligations and those obligations were guaranteed some of them by the holding company. So, the holding company was going to be in default. And that situation is what led Lehman's board of directors to decide that they had no choice but bankruptcy.

Beckworth: Yeah, a very jarring finding that the Fed allowed some parts of Lehman to tap in but not the others. And then in addition to the fact that the Fed later allowed AIG, Goldman Sachs and Morgan Stanley to tap into its facilities. Walk us through-

Ball: Yeah-

Beckworth: Go ahead.

Ball: And I would say one way to... There are a lot of details, one way to summarize my point is that if the Fed to had either treated Lehman the same way it treated Morgan Stanley, Goldman Sachs, other firms, Lehman would've survived, or if the Fed had treated all of Lehman the way it treated the New York broker-dealer, that would have allowed all of Lehman to survive.

Beckworth: Yeah. This raises a number of questions, but let's walk through a scenario where Lehman did survive. How would you see it playing out?

Ball: Well, again, it's a little hard to do counterfactual history. I argue in the book though there are probably three broad outcomes that we could have gotten to. One is simply that the Barclays acquisition would have been concluded. So, as we discussed before, there was this very specific problem that a shareholder vote by Barclay's shareholders was needed in order for the deal to go through. And that would have taken 30 or 60 days to organize. So, if the Fed had provided acquainted liquidity to Lehman for 30 to 60 days, there could have been the Barclays shareholder vote and Lehman might've just been acquired by Barclays. This is controversial. There were some people who say that British regulators were determined to fork the deal.

Ball: They didn't want Barclays taking on Lehman's problems, that the specific saying about the shareholder vote was the first excuse that British regulators hit on, if that excuse hadn't worked, they would have thought of some other reason to intervene. The British regulators have said that, that's not true, that they had no objection in principle to Barclays acquiring Lehman. They just wanted to be sure that the proper procedures were followed. So, I don't know where the truth lies there, but certainly finishing the Barclay's deal would be one possibility. A second possibility would be that Lehman like AIG, Goldman Sachs and Morgan Stanley, like many banks would have survived this liquidity crisis and eventually the situation would have stabilized and it would have survived as an independent firm. And I talked in the book about some of the things that Lehman might've done to stabilize the situation, how it might've tried to get some of its risky real estate assets off its balance sheet. Things that might have led to a longterm solution if it had had time to execute it.

Ball: The third possibility is that the Barclays deal would not have gone through, that Lehman would not have been able to solve its problems, that eventually Lehman would have gone bankrupt. But in that case there could have been a much more orderly situation in which Lehman wound down its operations and the losses to leave shareholders and the damage to the economy, I think would have been much less. Actually, one of the things that you learn from the bankruptcy examiner's report is that Lehman actually, again, on the afternoon... These things happen in a very condensed timeframe. On the afternoon of Sunday, September 14th, Lehman executives were actually putting together a wind down plan of over a two year period, the firm's going to be wound down and they a plan for that and they needed some certain amount of Fed liquidity support. But sometime that Sunday afternoon, the word came, "You can stop wasting your time on the wind down plan because the Fed's not going to provide a liquidity support and we're going to have to declare bankruptcy in a few hours."

Beckworth: Yeah. Things moved really fast that weekend. Near the end of the book, you talk about who was pivotal in making this decision to let Lehman file bankruptcy and you come up with the treasury secretary, Hank Paulson. So, why was he set on allowing Lehman to fail?

Ball: Right. So, the first thing to say is to recognize that Henry Paulson, the treasury secretary seems to have been in charge of what happened to Lehman Brothers. Again, there were these meetings with the Federal Reserve Bank of New York and Henry Paulson got on an airplane and went from Washington to New York and directed those meetings. And Kim Geithner, the New York Fed president was involved, but all the accounts that I read suggest that it was Paulson who was making the decisions. And that's a little bit odd because legally under the Federal Reserve Act, it was the Federal Reserve's job to decide whether or not they made loans.

Ball: The treasury secretary legally didn't have any more role than the secretary of agriculture or the governor of Maryland, but Henry Paulson just arrived at the New York Fed and started saying what was going to happen and people did what he said. As far as his motives it seems clear that politics was one factor. I'm not sure everybody completely remembers now, but there was such an intense backlash to the Bear Stearns rescue. And then also to the government takeover of Fannie Mae and Freddie Mac, which happened just a week before the Lehman crisis. Henry Paulson is quoted by many people saying, "I can't be Mr. Bailout," that he didn't want to go down in history as Mr. Bailout.

Ball: And again, Andrew Ross Sorkin in his book, too big to fail, the way he puts it is that the only bipartisan issue in Washington was opposition to bailouts. Bernie Sanders was saying, "This is socialism for the rich. We're giving away taxpayer money to reckless fat cats." Conservative Republicans were saying, "This is socialism. The government is taking over the banking system." Both of the presidential candidates at the time, Barack and John McCain issued very clear, stern statements. So, this was unacceptable to put up government funds to rescue these institutions. So, there was intense... And this by the way, is not at all and original point of my book, many people have said the decision was political, but everything I've seen is consistent with that.

Beckworth: Let me play devil's advocate on. Let me take a stand for Hank here. Tell me what you think. He was a treasury secretary. And you could argue that the bailouts had gotten big enough and as you mentioned, pronounced and scary in the press that any more bailout was perceived as real resources from the government and going to these financial firms and therefore you wanted someone from the government, not from the Fed, the Fed's this independent organization. It was Hank Paulson thinking along those lines, "Hey, I'm the fiscal representative here of the government of the people, therefore I should make the decision." Or was he just simply being a political operator when he stormed into New York and took charge?

Ball: I mean, I don't really know what his inner motivation was. I mean, I do think that your devil's advocate position in a way sounds very reasonable to me, but is not consistent with the law at the time. I mean the law at the time said it was the Federal Reserve's... I mean there was a procedure in which the Federal Reserve Bank of New York, if they wished to, could have said that it wanted to make a loan to Lehman. And it would have requested approval by the Board of Governors and the Board of Governors would have had a vote. That was what happened in the other cases. The treasury secretary just didn't have any role and fast forward to the president, one thing the Dodd-Frank Act did was to amend the relevant piece of the law to say, "Wow, any loan it has to be approved by the treasury secretary," but that was not in the law at the time.

Ball: Also, one thing you said, I think people often say it is a little misleading about, I forget your words, but about this was a fiscal decision and this involved a lot of government resources. The point of my book is that really no government resources would have been committed or risked in the sense that the Fed would have made these very safe over-collateralized loans. So, it was not the case that the Fed was giving away or risking taxpayer's money. The idea that Fed should have lent and it was their decision, I think that's consistent both with the law at the time. Also, with the classic theory of the lender of last resort going back to Badgett in the 19th century.

Beckworth: No, those are fair points. And again, the argument you make is that the government would not have been ultimately paying out. They would have maybe actually earned something like they did with TARP. One last question on Hank Paulson. As I mentioned earlier, he had this known rivalry with Dick Fuld from his days on Wall Street. Do you think that at all played into this decision?

Ball: Yeah, that's interesting. I've heard that question a lot and my answer is maybe a little bit, but not too much. I think that there is this caricature view that, and again, I don't know anything about Paulson and Fuld's relationship. I read various... All the rumors, but there's this view that they were these big rivals and Paulson was really happy at the idea. You could really stick it to Fuld and it's very clear that Paulson did not want Lehman to go bankrupt. He was very worried about it, very upset about it. He tried, he worked very hard, did everything he could to rescue it, short of allowing the Fed to make a loan. But he was not feeling happy that Richard Fuld was in trouble.

Ball: Now, the one nuance though, so again, part of the whole story at the last day, at one point Fuld managed to reach Paulson on the phone. Fulled was calling lots of policymakers on that weekend and not getting many of his calls returned. But at one point he reached Paulson and said, "Hey, if you don't understand, this is going to be a disaster for the economy. You have to do something." And Paulson seems to have just blown them off and said, "Oh, I'm sorry, there's nothing I can do."

Ball: The hypothetical that just occurred to me is what if Paulson had gotten that same phone call from Lloyd White V, his old colleague for Goldman Sachs saying, "Hey, if you don't realize this is going to be a disaster? You've got to figure out a way to do something." I have the idea that maybe he Paulson would have at least stopped to think about it a little bit if somebody he really respected was telling him this is going to cause the financial system to crash. So, sort of in that subtle way, I think the fact that Paulson probably didn't have much respect for Fuld and was fed up with all his unsuccessful attempts to arrange to take over for Lehman doomed that any chance that he was going to listen to last minute appeals for help.

Beckworth: Okay. So, what are the implications of your book for the next financial crisis? There's been some changes with Dodd-Frank, both with section 13(3) and the Federal Reserve Act. There's also the Orderly Liquidation Authority, but moving forward, what lessons should we take from the Lehman experience? Should we encounter something like that again?

Ball: Well, I think there's a straightforward lesson which actually from both the Lehman experience and the cases in which the Fed did rescue financial institutions of how important it is to have a rigorous lender of last resort, that financial crises can be greatly mitigated if the Fed lends to institutions facing liquidity crises or facing runs. And they certainly should do that in a situation in which there's good collateral and it's not risky to lend. So, I would like to just say we've learned the lesson that the next time there's a similar crisis, the Fed should step in and make the loan that it wouldn't make to Lehman. Unfortunately as you mentioned, the law has been changed and there are now a number of new restrictions on the Fed's legal ability to lend.

Ball: And so, going forward we could have a crisis in which a loan to Lehman or for that matter alone to AIG or the assistants to Bear Stearns might actually be all illegal. I mean, the most concrete policy implication would be that Congress should immediately repeal the part of the Dodd-Frank Act that limits the Fed's lending ability. And of course in reality we are going to see parts of the Dodd-Frank Act repealed. It's not going to be that part. But I've got the clear implication of my research.

Beckworth: In closing, I got one question to ask about the reception of your book. You're not winning any popularity contest at the Fed. Your book is very critical what the Fed did, you've had a paper earlier on Ben Bernanke, I'm sure that wasn't very popular at the Bernanke Fed. What has been the reception to the book?

Ball: Well, there honestly has not been a lot of reception. I mean I have not certainly not heard comments from any top Fed officials about the book. I mean, it gets probably not because they're so all struck by its brilliance that they don't know how to put it into words. I presume they don't like it, but they have not commented on it. I mean, some people I know at somewhat lower levels who work at the Fed have told me they don't like it but have not really gone into detail. I mean, I'm a little biased obviously, but in a sense, I don't think there's that much that can be said on the other side. I mean, I add up some numbers and the numbers are the numbers and I quote the transcripts of the Financial Crisis Inquiry Commission hearings and what people said is what they said.

Ball: And, again, with the obvious qualifications, that I'm not impartial. I don't really think this is a case where there can be a reasonable debate back and forth. I think that the facts are what they are. And in any case, I haven't heard anything from... I guess one journalist did reach Henry Paulson and Henry Paulson made a boiler plate statement about, he stands by everything he wrote in his memoirs as being correct. But that's all that I've heard as far as responses.

Beckworth: Well, maybe now that we're at the 10 year anniversary, this podcast, other discussions like it, your book, well, I'm sure will get lots of play now that it's been just released. Maybe we will hear more from them and more conversations about what they could do better and different next time.

Ball: Well, we will see. That would be great.

Beckworth: Okay, well, on that note our time is up. Our guest today has been Larry. Well, Larry, thank you for coming on the show.

Ball: Thank you so much. I've enjoyed it.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.