FORTUNE -- September 15, 2008 was a watershed moment for the financial crisis that consigned much of the world to an economic malaise from which we are still recovering. That day, government officials hastily arranged a sale of investment bank Merrill Lynch to Bank of America (BAC), while another bank -- Lehman Brothers -- was allowed to file for bankruptcy.
The failure of Lehman Brothers sent shockwaves through the global financial system, accelerating the crisis until leaders of the seven largest economies met on Oct. 10 and pledged to not let any more systemically important financial institutions go under. This promise led to the eventual passage of TARP and the much-maligned bank bailouts that, while politically unpopular, helped the world avoid a Great Depression-style meltdown.
Here's a slide from Ben Bernanke's 2012 lecture on the Federal Reserve's response to the crisis. It shows just how much this concerted action helped calm financial markets and dampen the severity of the crisis:
The chart shows the interest rates banks required to lend to each other overnight, an excellent measure of overall stress in the financial system. While they were at elevated rates going back to the middle of 2007, it was really Lehman's failure that sent financial markets into panic mode and the promise of government backstops that calmed the markets and set the stage for a recovery.
Given this picture, the decision to not even attempt to use whatever government powers were available to save Lehman Brothers is questionable. Ben Bernanke and other officials have claimed that they did not have the necessary tools to save Lehman. In the case of the Treasury Department, this may be accurate. TARP had not yet been passed and Secretary Hank Paulson didn't have a huge pot of money to pump into Lehman, as it later would with other major banks.
The Fed's claim that it didn't have the power to save Lehman is much more dubious, and is further weakened by transcripts released Friday morning of the central bank's 2008 meetings. The standard excuse for its inaction on Lehman is that central banks should be the lender of last resort to banks that are in a liquidity crunch, but are still solvent. That is, the Fed should lend money to any bank that has collateral to offer. When defending his decision to not intervene with Lehman, Bernanke has claimed that he could not offer anything because the bank was insolvent:
Lehman Brothers was in itself probably too big to fail, in the sense that its failure had enormous negative impacts on the global financial system ... But there we were helpless, because it was essentially an insolvent firm.
But the difference between a firm being insolvent and illiquid isn't cut-and-dried, and it hinges on how you value a bunch of inscrutable assets. Based on the opinions of Federal Reserve Open Market Committee members revealed in the recently released minutes, the decision to let Lehman fail seems to have much more to do with an ideological aversion to government intervention than anything else. Here's St. Louis Fed President James Bullard on Sept. 16, the day after the Lehman bankruptcy:
My policy preference is to maintain the federal funds rate target at the current level and to wait for some time to assess the impact of the Lehman bankruptcy filing, if any, on the national economy ... By denying funding to Lehman suitors, the Fed has begun to reestablish the idea that markets should not expect help at each difficult juncture. Changing rates today would confuse that important signal and take out much of the positive part out of the previous decision.
Hindsight is 20/20, of course, but it is stunning that Fed members thought that the Lehman bankruptcy could conceivably have no effect on the economy. Notice as well that Bullard paints the decision to not save Lehman as not one of necessity but of choice.
Boston Fed President Eric Rosengren was perhaps the most insightful member of the Fed Board in 2008, as he was one of the few in favor of lowering interest rates as early as September, and questions the wisdom of the decision to let Lehman fail:
I think it's too soon to know whether what we did with Lehman is right. Given that the Treasury didn't want to put money in, what happened was that we had no choice. But we took a calculated bet. If we have a run on the money market funds or if the nongovernment tri-party repo market shuts down, that bet may not look nearly so good.
Rosengren's statement is a bit murky here. He calls letting Lehman fail a "calculated bet" but then says that the Fed had "no choice." This waffling has the whiff of justification, however. In e-mails unearthed by the Financial Crisis Inquiry Commission, we can see that the Fed was clearly considering a $200 billion loan to help keep Lehman afloat. These emails called that approach "a gamble" that might be worth taking.
But the Fed never took it, and it appears they did so at least partly for ideological reasons. This is all the more confusing because the federal government had spent the last 30 years intervening in crises to prevent destructive financial system meltdowns. In light of this, economist Alan Meltzer has called the decision "one of the worst blunders in Federal Reserve history." Five years later, the recently released transcripts give us no reason to disagree with Meltzer's assessment.
Bank of America posted an $8.8 billion second-quarter loss as the biggest U.S. bank by assets tries to put its disastrous acquisition of Countrywide in the rearview mirror.
The Charlotte-based bank lost 90 cents a share in the quarter, reversing the year-ago profit of $3.1 billion, or 27 cents a share. Revenue, hit by $13 billion in mortgage litigation costs, plunged 54% from a year earlier to $13.5 billion.
Excluding the mortgage MOREColin Barr - Jul 19, 2011 7:32 AM ET
Are taxpayers getting the shaft in Bank of America's big mortgage putback settlement?
Rep. Brad Miller, a North Carolina Democrat who is a longtime critic of the big banks' mortgage lending misdeeds, contends they might be. He wants a top federal regulator, the Federal Housing Finance Agency, to join investors who are trying block the megadeal BofA (BAC) unveiled late last month, according to a letter he sent the FHFA this month.
BofA said MOREColin Barr - Jul 11, 2011 4:23 PM ET
With its damaged reputation and huge mortgage losses, Bank of America is still reeling from the financial crisis. But CEO Brian Moynihan may be the right guy to turn things around.
FORTUNE -- It's hard to think of a company that emerged from the financial crisis more despised than Bank of America. Sure, Goldman Sachs gets pilloried as a symbol of Wall Street greed and excess. But when you count up MOREShawn Tully, senior editor-at-large - Jul 7, 2011 5:00 AM ET
July 4 is coming right up, which makes it the perfect time to honor heroic Americans such as George Washington, Abraham Lincoln and Ken Lewis.
You may not immediately associate Lewis, the monomaniacal former CEO of Bank of America (BAC), with love of country. But value investor Bruce Berkowitz – who runs BofA's 12th biggest shareholder, the Fairholme funds – begs to differ.
A bet that isn't paying off
BofA has many problems, MOREColin Barr - Jun 10, 2011 6:23 AM ET
With all due respect to Mark Twain, history seems to be repeating itself pretty much line for line in the U.S. economy right now.
Bank of America cut its U.S. growth forecasts again Friday, citing high energy prices, softening global growth and tightening government purse strings. A run of "dreary data" means weak economic performance won't be limited to the disappointing first quarter, the bank warns.
"As the data continue to weaken, MOREColin Barr - May 27, 2011 10:10 AM ET
Summer is a month away yet, but the financials are already wilting. If we're lucky, this trend is just getting started.
Bank stocks fell for the second straight day Monday, as Bank of America (BAC) and Morgan Stanley (MS) sank within 5% of their 52-week lows. Another big trading bank, Goldman Sachs (GS), rose modestly but remains just 6% above its low of the past year.
The selloff is the latest sign MOREColin Barr - May 23, 2011 11:41 AM ET
BofA chief Brian Moynihan isn't making many people happy lately, but he made Wilbur Ross' day Friday.
Shares of Assured Guaranty (AGO), the Bermuda-based bond insurer that the billionaire vulture investor (right) bought into three years ago, surged as much as 30% after Bank of America (BAC) agreed to pay it $1.1 billion to close out policies backing 29 residential mortgage securities.
The deal, which eliminates any risk that Assured Guaranty will have MOREColin Barr - Apr 15, 2011 12:27 PM ET
Another day, another executive suite shakeup at foundering Bank of America.
The biggest U.S. bank said Friday it hired Gary Lynch, a former Securities and Exchange Commission enforcement chief, to oversee legal and regulatory relations. It is a big job, as BofA's (BAC) legal costs are soaring and its relationships with its regulators are in tatters, as evidenced by the bank's painful scrape with the Fed over its dividend plans.
Lynch was MOREColin Barr - Apr 15, 2011 8:27 AM ET
America's most delusional bank is back in black, but not as much as Wall Street would like.
Bank of America (BAC) posted a first-quarter profit Friday, reversing the loss it unexpectedly suffered at the end of 2010. But the bottom line was smaller than analysts were expecting, which will only add to questions about CEO Brian Moynihan's leadership following last month's humiliating dividend smackdown at the hands of normally somnolent bank regulators.
The Charlotte, N.C., bank MOREColin Barr - Apr 15, 2011 7:11 AM ET
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