Fed transcripts: Bernanke chose to let Lehman fail

February 21, 2014: 2:27 PM ET

Newly released transcripts cast doubt on the claim that the Fed didn't have the power to save the investment bank.

Ben Bernanke on Capitol HIll

Ben Bernanke on Capitol HIll

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.

MORE: Why gold might drop another 50%

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.

MORE: Janet Yellen's big fumble

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.

MORE: How a national sales tax could solve America's inequality problem

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.

  • World Bank hires ex-Lehman risk manager

    In the echoes-of-2008 department, the World Bank just hired a former Lehman Brothers risk manager to run its finances.

    The bank, which lends money to developing countries in a bid to curb poverty, said Madelyn Antoncic will "be responsible for maintaining the World Bank's high standing in financial markets."

    It is tempting here to make a joke about Antoncic's qualifications for that task. After all, you could hardly have a lower standing in MORE

    - Jun 23, 2011 1:26 PM ET
  • SEC hits a new low on Lehman

    You may have assumed the government couldn't come up any emptier in bringing the rich guys behind the financial crisis to justice. But think again.

    The Securities and Exchange Commission has so whiffed on its investigation of what brought down Lehman Brothers that it may resort to issuing a paper listing the allegations surrounding the firm rather than charging anyone with civil securities fraud.

    The news that Dick Fuld, Erin Callan and the MORE

    - Jun 6, 2011 12:00 PM ET
    Posted in: , , ,
  • Finra fines UBS on 'safe' Lehman notes

    Regulators slapped UBS with a $2.5 million fine for pushing some Lehman Brothers debt as safe just months before the brokerage collapsed.

    The Swiss-based financial services giant also agreed to restore more than $8 million to customers who bought the structured notes, whose returns were tied to stock market indexes but were billed as "principal protected," between March and June 2008.

    Finra said UBS literature played up the notion of principal protection MORE

    - Apr 11, 2011 1:30 PM ET
  • How Buffett makes money even on bad bets

    When Warren Buffett gets the markets wrong -- as in the case of insuring against junk bond defaults and owning GE -- he often still makes money because he gets the right price.

    One of the secrets of successful investing is price. Sell dear enough or buy cheap enough, and you can make money even if the market moves against you.

    Today's example involves Warren Buffett, who MORE

    - Mar 8, 2011 5:00 AM ET
  • Ernst & Young's jujitsu defense

    Can an embattled accounting firm turn the New York attorney general's greatest strength against him?

    Ernst & Young may try to do just that as it braces against a civil fraud suit claiming it helped conceal Lehman Brothers' accounting games in the years before its 2008 collapse.

    Ernst promised in a statement this week to defend itself vigorously in the complaint, which seeks at least $150 million in damages. The firm said it MORE

    - Dec 23, 2010 6:42 AM ET
  • Cuomo sues Ernst & Young

    New York sued the giant accounting firm Ernst & Young Tuesday, saying it helped Lehman Brothers deceive investors about its true health for seven years.

    The complaint, filed in state Supreme Court, seeks the repayment of at least $150 million in fees the audit firm collected between 2001, when Lehman's aggressive accounting began, and 2008, when the venerable bank collapsed, precipitating a global bank run.

    "Our lawsuit seeks to recover the fees collected by MORE

    - Dec 21, 2010 11:31 AM ET
  • No sympathy for the auditors in Lehman case

    "Auditors who can't say no" sounds like a support group in the making. But one embattled audit firm isn't getting a terribly sympathetic hearing.

    So says a quickie survey conducted Monday by the Argyle Executive Forum. The electronic poll of 498 members finds that nearly half of respondents -- 48% -- believe New York should move forward on civil fraud charges against Ernst & Young over its role in the MORE

    - Dec 21, 2010 6:26 AM ET
  • Lehman suit shreds auditors' teflon coating

    One of the toothless accounting watchdogs that did so much to bring us the financial crisis is about to get an overdue scolding.

    New York's attorney general is pursuing a civil suit against Ernst & Young, the Big 4 accounting firm that signed off on Lehman Brothers' financial reports in the years leading up to the investment bank's panic-inducing September 2008 collapse.

    The case comes nine months after the bankruptcy examiner in the Lehman MORE

    - Dec 20, 2010 11:47 AM ET
  • Judge slaps BofA for Lehman cash grab

    Troubled homeowners aren't the only ones having their issues with Bank of America.

    A federal bankruptcy judge ruled Tuesday that BofA (BAC) must return $500 million in collateral it seized without cause from Lehman Brothers two years ago, just after the investment bank collapsed in the biggest-ever U.S. bankruptcy.

    Bank of America's actions were "brazen…unauthorized and impermissible," U.S. bankruptcy judge James Peck wrote in a ruling Tuesday, the Wall Street Journal reports.

    BofA MORE

    - Nov 17, 2010 1:49 PM ET
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by WordPress.com VIP.