Why Lehman Brothers was allowed to fail
In a departure from its strategy on other banks, the US Federal Reserve refused to assume any of the risk faced by potential buyers. That decision had massive repercussions
Over the weekend of September 12th to 14th, 2008, an intensive series of meetings was conducted, including then US treasury secretary Henry, or Hank, Paulson, senior regulators and the chief executives of 14 leading financial institutions.
Paulson began the meetings by stating the government would do all it could – but that it could not fund a solution. The US government’s analysis on Lehman was that it did not have the legal authority to make a direct capital investment, and Lehman’s assets were insufficient to support a loan large enough to avoid its collapse.
Many commentators believe the Bush administration had run out of political capital to rescue Lehman. In addition to facilitating the rescue of Bear Stearns, on September 7th Paulson had nationalised Fannie Mae and Freddie Mac, the world’s two biggest mortgage lenders, with property exposures similar to Lehman’s.
On September 14th, it appeared that a last-minute deal had been reached with Barclays Bank in the UK to save Lehman from collapse. But the Financial Services Authority in the UK had concerns about Lehman’s liquidity and funding, while the British government wasn’t willing to commit taxpayers’ money to the rescue of a US bank. The deal fell apart.
Lehman no longer had sufficient liquidity to fund its daily operations and filed for bankruptcy on the following day. As a result of the collapse, the Dow Jones index plunged 504 points on September 15th. Bank of America was enticed to come to the rescue of Merrill Lynch.
On September 16th, AIG was on the verge of collapse; the US government was forced to intervene with a financial bailout package that ultimately cost about $182 billion. On October 3rd, 2008, the US Congress passed a $700 billion Troubled Asset Relief Program rescue package for the financial sector.
Federal Reserve chairman Ben Bernanke, speaking about the overall economic crisis, has conceded “there were mistakes made all around”.
Paulson and the others who made the decision to let Lehman go believed the bank’s implosion could be contained. However, with a balance sheet of $660 billion and extensive derivatives exposures, Lehman’s collapse reverberated through global markets.
Up to that point, the markets implicitly believed that no big bank would be allowed to fail by governments. Many believe that if he had his time over, Paulson would not have allowed Lehman to collapse. We’ll never know.