The bankruptcy of the investment banking firm Lehman Brothers in September 2008 was one of the precipitating events of the financial crisis and the Great Recession that followed. According to Larry Ball’s fascinating new book, this bankruptcy need not have happened. All that was required was for the U.S. Federal Reserve to perform its historical role as a “lender of last resort.” Instead, the Fed (in conjunction with the U.S. Treasury Department), wary of taking political flak for “bailing out” a major financial institution, declined to lend when Lehman suffered a loss of liquidity. This failure undoubtedly contributed to the length and severity of the recession.
The rationale for why central banks should serve as lenders of last resort was originally proposed by a 19th-century editor of The Economist, Walter Bagehot. In the 1873 book Lombard Street: A Description of the Money Market, he explained that many financial institutions are prone to “liquidity crises” because they finance long-term assets with short-term liabilities.
In times of crisis, creditors may hastily withdraw their funds, leaving the institution with no way to make repayment other than selling off their assets at “fire sale” prices. By adopting a program of short-term lending, the central bank (in Bagehot’s time, the Bank of England) can help the institution meet its liquidity needs without selling its long-term assets. The institution’s assets provide collateral for these loans. The loans can then be repaid over the longer term by the returns on bank assets, or by selling them at more normal prices.
The book explores the proposition that the Fed had no legal option to loan to Lehman.
All this was, of course, well-known by Fed chairman Ben Bernanke and the other members of the Fed’s board in 2008. But they claimed not to have the legal option to make loans to Lehman (because it was not a “depository institution”—that is, not a commercial bank), and, even if they could, they believed that Lehman’s assets were not of sufficient quality to ensure repayment. It is these two propositions that Ball explores.
He concludes that neither purported barrier stands up to close scrutiny. Ball—an economist at Johns Hopkins—provides an extensive legal analysis of the 1932 Federal Reserve Act and the ability of the Fed to lend to nondepository institutions. He determines that such lending is indeed allowed by the act and its subsequent amendments.
Perhaps the best proof of this is provided by the history of the Fed’s actions: They lent to Bear Stearns earlier in 2008 and made very large loans to the insurance company AIG only one week after the Lehman bankruptcy. Eventually, the Fed made substantial loans to Goldman Sachs, Morgan Stanley, J.P. Morgan, Bank of America and many other institutions. In practically all cases, these loans have now been fully repaid.
Ball’s most detailed analysis concerns Lehman’s assets and whether they would have provided enough collateral for the kind of liquidity loan the firm needed. Although some readers’ eyes may glaze over at the doggedness with which the author pursues this question (especially if the reader has little interest in so-called repurchase agreements), ultimately there seems little doubt that Lehman had plenty of collateral.
So why did the Fed fail in one of its most important duties? Ball blames politics—especially the fact that Treasury Secretary Henry Paulson came to play such a major role in the decision (even though technically it was solely the Fed’s to make). With an election coming up, Paulson did not want the Bush Administration saddled with the term “bailout,” and there may even have been some personal animosity between former Goldman chief Paulson and Lehman CEO Richard Fuld.
A more generous explanation may simply be that the Fed made a mistake. It quickly recognized the error and undertook a major lending program immediately after the Lehman bankruptcy. The question for the future is whether history will repeat itself. The omens are not good. Opposing “bailouts” of financial institutions has become a slogan for both political parties and some provisions in post-crisis legislation may make liquidity lending more difficult.
Until the public gains a better understanding of why any central bank must be a lender of last resort, we can expect more such mistakes in the future. Hopefully, Ball’s fine book will provide a start to that necessary education.