Thursday, August 25, 2016

Was It Hank Paulson's Decision to Crash Lehman Brothers?

In 2008, liquidity crises threatened the survival of many of the large financial institutions in the US. The Federal Reserve rescued firms such as Bear Stearns and AIG with emergency loans, and pumped money into Citigroup and Goldman Sachs but it did not rescue Lehman Brothers.

Aside from the question of whether the government should have pumped money into any financial institutions, why specifically was  Lehman Brothers left out to dry?

Laurence Ball, a professor at Johns Hopkins University; research associate at NBER; and Visiting Scholar at the IMF, thinks it was because Treasury Secretary Hank Paulson, who had been CEO of Goldman Sachs, let  Lehman Brothers, a Goldman Sachs competitor, go down because of "political considerations."

Ball writes in discussing a new paper:
In a recent monograph, I seek to set the record straight on why the Fed did not rescue Lehman Brothers (Ball 2016). To that end, I examine in detail the voluminous record on the firm’s bankruptcy, much of it from investigations by the Financial Crisis Inquiry Commission and the Examiner for the bankruptcy court. Both of these authorities had subpoena power, and they interviewed hundreds of people and gathered documents and emails from Fed officials and Lehman executives.

I conclude that officials’ explanation for the non-rescue of Lehman is incorrect... from a de novo examination of Lehman’s finances, it is clear that the firm had ample collateral for a loan to meet its liquidity needs. In particular, I estimate that Lehman could have survived with $88 billion of overnight lending from the Fed’s Primary Dealer Credit Facility (PDCF), and the firm had at least $131 billion of assets that were acceptable as PDCF collateral.

Also, Fed officials did not stand by passively as Lehman failed, but rather took action to ensure that the firm filed for bankruptcy. Specifically, the Fed denied access to the PDCF to Lehman’s broker-dealer subsidiary in London, forcing that part of the firm into default. (A week later, the Fed granted PDCF access to the London broker-dealers of Morgan Stanley and Goldman Sachs.)

Finally, the Fed took on more risk in rescuing Bear Stearns and AIG than it would have if it rescued Lehman. In the case of AIG, the collateral accepted by the Fed included equity in privately-held insurance companies, which is hard to value. The collateral might have been worth less than the $85 billion that AIG borrowed...

If legal constraints do not explain the non-rescue of Lehman, then what does? The available evidence supports the theories that political considerations were important, and that policymakers did not fully anticipate the damage from the bankruptcy. The record also shows that the decision not to save Lehman was made primarily by Treasury Secretary Henry Paulson. Fed officials deferred to Paulson even though they had sole authority to make the decision under the Federal Reserve Act.

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