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On Lehman Brothers & Investment Bank Runs
Nature vs. nurture
Let’s talk about the most recent “Lehman Moment”: Lehman.
This note is largely inspired by an impromptu question from David Beckworth when we spoke on Macro Musings in September (episode here). He asked me to respond to Larry Ball’s very, very good critique (book here; earlier monograph version here) of the Fed not rescuing Lehman Brothers on that fateful Sunday in 2008. While I offered a little bit of pushback (and will lay it out more thoroughly below), I consider this building on top of Larry’s work; Larry’s book is absolutely essential context for Lehman Weekend. (And, full disclosure: I work for the Yale Program on Financial Stability, which is chaired by then-FRBNY President Tim Geithner.) [Sources listed at end below.]
Where Ball Comes Out
I’m not gonna rehash Ball’s analysis here, but just to recap: he demonstrates that Lehman was likely financial-statement solvent, notwithstanding Fed officials’ later claims of insolvency. He also notes, correctly, that prior to Dodd-Frank, the law did not explicitly mandate that a firm be solvent to receive a 13(3) loan. Regardless, he shows Lehman (on a consolidated basis) had more than enough collateral to secure the necessary Fed liquidity to continue to operating for some time—allowing it time to fail more slowly and less disruptively, or find another solution.
The Fed & the Value of Investment Banks
Fed officials operated on the understanding that investment banks’ franchise value is fragile and somewhat ephemeral; it depends on their employees, market relationships, and trust of their counterparties. President Geithner laid out this view in his memoir:
Investment banks rely almost entirely on trust and confidence. They’re nothing without their reputation for stability.
Chair Bernanke shared this view in his memoirs as well:
Moreover, much of [Lehman’s] value . . . was as a going concern, based on its expertise, relationships, and reputation. In a full-blown run, already well under way, the firm’s going-concern value would be lost almost immediately, as customers and specialized employees abandoned ship.
This view that also helps explain the apparent inconsistency between letting Lehman fail on September 15 and rescuing AIG the next day. As Bernanke put it [my emphasis throughout the below]:
Unlike AIG, . . . Lehman had neither a plausible plan to stabilize itself nor sufficient collateral to back a loan of the size needed to prevent its collapse.
Geithner said similarly:
Unlike investment banks, whose franchise value consisted mostly of the willingness of other firms to trade with them, AIG had a vast global empire of income-generating insurance businesses, which over time could offset the losses from its quasi hedge fund . . . Those insurance businesses would have a good chance of retaining their value if the parent company didn’t go down.
Fed Concern Over “Lending into a Run”
Criticism over the Fed’s unwillingness to lend enough to prevent the failure of Lehman generally revolves around the idea that the Fed did not do an appropriate collateral analysis. Ball’s post-mortem of Lehman convincingly lays out that Lehman (on a consolidated basis) likely did have sufficient collateral to buy it time by borrowing at the newly expanded Primary Dealer Credit Facility (PDCF).
However, additional evidence suggests that Fed officials were also looking for Lehman to have enough collateral to prevent its failure at any point during the crisis. That is, even with Ball’s collateral analysis in hand, it’s not clear the Fed thought it was legally appropriate from a crisis management perspective to lend to Lehman.
In real-time, Fed officials expressed concern over “lending into a run.” Based on the words alone, that sounds nonsensical: the whole point of emergency central bank lending is to short-circuit a run. But: the holdup for the Fed instead seemed to go back to its understanding of investment banks’ business model and whether it was appropriate for the Fed to essentially engage in even highly secured debtor-in-procrastination financing.
As Roger Lowenstein wrote of a September 14 conversation—between Bernanke, Geithner, Paulson, and Fed Governor Kevin Warsh—in his chronicling of the crisis, The End of Wall Street:
Bernanke floated the idea of simply lending Lehman $100 billion. Geithner shrugged, “We’d be lending into a run. Banks would call their loans.”
Lehman’s bankruptcy examiner (in “the Valukas Report”) revealed a similar sentiment held by Bernanke, reporting his views as follows:
Lehman’s tangible assets and securities fell “considerably short of the obligations that would come due.” Bernanke believed that Lehman was insolvent by the week of September 8, 2008. Providing a loan to Lehman under those circumstances would be “lending into a run.” If, as was the case, Lehman’s collapse appeared imminent, a Federal Reserve loan would not stop the run; the collateral would run out before Lehman paid off all of the claims. Bernanke stated: “The assessment was that if there was a run, which there would be, the business value would be compromised, and all we would have accomplished would be to make counterparties whole and not succeed in preventing the collapse of the company.”
Bernanke’s memoirs corroborated:
I asked Tim whether it would work for us to lend to Lehman on the broadest possible collateral to try to keep the firm afloat.
“No,” Tim said. “We would only be lending into an unstoppable run.” He elaborated that, without a buyer to guarantee Lehman’s liabilities and establish the firm’s viability, no Fed loan could save it. Even if we lent against Lehman’s most marginal assets, its private-sector creditors and counterparties would simply take the opportunity to pull their funds as quickly as possible.
Additional pulled funds would’ve meant additional needed Fed loans. And with Lehman Brothers having no going concern value at that point, the Fed would’ve been left managing essentially Lehman’s entire asset book. Hmmm.
The New York Fed’s general counsel, Thomas Baxter, similarly testified the following to the Financial Crisis Inquiry Commission (FCIC):
Lehman had no ability to pledge the amount of collateral required to satisfactorily secure a Fed guarantee, one large enough to credibly withstand a run by Lehman’s creditors and counterparties . . . A look at the hypothetical alternative of lending to the Lehman holding company itself reveals that it was in fact not viable. By Monday, September 15, Lehman faced a total erosion of market confidence, and so the Federal Reserve would have been lending into a classic run.
Baxter repeatedly referred to the idea of extending a loan to LBHI as a “bridge to nowhere,” because it would not have stopped the run; he said there wasn’t much consideration of such a plan. In 2018, he reiterated that a loan to LBHI would not have been useful because “the run would have continued. It probably would have even accelerated.”
The Valukas Report noted:
Paradoxically, while the PDCF was created to mitigate the liquidity flight caused by the loss of confidence in an investment bank, use of the PDCF was seen both within Lehman, and possibly by the broader market, as an event that could trigger a loss of confidence.
Thus, it seems at least reasonable that a bridge loan from the Fed’s PDCF would not have sufficiently upheld the franchise value of the firm on a go-forward basis in the absence of a buyer. Indeed, Geithner noted that even after JP Morgan’s rescue of Bear—which included a $30 billion asset carve-out that was supported by the Fed (the Maiden Lane special purpose vehicle) and was paired with the rollout of the PDCF—“the run on Bear’s businesses continued until investors were confident the shareholders would approve the [JP Morgan] acquisition.”
Moreover, Geithner’s memoirs suggested that lending into a run was not only ill-advised, but illegal:
The Fed’s emergency authorities limited how much risk we could take; we were the central bank of the United States, and we weren’t going to defy our own governing law to lend into a run.
Elsewhere in his memoirs, however, he used the commonly accepted interpretation of the legal requirement that emergency lending be “secured to the satisfaction” of the Fed: that the Fed reasonably expect to be repaid: “…if we held onto the assets for a few years, we would probably break even…”
Notably, however, this was in the context of the Bear Stearns rescue, where Bear already had a guarantor of its ongoing business—JP Morgan.
He offered a more mixed assessment in a 2018 article, saying the decision not to lend to Lehman on the weekend of its failure was a combination of a legal constraint and a practical constraint. He said:
The legal constraint was that any loan we made had to be reasonably commensurate with the amount of unencumbered collateral the firm could offer. The related, practical consideration was whether such a loan would serve to save the company. With respect to Lehman, we believed it would not.
The Fed’s emergency authority does not require a determination of solvency, but we had to make a judgment about how much we could plausibly lend and whether a loan would work. This is hard to do in the context of a run on an investment bank in a fragile financial system. We used the information available to evaluate the factors behind the market’s loss of confidence, to assess the viability of Lehman’s underlying businesses, and to examine various outside views of the value of its various financial assets. That gave us what we considered substantial evidence there was not enough value for us to stabilize the firm with a loan against the available collateral. Lehman’s assets were underwater, and the bulk of the business was fragile—rapidly losing customers, with limited earnings capacity and little ability to retain employees and convince counterparties to continue to trade with it. […] To survive, Lehman would have needed capital and a guarantee . . .
Perhaps this is representative of the daylight between the legal minimum component of the Fed being “secured to its satisfaction” and the discretionary component of that language. On the former, Fed officials generally agreed that the legal test for “secured to the satisfaction” demanded at least a floor under the authority: that the Fed have a reasonable expectation of full repayment. But the “satisfaction of the Fed” may be a higher standard depending on the circumstances. And this may be partly behind why Bernanke, Geithner, Baxter, etc. continue to refer to the constraint on their ability to lend to Lehman on that Friday as a legal one.
In sum, it appears Fed officials had a somewhat kaleidoscopic view of their legal authority granted under them being “secured to their satisfaction”: it wasn’t just a narrow decision about the systemic importance of Lehman and sufficient collateral to arithmetically protect the Fed against losses; it was also about what the broader impact of Fed lending would be on the institution itself. It was about probable crisis outcomes beyond simply being repaid.
The balance of evidence suggests the importance of “solvency” and “sufficient collateral” to Fed officials wasn’t as much one of meeting the strict legal test of Section 13(3) as it was an analysis of crisis dynamics—and an acknowledgement of the market and balance sheet realities of investment banks—which only served to complicate Fed officials’ legal assessment of being secured to their satisfaction.
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Alvarez, Scott G. July 29, 2010. “FCIC Staff Audiotape of Interview with Scott Alvarez, Bill English, Kieran Fallon and Bill Nelson, Federal Res~1.” Financial Crisis Inquiry Commission. https://ypfs.som.yale.edu/node/7763
Ball, Laurence M. 2018. The Fed and Lehman Brothers: Setting the Record Straight on a Financial Disaster. Cambridge University Press. https://www.cambridge.org/core/books/fed-and-lehman-brothers/14BE6C2AD579DC4782EC27F2A6AF2FA6
Baxter, Thomas C. September 1, 2010. “Statement By Thomas C. Baxter, Jr.” https://ypfs.som.yale.edu/node/2396
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