“That Is What These Days Is Called an Alternative Fact”

Ten years later, is the story Bernanke, Geithner, and Paulson tell about the Lehman crash even true?

Pedestrian and vehicular traffic outside the Lehman Brothers building.
The New York headquarters of Lehman Brothers on Sept. 14, 2008. Photo by Michael Nagle/Getty Images

Ten years ago this month, the investment bank Lehman Brothers made the largest bankruptcy filing in American history, badly exacerbating what was already a serious recession and mortgage crisis. The chairman of the Federal Reserve, Ben Bernanke, along with the head of the New York Fed, Timothy Geithner, and the Treasury Secretary, Henry Paulson, have all argued that they did not have the legal authority to rescue Lehman Brothers. But for a decade there has been a debate over whether they could or should have done more. In a new book, The Fed and Lehman Brothers: Setting the Record Straight on a Financial Disaster, Johns Hopkins economics professor Laurence M. Ball argues that the Fed had the legal and practical ability to rescue the company, but instead let it fail for political reasons.

I recently spoke by phone with Ball, who is also a research associate at the National Bureau of Economic Research and a visiting scholar at many central banks, including the Federal Reserve. During the course of our conversation, which has been edited and condensed for clarity, we discussed whether saving Lehman Brothers could really have prevented the crash, how well equipped we are to prevent the next calamity, and why he still doesn’t buy the excuses of Geithner, Paulson, and Bernanke.

Isaac Chotiner: What’s the biggest lesson to take away, 10 years later, about the way the government dealt with Lehman?

Laurence M. Ball: One lesson is that a financial crisis, a crisis on Wall Street, can have devastating effects on the whole economy. The other things I’ll say are things that economists have known for a long time but might have forgotten a little bit. A central bank can be extremely valuable in containing a crisis by serving as lender of last resort and preventing needless failures of financial institutions. But also, in the case of Lehman, if a central bank is not doing its job as lender of last resort, that can be disastrous.

Geithner says it would have been illegal for the Fed to do that. Why is the argument he is making wrong?

That’s a very topical question. Actually, as we speak, there’s a conference going on at the Brookings Institution where the three of them were saying the same thing. At the risk of being a little bit catty, I wouldn’t say that they’ve exactly argued anything. They have claimed something. They have said it was not legal to rescue Lehman because they did not have enough collateral. But they’ve almost never even tried to back that up. It’s just been a matter of, “We’re the authorities, we know what we’re doing. We couldn’t rescue them because they didn’t have enough collateral.”

My book argues that is just not correct in two related but distinct senses. The first involves their decision-making. There’s a lot of evidence from a couple of investigations of the crisis that had subpoena power and got emails from Fed officials to each other before the bankruptcy. There is a lot of evidence that they were not talking about collateral or legal authority. They were discussing the possible economic risks if Lehman fails, what’s the political danger if we rescue Lehman, and politics seems to have won out. The idea about there wasn’t enough collateral so it wasn’t legal, that was developed sometime after the bankruptcy.

But then the second point is that, again, with the rich amount of information that’s been gathered by the Financial Crisis Inquiry Commission, and also the bankruptcy handler for the bankruptcy court about what Lehman’s liquidity needs were … they had plenty of collateral to borrow the cash they needed. Essentially the Fed could’ve done for Lehman exactly what it did for Morgan Stanley and Goldman Sachs, which is use the Primary Dealer Credit Facility to provide cash to deal with the runs they were all facing.

How do you think Geithner, Bernanke, and Paulson dealt with the crisis more generally?

I think they did a lot of good things. I heard Warren Buffett interviewed once, and he said, “Sure, they made a mistake with Lehman, but what’s really remarkable is how quickly they realized they made a mistake and reversed course and prevented things from getting even much worse than they were.”

If the three of them were to say, “We tried really hard. Maybe in the night of Sept. 14, in this unprecedented situation, we didn’t get it quite right. And that’s too bad, but at least we minimized the damage afterwards.” I mean, I would be the last person to say that anybody would’ve done better than that. But what irks me is that they have just dug in their heels and insisted. They’ve just said the same thing over and over, more and more insistently. That we knew it was going to be a calamity for Lehman to fail. We absolutely did everything we possibly could do. It was simply illegal and we didn’t want to break the law, so with great sorrow, as Bernanke put it at one point, we realized Lehman had to fail. That is what these days is called an alternative fact. And that’s just not the way it happened.

I asked you the question about how you thought they dealt with the crisis generally, and my next question was going to be, “How much do you think the crisis would’ve been different if Lehman had been rescued?” And so I guess those two questions are actually sort of intertwined, right?

There, of course, we’re into the realm of counterfactual history, where nobody can know, and different people can make different educated guesses. Having said that, my pretty strong educated guess is that the whole financial crisis would have been less severe. And that consequently, the whole Great Recession would’ve been less great. A lot of the things that happened in the fall of 2008 flowed directly from the Lehman failure, starting with the run on money market funds, after one money market fund lost money on Lehman’s commercial paper. And then just generally, the panic that gripped markets was because of this unprecedented event. So we’ll never know, but I think the whole crisis could’ve been much more contained if Lehman had been rescued.

It’s an interesting question because we were already in the midst of a mortgage crisis and a recession.

It would’ve prevented the worst … I mean, the way I look at it, there were some bad decisions about people buying securitized mortgages and investment banks taking on a lot of risk. So people were going to lose money, there were going to be economic effects. The unemployment rate was already creeping up a little bit before the Lehman bankruptcy. But my best guess is if Lehman had been rescued, we could be looking back on it the way we look back at the savings and loan crisis of the 1980s or the bursting of the dot-com bubble in the early 2000s. Those were cases in which people in the financial system made mistakes, quite a few billions of dollars were lost. There was some adverse effect to the overall economy, but there were not big 10-year retrospectives after those events. Those were relatively minor bumps. And I think Lehman could’ve been the latest, relatively minor bump.

Why did Lehman fail, and how do you view the men and women, I assume mostly men, who were running the company?

Actually, Lehman was notable for having a chief financial officer, Erin Callan, who was female, but let’s assume that’s irrelevant for our purposes. I think, actually, it is quite well understood how Lehman got in trouble. And one thing I’d like to emphasize is that it’s the same way all the investment banks got in trouble. From Bear Stearns to Goldman Sachs to Morgan Stanley. The ultimate outcomes were very different, based primarily on different government and Fed responses. But they all had basically a business model which, with 20/20 hindsight, is quite flawed. And there were three factors.

They made these risky and, in retrospect, imprudent bets on real estate when there was the real estate bubble, and lost a lot of money. The second factor was that they operated with very high leverage or very thin equity cushion. So when they started losing money on real estate, it didn’t take too much until their equity started going away and people started worrying that they’re insolvent, that they’re not going to be viable. And then the third fatal thing was that they relied very heavily on short-term borrowing to operate, hundreds of billions of dollars of short-term, even overnight borrowing.

So once people said, uh-oh, they’ve lost money on real estate, they might be insolvent, that led, essentially, to a 21st century version of a bank run. They weren’t operating based on deposits; it was short-term lending from other financial institutions. But it was cut off very suddenly. And that’s what ended up being fatal for Bear Stearns and Lehman, and probably would’ve been fatal for all the others if the Fed hadn’t stepped in.

How do you feel about the tools that the federal government has to deal with this today? Are they better or worse? And how much confidence do you have in the people in charge compared to 10 years ago?

So the first question is a good question. The rules, of course, have been changed by the Dodd-Frank Act. And at least at the moment, before things are rolled back further … I think I support the conventional wisdom of a lot of people that the Dodd-Frank Act in some dimensions goes in the right direction of higher capital requirements, some efforts to restrict certain risky activities, perhaps making a crisis less likely in the future.

The thing about the Dodd-Frank Act, though, that I think is a big mistake: Even though I’m very critical of what Bernanke, Paulson, and Geithner did, I fully support what they’re currently saying about policy, which is that the Dodd-Frank Act restricts the Fed’s ability to make emergency loans. And the details are somewhat complicated, but long story short, arguably if they were in exactly the same situation in the future, with another Lehman Brothers in the same danger of failing, it might actually be illegal for the Fed to step in. Whereas it was clearly legal in 2008.

I think it’s a little bit ironic that the policymakers from back in the day are saying it’s dangerous that our tools for rescuing financial institutions have been taken away from us, when they didn’t actually use the tools as vigorously as they should have during the crisis.

And do you want to weigh in on the people running our country?

[laughs] Well, I don’t have anything very reasonable to say. I mean, the Trump administration is horrific in every way we can imagine, including incompetence in economic advisers. So, yeah. Again, whatever failings I can see in Bernanke, Paulson, and Geithner, they certainly look like philosopher kings compared to the people currently running economic policy or other policy. So that’s certainly a risk—that if, heaven forbid, there were another big crisis soon, it would really be amateur hour and who knows what would happen.