Why the Government Didn’t Save Lehman Brothers

The bankruptcy of Lehman Brothers in 2008 triggered the worst of the financial crisis and almost caused a collapse of the financial system. I wrote a few months later that it was a major turning point, and the economy and markets were frozen until sometime after the Fed started quantitative easing in May 2009.

People often ask why the government allowed Lehman to fail. I’ve heard several people who were involved in the decisions made at the time give their explanations. The explanations are consistent, and here’s a good review of the details. The bottom line is that the Fed and Treasury couldn’t simply give money to or invest in businesses. They could make loan under certain circumstances, but the loans had to be backed by adequate collateral. The Fed was able to help save Bear Stearns earlier in the year and other firms in the past, because those firms had valuable assets that weren’t already pledged against loans. Lehman Brothers, according to those who looked at it at the time was leveraged to the limits. Some say it was leveraged beyond the limits.

Another reason, that I rarely see stated, is that after the Bear Stearns bailout members of Congress told top economic officials that there was no more appetite in either party for any more bailouts. The statements were made both publicly and privately. The anti-bailout attitude in Congress was so strong that the Treasury Department didn’t put forward proposals for emergency powers until after the Lehman failure caused the market collapse.

In the case of A.I.G., the Fed’s loans were collateralized by the entire assets of the firm, based on the observation that A.I.G. had potentially huge losses at its unit that sold credit default swaps but the rest of the firm was a successful insurer. The latter parts — the rest of the company — provided the collateral for the Fed’s initial loans, and eventually TARP funds were substituted for the Fed resources to provide the company with a better capital base rather than Fed loans. To be sure, it was hard to know in September 2008 that the value of the company would offset the potential losses in A.I.G.’s financial products division, but this turned out to be the case, with both the Treasury and the Fed turning considerable profits on their investments in A.I.G.

Such a successful outcome was simply less imaginable with Lehman than with either Bear Stearns or A.I.G. To all eyes, the problem at Lehman was one of solvency while the issue in the other two cases was liquidity. The Fed’s actions on Bear and A.I.G. were thus appropriate in its role as a lender of last resort and the same with its caution at Lehman. Indeed, after Lehman had filed for bankruptcy, the Fed did extend loans to allow the firm’s broker-deal subsidiary to function, but in bankruptcy these loans could be fully collateralized by assets within the brokerage subsidiary and not encumbered by obligations in other parts of the larger firm.