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My naive part in Lehman’s downfall

The Financial Times logoThe Financial Times 12/09/2018 John Gapper

Editor’s note: The opinions in this article are the author’s, as published by our content partner, and do not necessarily represent the views of MSN or Microsoft.

web_Lehman’s crash © Provided by Financial Times web_Lehman’s crash Ten years ago, Jim Wilkinson, then US Treasury chief of staff, sent a distressed email to a fellow official. “I just can’t stomach us bailing out Lehman . . . will be horrible in the press.” Two days later, his boss Hank Paulson warned others on a conference call: “I can’t be Mr Bailout.”

A few hours before Mr Paulson spoke, the Financial Times published a rather jaunty column by me, advising the Treasury secretary to take the weekend off to pursue his hobby of birdwatching. The government should resist the pressure to save Lehman Brothers, as it had Bear Stearns and Fannie Mae and Freddie Mac, the mortgage institutions, I wrote. It had “talked tough about moral hazard . . . but been a soft touch.”

Within days, Mr Paulson took my advice (and that of others) and allowed Lehman to collapse, triggering the worst postwar financial crisis and unleashing economic and social damage that still endures. It is rarely that an article backfires so rapidly and spectacularly, and I have had a decade to reflect on my part in Lehman’s downfall.

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Despite the passage of time, those involved still argue about whether the investment bank could legally have been saved by the government and the Federal Reserve, and how much difference ignoring critics such as me would have made. My conclusion is that I was wrong, but I wish I had been right.

Of course you were wrong, readers may feel: it should not take 10 years to work that out. But moral hazard is not just a construct to be avoided in economics textbooks. Consider the bitterness bequeathed by bailouts, the outrage at how bankers were saved from folly, and the price that others paid. Intervention turned out to be a necessity, but a very painful one.

Traders Gordon Charlop, left, and Edward Curran work on the floor of the New York Stock Exchange, Thursday, Sept. 6, 2018. U.S. stocks are little changed at the start of trading as retailers and industrial companies rise and energy and technology companies slip. (AP Photo/Richard Drew) © Catalyst Images Traders Gordon Charlop, left, and Edward Curran work on the floor of the New York Stock Exchange, Thursday, Sept. 6, 2018. U.S. stocks are little changed at the start of trading as retailers and industrial companies rise and energy and technology companies slip. (AP Photo/Richard Drew)

We cannot be sure whether rescuing Lehman itself would have lessened the pain. Scott Freidheim, a former Lehman executive, insists that it “would have prevented the carnage the world experienced”. Conversely, Jamie Dimon, chief executive of JPMorgan Chase, told the US Financial Crisis Inquiry Commission in 2010 that “you would still have had terrible things happen”.

I tend to the latter view. AIG, the insurance company that backed toxic mortgage derivatives, rapidly had to be saved and the system was too fragile to have been stabilised by one bailout. Paul Volcker, former Fed chairman, compared the rescue of Bear Stearns in March 2008 to the fictional Dutch boy who put his finger in a flood dyke to save Haarlem. But Wall Street was springing leaks everywhere.

FILE- In this Sept. 6 2018, file photo trader Gregory Rowe works on the floor of the New York Stock Exchange. The U.S. stock market opens at 9:30 a.m. EDT on Tuesday, Sept. 11. (AP Photo/Richard Drew, File) © Catalyst Images FILE- In this Sept. 6 2018, file photo trader Gregory Rowe works on the floor of the New York Stock Exchange. The U.S. stock market opens at 9:30 a.m. EDT on Tuesday, Sept. 11. (AP Photo/Richard Drew, File)

It does not matter to me that Lehman was treated more harshly than either Bear or, subsequently, Goldman Sachs and Morgan Stanley. The FCIC concluded that inconsistency “increased panic and uncertainty in the market”, but instituting a bailout formula would have encouraged further abuses. No bank should have had the right to expect, or to demand, salvation.

But none of this, nor my self-justification in 2010 that letting Lehman fold had been “a gamble worth taking”, gets me off the hook. My argument was about more than the fate of one foolish bank. It covered all of Wall Street’s investment banks and trading institutions apart from retail banks.

Trader Fred DeMarco, right, works on the floor of the New York Stock Exchange, Monday, Aug. 27, 2018. Stocks are opening broadly higher on Wall Street, extending the market's gains from last week. (AP Photo/Richard Drew) © Catalyst Images Trader Fred DeMarco, right, works on the floor of the New York Stock Exchange, Monday, Aug. 27, 2018. Stocks are opening broadly higher on Wall Street, extending the market's gains from last week. (AP Photo/Richard Drew)

What strikes me now is less my wrongness than my naivety. I hoped and believed — implausibly, given that barriers between commercial and investment banks had been weakened by changes in US law and mergers — that investment banks were still small and separate enough to collapse without precipitating a crisis.

Drexel Burnham Lambert had gone bankrupt in 1990 with a salutary lack of official intervention. The Fed was even criticised for corralling Wall Street banks into a room and cajoling them into a private bailout of Long-Term Capital Management, the hedge fund, in 1998. It strived vainly to limit public involvement in the same way on the fateful Lehman weekend.

Things had changed in ways that I utterly underestimated. The Fed’s guarantee of short-term funding “should prevent a run on the bank,” I wrote about Lehman. Ouch. By Monday, not only was it bankrupt but the entire US commercial paper market was locking up. As to AIG’s hidden place at the heart of the financial system, I had no idea and few others did either.

It was soon evident that the Fed and the US government had little choice but to salvage the system by propping up other banks, no matter how unpalatable it was. Letting them all go the way of Lehman would have punished the financial elite for its recklessness and avoided moral hazard, but the economic cost was too high.

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The dyke was breached and has been terribly hard to rebuild. Rather than trying to restore the old divide between systemic and risk-taking institutions, US regulators gave the biggest ones equal status. Banks are less leveraged but the system is just as amorphous — one study found that non-banks such as hedge funds make 30 per cent of loans to mid-sized US companies.

We live with the consequences of that week in September, not only in asset inflation and economic distortions but in the sense of unfairness that many people justifiably feel. I wish we were still in the state I imagined.

john.gapper@ft.com

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