It's been two years since Lehman Brothers failed (Sept. 15, 2008), and we still can't conclusively answer this question: what if the government had saved Lehman? Its bankruptcy was pivotal. Until then, deteriorating housing and mortgage markets had triggered what seemed a serious—but not unprecedented—recession. Once Lehman failed, the economy went into a frenzied free fall. It's hard not to wonder whether some of the ensuing turmoil could have been avoided.
Consider what happened after Lehman:
- Credit tightened. Banks wouldn't lend to each other, except at exorbitant interest rates. Rates on high-quality corporate bonds went from 7 percent in August to nearly 10 percent by October.
- Stocks tanked. After its historical high of more than 14,000 in October 2007, the Dow Jones industrial average was still trading around 11,400 before the bankruptcy. By October, it was about 8,400; by March 2009, 6,600.
- Consumer spending and business investment (on machinery, computers, buildings)—together about four-fifths of the economy—declined sharply. Already-depressed vehicle sales fell a third from August to February.
- Employment collapsed. Five million payroll jobs disappeared in the eight months following Lehman's collapse. The unemployment rate went from 6.2 percent in September to 9.5 percent in June 2009.
Lehman's failure had dire consequences because it suggested that government had lost control. No one knew which financial institutions would be protected and which wouldn't; AIG soon received a massive loan. Uncertainty rose; panic followed.
Worried they'd lose normal credit, companies hoarded cash by cutting jobs, investments and inventories. Disappearing work and wealth (stock losses from September 2008 to March 2009 totaled $3.9 trillion, reports Wilshire Associates) caused consumers to postpone discretionary purchases such as cars, homes, appliances.
The explanations of why Lehman was allowed to fail have subtly shifted in two years. Over that weekend of Sept. 13 and 14, Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke and New York Federal Reserve Bank President Timothy Geithner desperately tried to organize a private-sector rescue. They almost succeeded. They persuaded a consortium of other banks to assume $30 billion worth of Lehman's weakest investments. It seemed that Barclays, a major English bank, would buy Lehman, but British regulators raised last-minute objections.
At that point, only the U.S. government could have saved Lehman, which faced a self-fulfilling crisis of confidence. Its customers and lenders were fleeing because they feared they might not be paid. Someone with deep pockets had to stand behind Lehman to assuage these anxieties.
The standard explanation now from Paulson and Bernanke of why they refused is that legally they couldn't do otherwise. The Treasury said it lacked authority to make an investment; the Federal Reserve could lend but only if Lehman had adequate collateral, which was allegedly missing. That's the story now, but right after Lehman's bankruptcy, the emphasis was different.
"I never once considered that it was appropriate to put taxpayer money on the line in resolving Lehman Brothers," Paulson said. Indeed, his position initially drew praise as standing up to Wall Street. Bernanke gave similar justifications. Testifying to Congress on Sept. 23, he said that "the troubles at Lehman had been well known . . . [and] we judged that investors . . . had had time to take precautionary measures." In truth, an informal consensus had formed against using government funds to save Lehman. Harsh criticism of the earlier rescue of Bear Stearns -- done with Bush administration support and Fed money -- had left a deep scar. The Financial Crisis Inquiry Commission has published e-mails reflecting the mood. On Sept. 9, Treasury chief of staff Jim Wilkinson wrote that he couldn't "stomach us bailing out Lehman. Will be horrible in the press." Given this bias, there was no Plan B once Barclays withdrew its offer.
Paulson, Bernanke and Geithner later performed commendably in preventing a wider financial collapse and restoring confidence that, arguably, averted a second Great Depression. Though their measures (TARP, government loan guarantees and Fed lending facilities) were unpopular, they ultimately calmed markets. But the lingering question is whether Paulson & Co. were cleaning up a mess they helped create. Even now, it's unclear whether Lehman lacked sufficient collateral to justify a loan. There was a "senseless panic," argues William Isaac, former head of the Federal Deposit Insurance Corp., in a book with that title.
Or perhaps not. Maybe saving Lehman would merely have postponed panic and requests for broader powers to deal with a weakening financial system. Citigroup and Bank of America, among others, needed help. The nature of crisis is that people are surprised and overwhelmed by events, and in that sense, the mistakes made in dealing with Lehman might have been unavoidable. One way or the other, the first draft of history is still being written -- and it remains very rough.