New Light on Lehman

September 21, 2009 5:00 PM

The failure of Lehman Brothers over a fateful weekend in mid-September last year, and the chaotic aftermath as A. I. G., Merrill Lynch, and leading money markets funds tottered, "remain a source of widespread outrage and confusion," writes James B. Stewart in the New Yorker. What an understatement.

But like David Wessel of the Wall Street Journal in his book In Fed We Trust, reviewed here earlier, Stewart has cleared up much of the confusion while raising very interesting questions. My takeaway is that while Lehman executives were oblivious to the warning signs over the imminent failure of their storied investment firm, Treasury Secretary Henry Paulson may have increased the odds of a Lehman collapse by taking a hard line opposing a government role in its rescue. And Barclays and British authorities may have contributed to the problem by dithering, or at least not making their own intentions clear.

Stewart's lengthy magazine piece also reinforces the impression of Paulson, a former Goldman Sachs executive, as slow to realize that the Bush administration and the Fed had to go to Congress to get emergency approval of a bailout fund as Lehman took the global financial system on a downward spiral. While the Treasury secretary fretted over what might happen if they asked for the money, and Congress refused, Ben Bernanke, the Fed chairman, lost his patience for one of the only times in the crisis. "Hank! Listen to me," he implored the Treasury secretary. "We are done!"

Regarding Lehman, Paulson is described, as he was in the Wessel book, as drawing lines in the sand as he might in a financial negotiation—but as erring calamitously when he told all potential investors interested in buying or providing a lifeline to Lehman that the Federal government would play no part in any rescue. In other words, he rejected any repetition of the Federal role played the previous March to facilitate the acquisition of Bear Stearns by J. P. Morgan Chase.

Paulson's upcoming book may shed light on his thinking, but in a remarkable confession to Stewart, the Treasury chief acknowledges that the government was "more amenable to funding a rescue than it let on," Stewart writes. "We said, 'No public money,'" Paulson told Stewart, adding: "We said this publicly. We repeated it when these guys came in. But to ourselves we said, 'If there's a chance to put in more public money and avert a disaster, we're open to it.'"

If the Treasury had signaled what it was mulling privately, would someone have stepped in to rescue Lehman? Stewart puts it this way:

"Had Paulson said from the outset that a government-assisted deal was possible, a buyer might have emerged. Instead he summoned Wall Street's chief executives to the Fed, where he said emphatically that there would be no government assistance, as had already been indicated to the press. If this was simply a tough negotiating tactic, Paulson may have overplayed his hand. He succeeded in getting the Wall Street firms to cooperate, which would have provided welcome political cover from likely hostile reaction to another government bailout, but he failed to secure a buyer."

One of the more debatable aspects of Stewart's analysis of the Fed and Treasury arguments relates to their contention that they had no choice but to not lend money once it became clear there was no buyer. The argument is that because Lehman by then was completely insolvent, with insufficient collateral to secure an emergency loan, Federal aid was out of the question. As Stewart puts it: "The Fed has statutory emergency powers to lend to non-banks, but only against what it deems adequate collateral. Lehman, unlike A. I. G., with its healthy insurance business, didn't have such collateral."

But Stewart also notes that "Lehman clearly had some solid collateral" and that the day Lehman failed on September 15, the Fed loaned its broker-dealer unit $62.8 billion to help in an orderly wind-down, and it loaned $47.7 billion the next day and $48.9 billion the day after that. "It seems likely that such collateral might also have been adequate to support a rescue on the Bear Stearns model," he says. The counterargument is that although there was enough collateral to facilitate such a wind-down, there was not enough to cover the huge hole of tens of billions of dollars that dissuaded investors from stepping in to save or acquire it.

Finally, there was the confusion over the decision by Barclays in London to step back from buying Lehman. Early on Sunday, September 14, Paulson heard from the chairman of Barclays that Britain's top bank regulator would not approve Barclays rescuing Lehman if it put Barclays at risk. Stewart says Barclays was expecting their concerns to be assuaged by a deal like the Bear Stearns rescue—in other words, with a federal role. Callum McCarthy, chairman of the Financial Services Authority in Britain, was tasked to explain this to Timothy Geithner, then president of the New York Fed.

But that conversation seems not to have gone well. Stewart suggests that McCarthy might have been "too elliptical" in expressing concerns to Geithner, even when he told the New York Fed chief that the British would require shareholders to approve any deal for Barclays to acquire Lehman. Whatever he said left Geithner confused. "Callum, you have to decide," Geithner told McCarthy, according to Stewart. "Are you going to approve this or not? You're not saying no, you're not saying yes."

More conversations involving Paulson and Alistair Darling, Chancellor of the Exchequer, did little to clear things up. Stewart concludes:

"The various calls between the Americans and the British that morning remain a point of contention. From the American point of view, there was never a solid proposal that they could respond to. The British (and some on the American side) maintain that the issue of a shareholder vote is a red herring. The British also felt that they were never presented with a deal that they could respond to. 'It was not a high point of Anglo-American relations,' one person familiar with the conversations says."

So the episode that sent the world economy into what Ben Bernanke calls "anaphylactic shock," posing the threat of another Great Depression, remains murky. Like many turning points in history, however, it is likely to tantalize historians and policymakers with mystery for a long time to come.