Larry Ball on The Fed and Lehman Brothers

Welcome to the policy of McCollum’s podcast, a data driven conversation on the economic
issues up today in this series. We invite guests into our studio to provide a highlight
of their work presented during a visit to the University of Texas at Austin Policy.
Emma Combs is produced by the Center for Enterprise and Policy Analytics at the McCombs School of Business.
I am your co-host, Carlos Carvalho, with my colleague Mario Villarreal.
Our guest today is Professor Laurence Ball, chair of the economics department at Johns Hopkins
University. Larry Spada, the National Bureau of Economic Research and a consultant for the International
Monetary Fund. His research focuses on unemployment, inflation and monetary policy.
And Larry joined us today to talk about his recent book, The Fed and Lehman Brothers setting the record
straight on a financial disaster. Larry, welcome to policy,
Emiko. Thank you. I’m happy to be here. Give us a sense of what motivated you to write this book
and tell us a bit about the journey to get you here. It was a pretty natural process. I’m a macro
economist, so like a lot of people, I wondered why was there this big recession 10 years ago?
And at some level, the answer is because we had a big financial crisis. OK. Why did we
have a big financial crisis? Well, the Lehman Brothers failure was the pivotal event.
So why did Lehman fail? And then when you start looking into it, what’s striking is
that nobody else failed. Everybody else was rescued by the Federal Reserve or the Treasury.
So pretty quickly, the whole question becomes, why wasn’t Lehman rescued?
When I started looking into that, I quickly discovered that there’s a lot of information available on
that from from investigations by the bankruptcy examiner or the congressional
commission. So if one is willing to spend four years going through the details
and I’m kind of obsessive compulsive, detailed oriented person, you
could actually learn a lot. So and I reach some firm conclusions about the topic.
I’m glad you did it, because the book is a great read and I’d recommend this book to all of our audience. Listened to
it today. So give us a summary of the main argument in the book. The
main question is, why did the Fed allow Lehman to fail? The main answer,
in a sense, as a negative one, that the reason the Fed allowed Lehman to fail is not
the reason that Federal Reserve officials. Ben Bernanke’s on down have said over
and over again their explanation is that they did not
have the legal authority to rescue Lehman because under the law, Lehman did not have enough collateral
for the loan it needed. And the central point of the book is that if you look carefully at the evidence, it’s
beyond question. I think that Lehman did have enough collateral for the loan it needed. So
afraid rescue would have been legal for that matter. It would not have been very risky for the Fed
or taxpayers. Now, if the legal authority explanation is not right,
that leads to the question of what was the real reason. And they are my
basic answer is not terribly original. It’s primarily that it was a political decision
driven primarily by Treasury Secretary Paulson, who didn’t want to be known as Mr. Bail Out.
And again, that’s not original. Many people have said, oh, obviously, it was all political. But the value added
of my book is really establishing that the alternative history that Fed officials
have tried to build just doesn’t fit reality at all. And that’s, of course, very important
for us to understand how to think of all the problems going forward by understanding how the policies
of the Fed have to be set in place in order for whenever an event like that happened. Again, we’re better prepared.
Yes. So the point being that the Fed perhaps should have
have provided liquidity to Lehman. So let let us speculate a little bit and get your thoughts on
what do you think would have happened and and how the financial crisis would have unfold potentially differently
had the Fed provided the liquidity Lehman needed in that weekend of September 12th, 13 and
to answer. I think I’m pretty clear on what did happen, given there’s a lot of evidence. Reasonable
people can disagree on how much difference that would have made. Having said that, I’m on the side
that really the Lehman failure was the critical event which caused strains
in financial markets and the risk of a mild recession to turn into a complete
disaster. And the Great Recession. And that if Lehman had been rescued,
there would not have been anywhere near the panic in financial markets, how the whole financial crisis
would have been less severe. Quite possibly other Fed rescues
and government assistance would not have been as necessary. And the whole Great Recession,
I think, would have been less severe. And if you want to carry it further. The whole
last decade would have been a happier period for the economy. Who knows how politics
would have evolved, but it would have been a very different world, I think, for the benefit of our general
audience. It seems that there are bankruptcies in many industries
around the world, but not all of them lead to the catastrophic results
that Lehman Brothers and the whole financial crisis had. What is peculiar
about the financial industry? Read that in. In facing these events leads to
catastrophic results. So that’s a great question, which I think I can
answer on a couple levels. Finance is
one industry. It’s not that big a share of GDP, but it’s something which is used
by all other industries. Every kind of business has cash flowing through
to needs to use. Credit needs to extend credit. So if finance
breaks down, that affects the ability to operate of every firm
in the economy. Larry Summers, once I’m borrowing this from him, use an
analogy to electricity that if you imagine what happened, if the electricity
went off in the country for three months, you might say, well, electricity is not that
big a percentage of GDP. And if we lose three months, that’s not that much of a loss. But of course,
everybody everything depends on electricity and there would be disproportionate disruptions. The
other thing I’ll add a little bit more technically, bankruptcy law, Chapter 11
bankruptcy is set up very badly for financial institutions.
The whole idea of a Chapter 11 bankruptcy is if a firm’s
in financial distress, you freeze its finances or put that under court supervision.
The borrowing and lending and flows of money. And then if you’re a car company, you keep on producing
cars while people work out the financial problems. But there’s nothing
analysis to continuing business as usual because for investment, bank borrowing
and lending money and flows of cash, that’s all there is. That’s the whole business. So if you if you freeze that,
you’re you’re shutting down the business. So there’s a gentlemen’s
understanding also of the role that the Fed has as a lender of last resort. In the in the financial system,
can you speak a little bit about that? And also tried to give a sense of this notion that
the loan that perhaps would have been needed or it’s done oftentimes by the lender of last resort
cannot necessarily be characterized as a bailout? Is that a gift is a loan that happens. Depp tends to
be repaid to the taxpayer and an end in that same line of questioning?
Well, given what we saw after the fact, what would you think would be the potential losses
that taxpayers would have been facing? We would have faced if the the Fed had decided
to provide liquidity to Lehman. That’s an extremely important question going forward. And I think there
is a tremendous amount of unfortunate misunderstanding by the public and by
elected officials. If I were running the world, I would banish the term bailout
because it’s pejorative. It doesn’t sound like something good.
I would use the term emergency loan or maybe emergency liquidity assistance
or something innocuous or technical sounding like that. Substantively, the point
is, as you suggested, what Lehman Brothers needed in particular
was a short term loan against good collateral.
That was a loan which was very likely to be paid back, even if somehow bizarrely
it had not been paid back. Again, there was good collateral that the Fed could have held on to.
So really, there was no risk to the taxpayer. I mean, it’s really a very sad irony
that people say, well, it’s good that the Fed stuck up for the taxpayer
by not bailing out Lehman. There was no benefit to the taxpayer.
The implication for the taxpayer is that we had the collapse of Lehman, of the financial crisis
and the recession, and a lot of taxpayers lost their jobs really unnecessarily as
a result of the financial crisis. So I wish one thing I’ll add there
in recently, the officials at the time, Ben Bernanke, he and Tim
Geithner and Henry Paulson, who were the top officials at the making policy,
they have talked about the fact that the Dodd-Frank Act, the financial reform in 2010,
has limited the Fed’s ability to make emergency loans.
And they’ve pointed out that that’s dangerous and because we may need the Fed’s emergency lending
in the future. And I agree 100 percent with Bernanke and Geithner and Paulson that
it’s dangerous, that Congress has limited the ability of the Fed to lend. I personally
find it a little bit ironic that they stress that given that when there was greater authority
to for the Fed to lend, they didn’t use the authority when it was really needed.
And just to piggyback on that, that my understanding of the modification
on Dodd-Frank associated with that restriction is the fact that now Treasury has to approve
any decisions of liquidity provision made by the Fed on an event of a of a crisis like that. Is
that correct? Yes, there are several restrictions. There are restrictions about what types of loans and what
types of circumstances which arguably could make something like
the AIG loan or the Bear Stearns rescue illegal. There’s also, though, you’re right.
The requirement that the Treasury Secretary approve anything. I think my
reading of the crisis is that de the Fed gave
Secretary Paulson veto power over their actions, but they didn’t have to do that. A more independent
minded Fed could have said, we don’t care what the Treasury Department says, it’s none
of their business. But but now in the future, no matter how independent,
independent minded the Fed is, if the treasury secretary doesn’t want a quote unquote, bailout,
he can he can now veto it. And it does surprise me, given that actors involved here, because
it’s not like they were not involved after the fact and participate in the discussions with Dodd-Frank. Both
Bernanke continue to be the Fed chairman and Geithner became the treasury secretary. And. And
still that authority and that the modifications still made. This may be a natural follow up
of this narrative and perhaps rightly so.
One of the reactions after the crisis was to demand an intervention designed to prevent
this from happening again and the political, economic public policy
response to these west to enact more regulation. You’re critical about that in your book.
Is your criticism about the specific form that that regulation took meaning
Dodd-Frank’s or is a more general critique about the prospects of any regulation
of being effective in taming these forces? My criticism and the
things I feel strongly about are pretty specific about the Fed should have
a very flexible ability to be a lender of last resort. The Dodd-Frank Act,
of course, covers lots of other things, lots of other regulations, and the details,
of course, are mind bogglingly complex. I for what it’s worth, I tend to be
more on the side of of we should have pretty extensive regulation, we should have robust
capital requirements, restrict kinds of risk richy activities, recognizing
that that will never be perfect. I mean, I think again, this is an analogy other people have used.
Actually, Ben Bernanke, he once used an analogy to the problem that burning buildings catch on
fire and burn down. What do we do about that? I mean, we we have to attack it in
two ways. I mean, first of all, we need to have the best possible building codes
trying to make sure people’s electrical wiring is sound and so on to try to minimize the risk
of fire. Having said that, it’s never going to be perfect. They’re going to be fire sometimes. So we also
need a fire department that’s going to come quickly to the rescue.
And the problem with the Dodd-Frank Act, I think, is that they put barriers
in front of the fire trucks. And given that inevitably there will be another crisis.
It’s going to be harder to respond. Is there a way to balance political incentives
with the pursuit of sound financial economic policy? If I might borrow from that analogy, what if
the house owner or the landlord or whoever is running that led decides to
plug plenty of things because we’re having a huge party and overcharge electrical wires and electrical system
for his or her own benefit? Is there a way to balance those two things? So
that’s a that it is a good analogy, I think, because people’s people
talk about moral hazard is the jargon that if you rescue financial firms, they’ll they’ll
be sloppy or reckless in the future. But I think actually
my attitude is similar. You mean you could imagine right now that a fire breaks
out in Austin, Texas, and the fire trucks are going there and and
citizens rush into the street and say, tell the fire trucks to stop and say, don’t you know
you’re encouraging people to be, you know, to be reckless with their electrical wiring? Most people would
say, you know, the costs are you know, the cost are just too great of letting the house burn down. Let’s save
the house then. Let’s do the best we can in the future to have better regulation.
And I think that’s probably the right. The right. You know, we wouldn’t want the house to burn down or
in the case here, we don’t want the whole world economy to burn down just to make a point about
moral hazard. You brought up a point of cap, the requirements associated with
banks in general, the financial system, in your opinion, and after you did a very careful analysis of Lehman’s
balance sheet to understand its solvency at the at the crisis time, do
you think we are at a good place in terms of our current capital
requirements, the amount of leverage banks can take in? Because obviously we’d let less leverage the
magnitudes of a potential run on a financial institution. The fire
essentially in his analogy. It’s a smaller fire. If if leverage is at lower levels,
where were we and where are we now? Relatively. And do you think from from your analysis that that
are in a good place or a bad place? That is a good question. Very controversial.
I honestly don’t know the answer for sure. I think we’re in a better place, of course,
with hindsight. I like like a lot of disasters in some ways easy to look back and say, what were people
thinking with investment banks doing these very risky things and having
asset to equity ratios of 40 or 50 being so
that show just a really small loss would be enough to push them into insolvency. I
think the situation is better now. How much better it is?
It’s difficult to measure. It’s hard to know what’s coming in the future. I would probably
ere on the side of better safe than sorry. You know, there may be some
inefficiencies or costs of higher capital, but the costs
of not having enough capital are we’ve seen again and again in history or so disastrous.
I’d probably ere on the side of being pretty cautious during his life presentation.
I asked Larry about the institutional backdrop surrounding the decision to let Lehman go.
It is safe to say that Treasury Secretary Henry Paulson made the final call and by law he had
no authority to hear. Ten years have passed and we have books and documentaries celebrating the people
trying to save us from a financial disaster. But most people fail to appreciate that we saw an
institutional breakdown. What should have been a technical decision address independently by
the Federal Reserve ended up being co-opted by the political process. Yes, that’s a fascinating
part of the story. Right. So the classic theory of the lender of last resort says the central bank
should be the lender of last resort, not the government. And the Federal Reserve Act says
the Federal Reserve can decide whether the Federal Reserve lends. And there’s a procedure in which
the Federal Reserve Bank of New York can ask the board of governors or the Federal Reserve in Washington
to approve a loan and the board of governors votes on it. The rule of the treasury secretary in
that process is exactly the same as the role of the secretary of agriculture.
It’s exactly the same as the role of the mayor of Austin, Texas.
It’s not supposed to be any of his business. Now, what what happened
in this episode was when the basic facts are Henry Paulson got in an airplane and went
to New York, went to the New York Fed and starting charter, telling Tim Geithner, the president,
New York Fed, what to do. And Tim Geithner did what Henry Paulson said and
Henry Paulson made the decision. At some point, Henry Paulson said words, you know, you know, very
closely approximated by Lehman has to declare bankruptcy. And
so there’s question of why. Why did they defer to Henry Paulson and. Maybe I won’t
even say anything about that right now. I bet, like, look, that it’s in
here. You got it. I mean, the best I can do is just sort of force of personalities
that Henry Paulson was the kind of person who over his career was used to going into rooms and telling
people what to do. If he didn’t do it the first time, he said it louder and with. But actually,
if you read Andrew Ross Sorkin’s book, these guys really used it, you know,
you know, inappropriate for the office language and talking about these things. And
Geithner and Bernanke, he just for whatever reason, didn’t didn’t resist that.
I mean, Geithner could’ve told Paulson. You know, we’re going to have the security guards of
the York Fed escort you out of the building. But but he didn’t do that for whatever reason.
Mario, after the great discussion with Larry. What are some of your highlights? Well, Larry provides
a very lively account of the meetings and discussions that happened in the initial days of the 2008 financial
crisis. His narrative includes conversations and the statements from important figures, including
those that later would play a crucial role in the post-crisis discussions. One of these figures is Barney
Frank. The Frank in the 2010 Dodd-Frank Act, he has an interesting sense of humor
and offer a colorful description of the mid-September 2008 events. Three
things could happened. One is they could have eventually gotten the Barclays deal through.
The second is that that didn’t work. And but Lehman was able, like AIG, like
lots of firms, to do some restructuring, to maybe raise some capital to survive. The third
is that that didn’t work. And Lehman ultimately like, say, long term capital management
had to be wound down. But as I discussed in the book, even in that case,
having wine down over a period months where they can sell assets
and close out contracts would have been much less disruptive.
I think there were a couple of law professors this morning who back me up on this, that the idea of telling
a corporation you have to file the biggest bankruptcy petition in U.S. history
by a large margin and you have six hours to do the bankruptcy petition is just
like science fiction. So it accounts for how this or so buying time would have made a
would’ve made a big difference. Actually, Ben Bernanke in his memoir has an interesting passage
in which he talks about one of Lehman’s strategic plans, which was you hear the jargon about
a good bank and a bad bank. It was going at Lehman. It was a spin off its bad assets, get different investors
and break. He actually says, you know, that kind of scheme works sometimes. That wasn’t a crazy idea.
But then he dismisses that. He says, well, obviously, they didn’t have time to implement that. They were about to go bankrupt the next day.
But the reason they didn’t have time to implement it was that the Fed wouldn’t provide the loan.
One key lesson here is that in some cases, thinking about regulation as an effective
instrument in preventing bad things from happening in this instance and other financial disaster,
Mamie’s lead the way regulation is crafted and enacted, according to Larrys analysis.
That is what happened with the 2010 Dodd-Frank banking law. Perhaps overreacting to
dramatic consequences of the crisis and with the hopes of preventing future instances of costly financial
turmoil. The Dodd-Frank Act limited Fettes abilities to lend money, thus making
future financial crisis more difficult to manage. That’s a great point, Mario,
before we wrap up. You can get more information and watch Larry’s full presentation in our medium page.
Thanks for listening to Policy McCombs. See you next time.