Must-Read: Either Lehman was a reasonable organization caught in a perfect storm–in which case its creditors should have been bailed out as part of its resolution–or Lehman should have been shut down and resolved while there was still enough notional equity value left in the portfolio to cover the inevitable surprises and the likely negative shock to risk tolerance. As I have come to read it, Paulson, Bernanke, and Geithner were afraid to do their job in spring and summer of 2008, and also afraid to take responsibility to do what their forbearance with Lehman in the spring and summer had made prudent in the fall.
Perhaps Paulson, Bernanke, and Geithner thought that although the way they handled Lehman was a small technocratic policy mistake, it was a political economy necessity. Perhaps they thought an uncontrolled Lehman bankruptcy that would deliver a painful shock to asset markets and economies would generate strong political benefits: constituents would feel that shock and then complain to congress, which would then give the Fed and the Treasury a free hand to keep it from happening again. Perhaps such considerations made it the right political-economy thing to do. Perhaps not.
But we have never had the debate over that. Paulson, Bernanke, and Geithner have instead claimed that they did not have legal authority to resolve Lehman in the fall. Combining with their failure to resolve it in the summer to generate the conclusion that they did not understand what their jobs were:
‘Lehman Brothers: A Crisis of Value’ by Oonagh McDonald: “The collapse of Lehman Brothers in 2008 was… a spectacular curtain raiser…:
…Oonagh McDonald, a British financial regulation expert and former MP, brings a regulatory perspective to the story, exploring the multitude of flaws in the patchwork of rules… examines how, one weekend in September, Lehman went from being valued by the stock market at $639bn to being worth nothing at all…. Lehman… was so highly leveraged that its assets had only to fall in value by 3.6 per cent for the bank to be wiped out. The tale of how the management reached this point under the leadership of Dick Fuld is compelling. The response… to the credit crunch that began in mid-2007 was pure hubris. Having survived episodes of financial turmoil when many expected the bank to fail, Mr Fuld and his colleagues decided to take on more risk. Meanwhile, they neglected to inform the board that they were exceeding their self-imposed risk limits and excluding more racy assets from internal stress tests…. Much of the decline in the value of Lehman’s assets came from direct exposure to property….
The conclusion is a broader, provocative exploration of the concept of market value, in which McDonald tilts at the efficient market hypothesis that underlay much of the thinking in finance ministries, central banks and regulatory bodies before the crisis…. The brickbats McDonald aims at regulatory behaviour before the crisis are amply justified. More questionable is her critique of crisis management by the US Treasury and the US Federal Reserve. She thinks Lehman could and should have been bailed out in the interests of systemic stability, but does not address the question of how the troubled asset relief programme would have found its way through a hostile Congress without the extreme shock of Lehman’s collapse…