Government's Best Move in 2008? Letting Lehman Fail

It's conventional wisdom on Wall Street that the biggest government mistake of the last year was letting Lehman Brothers (LEHMQ.PK) fail. I guess the barons of capitalism still don't get it.

Here's how the Wall Streeters see it: The March 2008 government bailout of Bear Stearns—if you can call a $2-per-share fire sale a bailout—sent a signal that the feds would not let a big investment bank go down. When Lehman started to sink in early September, the presumption was that the government would prevent an all-out liquidation because of the collateral damage it might cause throughout the financial system. By that logic, when the feds stepped aside and Lehman filed for bankruptcy on September 15, investors were so shocked that credit froze worldwide and the stock markets went into a record plunge from which we still haven't recovered.

[See the 10 worst assumptions of 2008.]

There's obviously some truth to that. But as historians unravel the intricate cause-and-effect correlations of the 2008 meltdown, it's quite possible that a different view will emerge. We know now that Lehman Brothers in the summer of 2008 had many of the hallmarks of a firm destined for failure. It had violated the rules of its own business, taking poor risks and accumulating astounding levels of debt. An incisive New York magazine story details how Richard Fuld, Lehman's headstrong CEO, turned down offers to buy his firm when there was still a chance to salvage it. A Wall Street Journal exposé shows how Fuld and his Lehman chums, convinced that their firm was impervious to market forces, basically vaporized $75 billion worth of assets by failing to plan for an orderly bankruptcy. "Lehman was a recklessly run company," says financial historian James Grant, publisher of Grant's Interest Rate Observer. "It was hugely leveraged. Management was arrogant. This was a bad firm."

[See how the smart money turned dumb in 2008.]

Lehman was also an egregious example of corporate greed. Fuld earned about $240 million between 2005 and 2007—$80 million per year—while making the very decisions that would doom his firm. On average, the CEO of a public company listed on the S&P 500 index earns about $15 million a year, according to the Corporate Library—and most of them run companies that earn a profit and stay in business. Fuld and his Wall Street brethren believe they deserved such lavish earnings because they're smarter than everybody else and can spin a derivative on the head of a pin. Out in the real world, we're still puzzling that one over.

So, why should the government have saved Lehman Brothers? Oh, right—because the government saved a bunch of other floundering companies, like Citigroup (C) and AIG and, later, General Motors (GM) and Chrysler, that happened to employ a lot of people and do a lot of business. And because Lehman was so vital to the financial system that it held the world's economy hostage.

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Except maybe it didn't. What we learn from 2008 will help shape major reforms sure to come in the Obama administration and transform the financial system in ways that could last for decades. So, as the Lehman Brothers postmortem begins to solidify, here's some new thinking on why it may have been perfectly legitimate to let Wall Street's oldest investment bank fail:

Bear Stearns was the real mistake. There's clearly a disparity in the way the government handled Bear Stearns and Lehman Brothers. Bear Stearns was smaller, yet the government stepped in to broker the sale of that firm to JPMorgan Chase (JPM) and take over $29 billion worth of bastardized securities that nobody would buy, at any price. The Federal Reserve and the Treasury Department did, in fact, send a strong signal that they would intervene to prevent one firm's problems from setting off a financial chain reaction. So six months later, with even more at stake, it stood to reason that Lehman would get the same treatment.

But what if the feds had never set the precedent? "Maybe the mistake was rescuing Bear Stearns," says Mary Miller, director of the fixed income division at investing firm T. Rowe Price. "The Bear bailout gave a false sense of security to the markets. Lehman was the wake-up call." If the government had let Bear fail completely, there might have been a credit freeze and market plunge in the spring instead of the fall. But it probably would have been less severe. And as Lehman's troubles mounted, Fuld and his minions almost certainly would have acted differently if they knew that oblivion was a real possibility.

As it turned out, Lehman came to embody the risks of "moral hazard"—the notion that decision makers will behave recklessly if they don't believe they have to bear responsibility for their own actions.

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Lehman may not have triggered the financial meltdown after all. There were so many cataclysms in mid-September that it's easy to forget who else was reeling. But one day after the Lehman Brothers bankruptcy, the government granted the huge insurance company AIG an $85 billion emergency loan to prevent it, too, from going belly-up. AIG had nearly twice the revenue of Lehman, four times as many employees, and a massive web of investments that the feds clearly thought could trigger a global catastrophe if the firm collapsed.

It wasn't all that surprising that Lehman, a deeply indebted investment bank, got into trouble when too many risky bets went sour. But the spectacle of a huge insurer like AIG—part of the institutional safety net that's supposed to prevent widespread catastrophe—suddenly faced with collapse itself was deeply unnerving. "The real surprise wasn't Lehman Brothers, it was AIG," Frederic Mishkin, a Columbia Business School professor and former member of the Federal Reserve Board, said in a recent speech. "Who would have thought that an insurance company would have been affected by all this? When that happened, all bets were off."

If it turns out that AIG's near-death experience was the most powerful trigger for the financial freeze-up that followed, then Lehman's failure looks tolerable by comparison. And the bank looks a lot less vital than its Wall Street apologists believe.

Somebody has to fail. Maybe there are a few institutions that are truly "too big to fail." But most aren't, and the failure of unsuccessful firms used to be capitalism's way of clearing the decks for smarter entrepreneurs with fresher ideas and better products. "Success stories are almost always preceded by failure," says Sydney Finkelstein, a professor at Dartmouth's Tuck School of Business and author of Why Smart Executives Fail.

It's like the way nature needs forest fires. It's nature's way of regenerating growth. There's something equally fundamental about the need for failure in a capitalistic society.

Pure free-market capitalism can be ruthless and volatile, which is why we have thousands of government regulations to protect workers and consumers and promote stability. But that doesn't give companies a license to screw up and then beg for forgiveness—and a taxpayer bailout. As the Category 4 winds of 2008 recede, Lehman Brothers looks increasingly like a firm that we're better off without. Now that it's out of the way, maybe somebody with better ideas—and a bit more decency—might take its place.

Disclosure: no positions

Comments

[prudentinve...:]

The real mistake was TARP and all the gyrations that siphon trillions of taxpayers' funds to prop up failed financial companies.

Any bank that put itself in a position to fail should have been nationalized before taxpayers' money was put into it. The management should have been replaced by the government receiver, and once stability has been restored the nationalized banks would have been sold, recovering some of the taxpayers' money.

This is the model that was employed by several major European countries, whether it be banks, mines, or other strategic industries. It preserves the system for the greater good without rewarding the irresponsible.

2008 Dec 31 08:34 AM

[eternitus:]

Agreed. It is inconceivable to me that we could extend a lifeline to a company (GM) that has lost 72 billion over the last 5 or so years and not demand any sort of change. Drives me crazy.

2008 Dec 31 09:05 AM

[Robert Perrego:]

Oh yeah - great move, along with setting loose the cascading CDS destruction of wealth of trillions that could have been averted with an AIG type deal. You are on your high horse here saying it was a great move - you are completely wrong when measured in the real pain and suffering many common people will feel as a result. get a clue.

2008 Dec 31 09:11 AM

[Tom Armistead:]

Letting Lehman fail in the most disruptive and destructive way possible was incredibly stupid. Far better to have closed it down without endangering the system.

Controversies around the decision are useless at this point in time: what is needed is a new style of regulation:

Prudential regulation allows a free market place, but prevents individual players from unduly harming other participants or creating systemic risk. If CDS and Investment Banks had been regulated along these lines, much harm could have been prevented.

2008 Dec 31 09:26 AM

[Bill M:]

Agreed, should have let AIG, Citibank, GM, and all the others that had their hand out.

2008 Dec 31 09:34 AM

[Camden:]

For the most part I agree with the idea that it was a good idea to let Lehman fail. That decision ensured the financial system would have to come to grips with it's excessive leverage – the entire system FORCED to change it's ways. It must have been known that Lehman's failure would set off a cascade of asset sales to raise cash to pay down bad debts. In the long run the world's financial system will be MUCH stronger as a result. In the short term, we all suffer the effects of de-leveraging across all financial markets.

However, those that think it would have been a good idea to let AIG, CitiGroup, and other fail don't understand how that would have caused the default on many TRILLIONS of dollars of derivatives – perhaps a value grater than all the common stock on the planet. Seriously. The meltdown of those markets – which was a real possibility – could have wiped out most of the world's wealth and bankrupted many nations. Very, very ugly.

I'm of the opinion that our current situation is painful but healthy and bodes well for a stronger, much more stable, slower-growing world economy in the future.

2008 Dec 31 11:54 AM

[CautiousInv...:]

A very interesting article that challenges our thinking; I think it will be debated for some time with little consensus.

My first thought, is that the current situation is a result of government failure to bring regulation to an increasingly complex financial services industry. Markets can only be efficient when there is transparency and the opaque industry of synthetic financial products, including credit default swaps, is anything but transparent. Thus, there are pricing issues and fear of counter party risk.

Had government performed its function of providing the infrasturcture needed for markets to operate efficently, it is unlikely that it would have had to place the GSE's under receivership and taken other steps mentioned in the article. Intervention was required because there was lack of anticipation.

The decision to allow Lehman fail is covered well in the article but was followed by unintended consequences. Fears immediately consolidated over the viability of AIG, Goldman and Morgan. And the government did not forsee the depreciation of Lehman's bonds leading to a run on money market deposits.

The take away is that the government's function should be to assist private enterprise by providing a regulatory environment that offers transparency and promotes efficiency. Direct intervention is a moral hazard and leads to unintended consequences.

2008 Dec 31 12:17 PM

[N.John Joseph:]

The present global financial crisis was precipitated by the failure to bail-
out Lehman Brothers. Lehman Brothers should withdraw bankruptcy
petition and pass their bad paper to the TARP. This will restore the investor
confidence and stabilize the markets. Implement new regulatory
measures to secure financial growth.

An investor and a father of two about to lose job.

Jan 01 12:06 PM

[countrybanker:]

Perrego and Armistad:

Its generally agreed today that the risks the banks, insurance companies and investment banks were taking were imprudent. These practices had to stop. Further, as as the author suggests, the handling of BEAR (by burying the problem in the govt and not forcing Bear creditors, ie the market, to take the losses, did not appear to change these imprudent financial industry practices.

Why then, wasn't the decision allowing Lehman to fail(thus the market) not a wise one? How else do you suggest the required changes would have come about?


On Dec 31 09:11 AM Robert Perrego wrote:

> Oh yeah - great move, along with setting loose the cascading CDS
> destruction of wealth of trillions that could have been averted with
> an AIG type deal. You are on your high horse here saying it was a
> great move - you are completely wrong when measured in the real pain
> and suffering many common people will feel as a result. get a clue.

Jan 01 03:46 PM

[Tom Armistead:]

It's like when the oil light goes on in your car: it's too late, you should have changed the oil long ago.

It was not possible to do the right thing about Lehman because the CDS industry was not regulated from the beginning, as it should have been. Likewise, capital requirments for the investment banks should never have been relaxed.

Normal prudent regulation, similar to changing the oil, would have avoided an expensive breakdown of the financial system.




On Jan 01 03:46 PM countrybanker wrote:

> Perrego and Armistad:
>
> Its generally agreed today that the risks the banks, insurance companies
> and investment banks were taking were imprudent. These practices
> had to stop. Further, as as the author suggests, the handling of
> BEAR (by burying the problem in the govt and not forcing Bear creditors,
> ie the market, to take the losses, did not appear to change these
> imprudent financial industry practices.
>
> Why then, wasn't the decision allowing Lehman to fail(thus the market)
> not a wise one? How else do you suggest the required changes would
> have come about?

Jan 01 03:55 PM

[countrybanker:]

Tom: You did not answer the question. Its easy to say 'normal prudent regulation' would have prevented..... But your earlier post suggests that allowing Lehman to fail was wrong. Please re-read my post...how else do you suggest the required changes come about? looks to me like Lehman failure brought this nonsense to a head, which needed to be done and eventually had to be done.

Using your analogy, when the oil light comes on, its too late. However, what then does the owner/driver do? Your post suggests driver(Fed/Treas) just unplug the light, hide the problem, see no evil and keep driving the car. I suggest that the driver(Fed/Treasury) pull over, disclose to his passengers the engine/car has problems, go to the mechanic, fix it and pay the big bill.

You see Tom, my car then still runs; yours is a zombie,with hidden, non transparent problems, that will implode soon on you or the fool you sell it to.

Thanks, for the great analogy which further makes my case.


On Jan 01 03:55 PM Tom Armistead wrote:

> It's like when the oil light goes on in your car: it's too late,
> you should have changed the oil long ago.
>
> It was not possible to do the right thing about Lehman because the
> CDS industry was not regulated from the beginning, as it should have
> been. Likewise, capital requirments for the investment banks should
> never have been relaxed.
>
> Normal prudent regulation, similar to changing the oil, would have
> avoided an expensive breakdown of the financial system.
>
>

Jan 01 05:05 PM

[Curious Inv...:]

With Lehman's selling at 3 cents per share and filing bankruptcy to restructure, might they be a good avenue for some Mad Money? 10,000 shares for $300 could be something in 10 years if they survive and rebuild.

Jan 02 11:05 AM

[Mad Hedge F...:]

Here’s another one for the unintended consequences file. The bankruptcy of Lehman Brothers could lead to up to 50 of London’s better restaurants going under. The defunct investment bank was a profligate spender of expense accounts, corporate events, and bonus payments, racking up huge bills. Restaurateurs are coping by cutting staff costs, offering cheaper cuts of meat and more chicken dishes, bargain wines like Argentinean malbec and Spanish rioja, and great value for money prix fix menus.

Feb 21 08:47 AM