The Lehman Bankruptcy: Should All Big Banks in Trouble Fail?

Includes: AIG, FMCC, FNMA, JPM
by: Joseph Tibman

After toiling to cobble together an industry solution to prevent a Lehman failure, the government, in the person of Hank Paulson, flanked by Geithner and Bernanke, determined that Lehman would file for bankruptcy. Paulson was very clear that he could not stomach another bailout, on the heels of Freddie (FRE), Fannie (FNM) and Bear. He was very specific that Wall Street would have to learn a "moral hazard" lesson.

From a practical standpoint, Paulson's reasons for pushing Lehman to file are irrelevant. Outside the bubble of Manhattan, the American public was also weary. A clear majority would not support a bailout. They would regard such action -- not without reason -- as a use of taxpayer money to bailout a bunch of greedy investment bankers who had brought this on themselves. Moreover, there was little support to be found in Washington for further government backing of Wall Street.

Even if memories were long, only a rather small minority of Americans could remember the Great Depression, the last crisis to meet or exceed the severity of our current woes. (The failure of the Bank of the United States early in the Depression has been widely viewed as a mistake that created havoc in 1930s financial markets). And unfortunately, our Congress is not teeming with politicians with a financial or economic background that enabled them to understand the potential implications for the global financial system of a Lehman failure.

By mid-September of 2008, bailout fatigue held our government and many Americans in its grip. And so Lehman filed for bankruptcy. There were many factors that over time created the conditions for the failure of a Lehman. In this moment, however, it was largely a combination of government and public sentiment, together with Paulson's "moral hazard" resolve that required a bankruptcy rather than another shotgun marriage like that of Bear Stearns and JP Morgan (NYSE:JPM).

The filing occurred in the early morning hours of Monday September 15, 2008, with Asian markets well into their trading days. Panic erupted and makets in Asia plunged. As the world rotated and sunlight crept westward across our planet, one market after another experienced near free fall, with equity markets in the U.S. experiencing their worst one day drop since 9/11.

Secretary Paulson, caught off guard by the severe market reaction to the Lehman bankruptcy, quickly shifted gears. He hastily met with key Congressional leaders to inform them that if they failed to act quickly to stabilize financial markets the world as they knew it would alter in a matter of days. In this careening environment, public and government opposition to widespread bailouts waned. "Moral hazard" was certainly no longer Paulson's first priority, as he quickly moved to salvage AIG (NYSE:AIG).

To his discredit, he soon indulged in revisionist reasoning, claiming that a Lehman bankruptcy could not be prevented due to legal impediments. Bernanke and Geithner used the same excuse to dodge blame -- Geithner at his Treasury Secretary confirmation hearing. This is simply untrue. The same mechanism utilized to enable JP Morgan's absorption of Bear could have been used to enable Barclays to acquire Lehman without a Chapter 11 filing. The rest is well known. The government passed the extremely messy TARP legislation, a bill replete with pork, and proceeded to clumsily manage the financial system that many considered quasi-nationalized.

There are few who will argue that any economic system other than capitalism has proved it can endure. And certainly free markets, unfettered by unnecessary regulation are a desirable feature of our capitalist world. The key word here, however, is "unnecessary." How extraordinarily preferable it would be if we could trust financial market players to police themselves, as Greenspan long believed they were well-suited to do. There would be no reckless risk accumulation and no failures of large financial houses.

But this is not the world in which we all live. Poor judgment, greed, arrogance, and distorted reasoning are not in short supply. The departures of Dick Fuld, Joe Gregory, John Thain and others of their ilk from active duty has not rid us of people whose actions reflect these human failings. The recklessness that brought on the current financial crisis will never be driven from Wall Street. This would require a fundamental change in human nature.

Moreover, while it is clear that executive compensation has been out of control and one must live in a seriously insular world to argue otherwise, I believe it is unlikely that reduced compensation will solve our problems. The prospect of great wealth is certainly an enticement to take risk. Still, at Lehman, for example, those who threw what was actually a solid risk management infrastructure (contrary to popular myth) under the bus, pushing aside all who opposed them, were already tremendously wealthy. The potential profits on the risks taken would not have appreciably changed their lives, It was ego, a narcissistic need of those who ruled Lehman to outperform, that drove the disastrous plunge into toxic real estate at the worst of times.

Indeed, on a Lehman Brothers alumnae website,, a poll measuring former Lehman employee opinions as to what caused Lehman's failure ranks "arrogance" first. The other three choices are greed, jealousy, and incompetence. Frankly, it is again irrelevant as to which of these was most responsible for the Lehman collapse. The key takeaway is that it was flawed decision-making that destroyed the firm. Only strong, improved regulation strictly enforced can better prevent what we have endured. Such regulation should not smother markets. But without a sound framework that both protects Wall Street risk-takers from themselves, as well as protecting the larger world from their missteps, we remain vulnerable to a Lehman repeat.

This above plunges us into an issue now hotly debated: Should we allow free markets to fully rule, permitting the insolvency of major financial institutions that require government funding or backing to avoid bankruptcy or should we continue to support these large institutions because the cost of their failure is too great?

Lehman deserved to file for bankruptcy, just as Enron and Worldcom had. That a small number of people were most responsible for Lehman's downfall is irrelevant. Free market discipline requires the failure of insolvent companies if only to ensure that our economy remains competitive. Propping up failed enterprises and industries is folly. It ensures survival of the weakest and stifles economic evolution.

However, large financial institutions, from a purely practical standpoint, are a special case. The bankruptcies of Enron and Worldcom were contained. Collateral damage was insignificant. The contrast with the Lehman bankruptcy fallout is obvious. The tentacles of large financial institutions are so vast and complex that when these institutions obligations are frozen by bankruptcy the world pays a high price. Yes Lehman deserved to fail. The world, however, did not deserve to suffer from the fallout.

Many suffered from the Lehman bankruptcy. Ironically, Lehman employees suffered least. Certainly there were job eliminations as Barclays Capital and Lehman's operations were combined. But this would have occurred regardless of the whether Lehman was acquired as it was or without a bankruptcy filing. Moreover, in investment banking and sales and trading, the number of Barclays capital professionals who lost jobs far outnumbered those whose tenure was at bankrupt Lehman.

Of course, most would have preferred that their old firm remained sturdy. But once its days were numbered as an independent firm, the eventual purchase of the North American operations by Barclays -- free of the toxic assets -- provided a safe harbor and employment. The rest of the world, by and large, paid a far greater price for the Lehman failure than any of its employees. (An exception are thoe employees whose jobs were eliminated prior to the bankruptcy. When Lehman failed, their severance and benefits screeched to a halt.)

Still, global bankruptcy fallout could have been worse. Indeed, in a sense it is fortunate that it was Lehman that failed. Had the much larger AIG gone under ahead of Lehman, the collateral damage would have been far greater. If we consider only the volume of credit default swaps guaranteeing the shaky real estate assets of major institutions that would have been rendered worthless, major financial enterprises would have likely fallen like dominoes, resulting in a barren global financial and economic tundra.

As the most devastating days of the financial crisis have faded, more are raising their voices in complaint about the government safety net, calling for pure free market discipline that allows the failure of major institutions. Christopher Mahoney, in a recent Barron's article points out that the banking crisis of 1930-1933 would have been avoided, or at least mitigated, had the government bailed out the Bank of the United States, whose failure sparked a crisis not unlike the one ignited by the Lehman bankruptcy. Bernanke, a Depression scholar has famously written that Depression-era government policy allowing the failure of banks deepened and lengthened the Great Depression.

There have been recent calls for banks that received TARP funds from the government, including Bank of America (NYSE:BAC), to repay these cash injections. This would appear to reflect the growing impatience of politicians and many Americans with the taxpayer bailouts. No doubt this is stoked by reports that 2009 will be banner year for the bonuses of many Wall Street professionals.

Still, Bank of America struggles to turn a profit, new nonperforming loans continue to grow as quickly as existing ones are charged-off, reserves set aside to absorb losses on these nonperforming loans barely cover them, and values assigned to impaired assets are highly suspect. It defies common sense that under these circumstances we demand repayment of government funds. Should bank of America juggle its books to repay the government, this struggling giant will reside on even shakier ground than that which it currently occupies.

Are our memories really so short that we are willing to risk another failure to fully understand that support is necessary until both individual banks and the system are healthier? The failure of Lehman did not cause the financial crisis. It did, however, take it to another level. It is not just or fair that large financial institutions represent a special case among our sizable enterprises. However, a lesson learned from Lehman is that allowing such a failure hurts us all. Moreover, those most culpable in the financial crisis have generally walked away with their coffers still overstuffed.

Must we really see a string of failures among large institutions to understand that the compound impact would render Lehman a footnote in the history of financial crises?