Most people see the bankruptcy of the Lehman Brothers investment bank on September 15, 2008 as the event that turned a more or less normal recession into the Great Recession. Why didn't the Federal Reserve loan Lehman the funds that would have allowed the firm to survive long enough to gradually unwind its investments, find another financial firm to sell itself to, or, possibly, even survive long-term as an independent firm?
Central banks were established to make loans to banks having liquidity problems. Banks are inherently illiquid because they borrow short term and lend long term. With commercial banks, the short-term borrowing mostly takes the form of deposits. Investment banks like Lehman borrowed short term by executing repurchase agreements (repos) with other financial firms. Repos are essentially overnight loans collateralized by securities such as Treasury bills.
For decades, the Fed had been comfortable in its role of lender of last resort to commercials banks experiencing short-term liquidity problems caused by deposit withdrawals. In March 2008, as the repo market was experiencing problems, the Fed set up the Primary Dealer Credit Facility (PDCF) to also provide liquidity to investment banks. But Fed officials interpreted the Federal Reserve Act as requiring that loans the Fed made through the PDCF have sufficient collateral to make repayment likely.
So why did Fed Chair Ben Benanke and colleagues allow Lehman to fail rather than make the loans that would have allowed the firm to deal with its liquidity problems? The party line has been that Lehman lacked sufficient collateral, which left the Fed's hands tied. Bernanke has made this point multiple times in the years since 2008; arguing that legally the Fed could not make the loans that would have saved Lehman. He also claims that he was fully aware that the failure of Lehman would be catastrophic for the financial system and the economy.
Laurence Ball argues -- not to put too fine a point on it -- that Bernanke is lying. Ball marshals considerable evidence to show that Lehman easily had sufficient collateral to back the loans it needed to survive, at least long enough to gradually unwind its investments. He also shows that at that time Fed officials never discussed the possibility that they lacked the legal authority to make the loans. Amazingly enough, Ball also shows that Bernanke was barely involved in the final decision to let Lehman fail. He also argues that neither Bernanke nor other Fed officials realized how big a blow to the financial system Lehman's failure would be, despite their later statements to the contrary.
In Ball's telling, the decision to let Lehman fail -- actually, to actively push the firm into bankruptcy -- was made by Treasury Secretary Henry Paulson. Legally, it was strictly the Fed's decision whether or not to make the necessary loans. But through force of personality, Paulson took charge of the negotiations and made the key decisions. After the Treasury and Fed had taken action the previous spring to underwrite J.P. Morgan Chase's purchase of the Bear Sterns investment bank -- thereby saving Bear from bankruptcy -- Paulson had come under fierce public criticism. He told Fed officials that he refused to become known as Mr. Bailout by taking action to save Lehman. If Lehman was to survive, other financial firms would have to save it.
Ball tells an amazing tale, which, if it becomes widely accepted, will deal a heavy blow to Bernanke's reputation. It will be interesting to see if Bernanke, Paulson, or other Fed officials respond. Ball's evidence seems overwhelming, so I have a feeling none of those folks will attempt to dispute his conclusions.
The book is largely non-technical; Ball explains simply and clearly the financial basics necessary to understand his argument. He writes well and the book is a fast read. If I have one complaint, it's that he doesn't appear to have made much attempt to interview any of the many people he writes about. Nearly his entire argument is based on publicly available documents. He does say that "half a dozen people with first-hand knowledge" spoke to him, but only off the record. Ball is an academic, not a journalist, so perhaps it's unsurprising that he apparently didn't attempt to get a response from the main players.
Still, that's a nitpick because this is a compelling book. The financial crisis is the most significant economic event in the lives of most Americans. I would think that many readers will want to know the truth behind its key event. I hope this book gains a wide readership.
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