Liaquat Ahamed on Lehman Brothers' Fall

It has become conventional wisdom: the signal event of the current crisis, the transformative moment when things truly really began to spin out of control, was the government's decision to let Lehman Brothers fail. But when one looks closely at what happened in the weeks after the bank's fall—by any measure the most turbulent and dramatic period in the last 75 years of financial history—Lehman's collapse was not in fact to blame for pushing global markets and the economy over the edge. Sure, it was a shock. But the Fed's response was sufficiently imaginative, far-reaching and aggressive to mitigate most of the knock-on effects. Instead it was the political battle in Congress, which ensued over the bank bailout package, that really caused the meltdown.

The current crisis took an unusually long time to reach its crescendo. It began in the summer of 2007. Throughout the first year, central banks around the world assumed they were dealing with a run on the financial system caused by risk-averse and overly fearful investors—a classic liquidity squeeze in which banks face a temporary shortage of funds—and dealt with it by providing several hundred billion dollars of short-term loans to the banking system.

In March 2008, it became apparent that investor fears were not wholly irrational. The investment bank Bear Stearns lost so much on its holdings of ill-conceived mortgage-backed securities that it became insolvent. This was a much more complicated problem, one that could not be solved by temporary loans from the central bank; this required the injection of new capital. The authorities, fearing that the failure of such a large financial institution would cause a contagion of bankruptcies but still unwilling at that stage to ask Congress for money, tried to deal with the problem as best they could. The Fed engineered a rescue of Bear Stearns by JPMorgan. But in order to ensure that the deal went through, it had to put some $30 billion of its own money on the line—taking the unprecedented step of providing risk capital rather than a temporary loan.

By late summer, it was becoming clear that Bear Stearns was not alone; many more institutions were insolvent. The most prominent among them—the two giant government-sponsored mortgage companies, Freddie Mac and Fannie Mae—had to be taken over by the government on Sept. 8.

The following week a run began on Lehman Brothers. On the evening of Friday, Sept. 12, the New York Fed summoned the great barons of Wall Street to its downtown offices to try to organize a rescue of Lehman, along the same lines as that of Bear Stearns. Treasury Secretary Hank Paulson, worried about the precedent of bailing out every financial firm in trouble, was adamant that no public money would be provided this time to grease the wheels. After a weekend of cliffhangers when one deal after another seemed imminent only to evaporate a few hours later, no buyer could be persuaded to come forward on the terms that the U.S. Treasury was willing to offer. On Sunday, Sept. 14, it was announced that Lehman would close its doors the following day.

The decision to allow Lehman to fail did indeed come as a terrible shock to the financial system. The immediate loss to investors and counterparts actually turned out to be quite manageable. Lehman's shareholders had already taken their lumps weeks before, as its stock price plummeted. The biggest hit from that weekend's events was to Lehman's unsecured creditors—the holders of its bonds and commercial paper—who registered an unanticipated loss of some $75 billion to $100 billion. But the losses were well dispersed, and no single institution was threatened. Most of Lehman's trading counterparts had been worried about the survival of the investment bank for a while and had had time to take steps to protect themselves—although there were some losses in the U.K. measured in the tens of billions from Lehman's practice of using its customer's securities as collateral for its own borrowings.

The main impact of the Lehman failure was psychological. One of the oldest and most prominent money-market funds in the country held almost a billion dollars of Lehman commercial paper, and was forced to announce to its investors that their funds had fallen below par—something that had not happened in the money-market fund business for 14 years. This provoked an across-the-board run on money-market funds. By one Wall Street Journal calculation, some $200 billion, out of the approximate total of $3.5 trillion invested in money-market funds, was pulled out. These funds in turn dumped some $100 billion in commercial paper in favor of government-guaranteed Treasury bills.

The prospect that financial firms could now be allowed to default also dramatically raised the cost of borrowing for other financial institutions—especially the two remaining independent investment banks, Morgan Stanley and Goldman Sachs. As a corollary, the price of insurance in the credit-default-swap market shot up. This in turn required the biggest seller of credit-default insurance, AIG, to have to pony up more than $15 billion in cash, tipping it over the edge. In what seemed like a dramatic reversal, the Fed announced that it would rescue AIG, once again stretching its mandate and legal authority by putting $85 billion of its own money at risk.

The turmoil that followed Lehman's failure was largely caused by investors fleeing to safety. The Fed, as the lender of last resort, had been expressly created to handle this sort of market panic and over the years had acquired a lot of experience about what to do. Over the weekend Tim Geithner, then president of the New York Fed, alerted his colleagues of the need to "spray foam on the runway" to cushion the blow after the Lehman crash. The Fed was thus well prepared for the turmoil to come.

In the weeks that followed, the Fed injected more than a trillion dollars of reserves into the banking system. On Sept. 18, the authorities expanded the scope of government guarantees to cover the $3.4 trillion in money-market funds. On Sept. 21, Goldman and Morgan Stanley converted themselves into bank holding companies, making them eligible for the FDIC guarantees on bank debts that were unveiled in early October. Also in early October, the Fed opened up a window to lend on the basis of commercial paper. Thus while the collapse of Lehman caused a massive disruption to the credit markets, the response of the Treasury and the Fed was no less momentous, and they did all they could to contain the psychological damage of the aftermath.

Allowing Lehman to go under did bring one big benefit. By making the fragile state of the U.S. financial system so glaringly obvious to both the administration and Congress, it exposed the inadequacy of the strategy to date, especially the excessive reliance on the Fed. Secretary Paulson was forced to finally recognize that he was not just dealing with a bunch of spooked investors but with a financial system with a large hole in its balance sheet. He was persuaded to abandon his deal-by-deal approach and come up with a proposal for a systemic solution. On Sept. 18, he and Fed Chairman Ben Bernanke went up to Congress and in a series of closed-door sessions with the leaders of Congress, in which they acknowledged that the U.S. banking system was close to meltdown, requested a large grant of public money to inject into banks as risk capital.

The result was to stabilize markets. Thus two weeks after the fateful weekend when Lehman had been allowed to fail, the Dow still stood at 11,143, down barely 2.5 percent.

If it was not the collapse of Lehman that tipped the U.S. and the world financial markets over the edge in late September and early October, what was it? On Sept. 29, the House narrowly defeated the bailout package submitted by the Treasury. It was this event more than anything else that shattered market confidence. Over the next two weeks, the Dow fell close to 2,700 points, a decline of almost 25 percent. Though a modified bailout package was finally passed on Oct. 3, the damage had been done. The specter had been raised that America's dysfunctional political system might paralyze the country in dealing with the worst banking crisis since the Great Depression. That fear still remains with us today.