Saving Lehman's: A good idea?

We asked economists and business leaders: Would the world economy and financial system be in better shape had Lehman Brothers been saved a year ago? These are their responses

Tuesday 15 September 2009 00:00
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Martin Weale, Director, National Institute for Economic and Social Research

Things would have been better if the US authorities had nationalised Lehman Brothers.

The failure of the bank caused great international disruption, which led to the steep contraction we saw in the last quarter of 2008 and the first quarter of this year.

In particular, it made people worried about counterparty risk, and that had a particularly severe effect on confidence in international trade.

Allowing Lehmans to fail did nothing to help us tidy up the sub-prime crisis, or solve the financial crisis more generally.

It didn't really teach the world a lesson about moral hazard – the worry is the other way round now: the collapse at Lehmans was so disastrous that regulators will consider such an event happening again unthinkable.

Nationalisation does address moral hazard to the extent that shareholders lose out, as we saw with the nationalisation of Northern Rock.

The lesson of Lehmans is simply that, as Mervyn King, Governor of the Bank of England, said, that if a bank is "too big to fail", then it is too big.

Regulation has to be taken seriously. Special resolution regimes and "living wills" can help to restore moral hazard by making bank failures more orderly.

Charles Goodhart, Professor emeritus of banking and finance, LSE

I think the argument put forward by Kenneth Rogoff at Harvard – that until something awful happened things would probably have got worse – is quite a strong one. Because Lehmans went down so spectacularly it forced governments into a much stronger response to the crisis than they would otherwise have done. It was a reality check.

The Lehmans collapse has changed the world significantly: no systemically important financial institution will ever be allowed to default again, because the results of the Lehmans failure were so awful and so widespread, and the costs so much greater than expected. The old market discipline that said there was a danger that you would go bust has effectively gone; it is hard to find a new discipline to replace it. Essentially there will have to be wider and more effective regulation to ensure that financial institutions behave themselves.

The old, classic approach to central banking written about by Walter Bagehot in the 19th century – that they only supported troubled but solvent institutions where the collateral they offered for lender-of-last-resort facilities was good – is also gone. We're now in the insurance game, where liquidity and risks run by private institutions are pretty much insured by government. So they – these insured-type institutions – will have to made to be more careful, but we are a long way from that happening.

George Magnus, Senior Economic Adviser, UBS

The only question surrounding the failure of Lehmans a year ago is how, not whether, it should have been allowed to fail. Because we know that its failure precipitated the closest thing to a systemic banking collapse any of us have seen, it is clear that the authorities got their decision badly wrong.

They should have been aware of the implications – there were enough former senior bankers at the political and supervisory helm – and had a plan in the event that systemic risk threatened. They failed on both counts. Alternatively, they could have taken it over, as they had done the week before to the two housing finance giants, known as Fannie Mae and Freddie Mac, but they lacked the political courage or will.

A year on, the financial system has been brought back from the brink, though it is still dysfunctional and dependent on governments and central banks. As far as banks are concerned, we have learnt that deregulation went too far, but re-regulation has been painfully slow. We learnt that too-big-to-fail banks incorporated catastrophic risk, but we've created even bigger ones which no one seems to want to break up. And we learnt that in extremis, public authorities could stabilise the system, but without clear understanding of how to leave the stage or whether it would work a second time.

Joseph Stiglitz, Nobel prize-winning economist, Columbia University

The thoughtless shutting down of Lehman Brothers was obviously a mistake, but it would be wrong to say it caused the whole economic crisis. Our banks had made very bad loans on the basis of a bubble, and the problems were beginning to show for a long time, with the first real tremors in August 2007. With or without Lehman Brothers, we were headed for a crisis. We would have had a serious recession. Indeed, the recession in the US is dated to December 2007. The failure of Lehman was a consequence of the recession, not a cause, but it accelerated the process. The downfall was faster and the depth greater.

We learnt the wrong lesson from it. The lesson too many people took away is that if you have a banking problem, you write a blank cheque. The blank cheque policy completely undermines capitalism, because you are bailing out shareholders and bondholders and you are socialising losses while privatising gains.

We should have begun by asking the questions, what kind of a financial system do we want, what size of financial system do we want, what functions should a financial system perform, and how do we get from here to there?

Instead, we've created a financial system that is more concentrated, with more institutions that are too big to fail.

Willem Buiter, Professor of European political economy, European Inst, LSE

Lehman's failure made the crisis shorter and less costly, cumulatively, than it would have been. We endured six months of misery and pain, but the alternative was an even worse fate; a longer, slower death. That is because the failure really made governments take the banking crisis seriously.

Taken with the AIG collapse, it showed that much of the banking system across the north Atlantic was insolvent. By 14 September last year, letting Lehman Brothers go was the right thing to do. The strategic choice at that point was between bailing out the immensely undeserving at great public expense, or using this unfortunate incident to teach the only serious lesson in moral hazard of the entire crisis.

But if we start the clock at a different point, the answer is different. From 2004 onwards, it was a huge scandal and massive failure of regulation that the authorities did not have a specific special resolution regime for investment banks, a "Chapter 11-lite". It was even more incomprehensible that, after Bear Stearns got into difficulties in March last year, there was still no movement towards a special resolution regime.

Even by early September the authorities could have done what they did later with Morgan Stanley and Goldman Sachs, and turn Lehman into a bank holding company, with Lehman's debts turned into equity in the new company.

John McFall, Chairman, Commons Treasury Select Committee

We were heading for a fall anyway, there is absolutely no doubt about that. Lehman Brothers exemplified what was going badly wrong in the global financial community. The mad amount of risk-taking and the hugely excessive leverage that had been allowed to build up.

What I don't think the US authorities realised was what the implications of their actions – of not doing anything – would be. Intervention would not have saved Lehman Brothers, but what intervention could possibly have done was to have helped bring about a more orderly demise of the institution.

When you look at the leverage that Lehman Bothers had been allowed to build up – something like 44 times the capital they were holding – it was hugely excessive.

What worries me still is that the lessons from it haven't been learnt. Governments are talking about bonuses. Important though they are, that doesn't address the fundamental problem, which is about having institutions that are just too big to fail. Lehman Brothers was too big to fail. That has not been dealt with.

We need to make sure we implement the concept of banks having living wills so that there can be an orderly wind-down as quickly as possible. In the words of William McChesney Martin, the former chairman of the Federal Reserve, we need to be able to take away the punchbowl when the party is in full swing.

Sir Martin Sorrell, Chief executive and founder of the WPP advertising group

In the short term it clearly would have avoided a lot of chaos if the US government had saved Lehman Brothers. When you ask people intimately involved with the situation, which WPP certainly wasn't, most think it would have saved a lot of pain if it had been saved.

Really, though, it just would have postponed the "evil day" for a little while.

They would have had to confront the issue at some stage. When the next institution was on the verge of collapse, and the same decision would have had to be made.

How far could they have gone? Lehman was about grasping the nettle.

On balance it was unpleasant in the short term, but look at a year later and there is $37bn-worth of deals announced on Labor Day.

This could be the calm before another storm. In terms of WPP, Lehman's collapse hit the credit markets, and we saw the effect on many of our clients. Many had a sharp pause in sales, especially on the luxury end.

There was a negative effect in the first three to six months after the collapse. It also affected people's thinking. They found it such an unpleasant experience they altered their attitude and became risk-averse. It continues to have an impact and people will only respond when they really think a recovery is underway.

Angela Knight, Chief executive, the British Bankers' Association

It wouldn't have changed some of the fundamentals – the problems of being unable to value assets, specifically US sub-prime assets. Those were problems that were already within the system.

However, if Lehman had not collapsed the shock to the global economy and the world financial system would possibly not have been as great as it was.

The world financial system may not have suddenly come to a halt and the government interventions that had to follow may not have had to have been quite as big as they were.

You have to remember that when Lehman Brothers collapsed, everything came to a complete halt. Financial markets stopped.

If they had intervened there would have been the ability to handle the issues that were created by Lehman Brothers over a longer period of time. The subsequent crisis might not have been as bad and the losses as a result of it might not have been so great. After all, the degree of the problem that we have had has been caused by the complete loss of confidence in the world financial system that followed the collapse of Lehman Brothers. Had intervention happened, the consequences of what followed on from the collapse might not have been quite so severe. We would have been able to handle the issues in a way that was more phased and without quite the sense of crisis that we were dealing with at the time.

Steve Forbes, Chief executive of Forbes Inc, former presidential candidate

The answer is yes, given what preceded it and given all the aftermath.

Having saved Bear Stearns and Fannie Mae and Freddie Mac, the US government then let Lehman Brothers go, despite the fact that it was infinitely more important, including in the $4 trillion money markets.

They had to reverse course 48 hours later to rescue AIG, the insurance group, and strew government guarantees everywhere, including on the money market fund industry, because the system had gone into cardiac arrest.

The credit crisis was the financial equivalent of a natural disaster, and when you are faced with a natural disaster, you use temporary emergency resources.

You throw in food, you throw in water, shelter and medicine – and then you think about pulling out later. Of course, they created this emergency; through the mistakes of the Federal Reserve, through Fannie and Freddie, and through the crazy system of mark-to-market accounting.

Extending the natural disaster metaphor, they had turned the flood into a tsunami. And now they are acting in ways that will make the recovery a slow and painful one.

One year on, the lesson from Lehman Brothers is this: Ronald Reagan was right, government is not the answer.

Simon Johnson MIT professor and former chief economist of the IMF

I might have let Lehman Brothers fail if I had been them. They wouldn't have done it if they knew the consequences, and I wouldn't have done it if I knew the consequences, but who knew? Of course, it turned out to be a mistake, pure and simple. With the financial panic, the jobs and houses and healthcare lost, the failure to save Lehman affected tens of millions of people.

That's not to say that I am in favour of propping up financial institutions. We are in a terrible quandary, and President Barack Obama's speech to Wall Street on the anniversary of Lehman just made me terribly sad. Nothing he is proposing would address the problem of "too big to fail". There is nothing proposed to regulate or constrain dangerous innovation. We are missing a once-in-a-generation chance, and there is no hope that the G20 meeting in Pittsburgh will achieve more. The G20 leaders are behaving like economic donkeys. They don't learn and they don't change, and they have every incentive just to hope recovery is coming.

I'm sorry to say that if we are to get a financial reform movement, we will need another crisis. It's the Oscar Wilde principle. To have one financial crisis is unfortunate, but you can get away with it. To have two, and people will start to ask the tougher questions.

Richard Saunders, Chief executive, Investment Management Association

It is hard to say whether things are in better shape now than they would have been had Lehman Brothers been saved. But on balance my answer is no.

If Lehman had been saved we might not have seen the convulsions that went through the financial markets in September and October last year.

But the underlying problems of undercapitalisation and over-leverage would still have been there in the banking system.

And while the UK and US governments might not have had to bail out their banking systems at that point, they would quite likely have had to do so later.

One way or another, the excessive risk and lending in the banking system would have had to be unwound, and it would have been traumatic whenever it happened. </p><p> Much the same goes for the economy. Economic growth cannot be sustained indefinitely on the back of rising house prices and increasing borrowing.

It was always going to have to reverse out, with inevitable consequences for growth and employment.

Lehman was a symptom, not a cause. If it had been saved, the world today would doubtless look different. But better? I doubt it.

Credit crunched How the financial crisis unfolded

*15 September Lehman Brothers calls in administrators after weekend of talks fails to secure a sale of the Wall Street bank

*16 September US takes 80 per cent stake in AIG as it rescues insurance giant with $85bn loan

*17 September Lloyds buys HBOS in £12.2bn rescue deal. Gold records biggest one-day rise in history

*18 September US Fed Reserve pumps $180bn into markets through loans to fellow central banks. FSA imposes ban on short selling financial stocks. US unveils $700bn bank bailout

*21 September End of investment banks on Wall Street as Goldman Sachs and Morgan Stanley convert to bank holding companies

*25 September Washington Mutual becomes largest US bank failure. JPMorgan buys assets for $1.9bn

*29 September Bradford & Bingley nationalised in UK: branch network and retail deposits sold to Santander of Spain. Belgium, the Netherlands and Luxembourg in €11.2bn bailout of banking and insurance giant Fortis

*3 October Wells Fargo trumps earlier Citigroup rescue and agrees to buy troubled US bank Wachovia for $16bn

*8 October As global markets plunge, US Fed leads co-ordinated round of emergency interest rate cuts

*9 October Iceland takes control of Kaupthing, its biggest bank, in its third nationalisation in a week

*13 October UK injects £37bn into RBS, HBOS and Lloyds TSB as governments around the world pour money into their banking sectors

*29 October IMF leads $25bn bailout of Hungary

*31 October Barclays raises $7.3bn capital from Qatar and Abu Dhabi

*15 November G20 summit in Washington pledges to support global economy and get tough on banks

*23 November US bails out Citigroup, taking on $306bn of toxic assets

*27 November Woolworths calls in administrators

*11 December Bernard Madoff arrested for $50bn Ponzi scheme

*19 December US gives Detroit car makers $17.4bn-worth of support

*13 January Germany unveils €1.5bn aid for car firms, including "cash for bangers" scrappage plan

*9 February UBS posts Sfr19.7bn loss for year – the biggest in Swiss history

*17 February President Obama signs $787bn stimulus package; Allen Stanford charged with $8bn fraud by Wall Street regulators, the SEC

*26 February RBS post record £24bn loss – the biggest annual loss in UK corporate history

*2 March US rescues AIG for 3rd time

*5 March UK cuts rates to 0.5 per cent, lowest level since the Bank of England was created in 1694

*2 April G20 leaders meet in London and agree to commit $1.1 trillion to world economy. UK borrowing soars to £90bn, highest on record

*30 April Chrysler files for bankruptcy protection in US and sells its car marques to unions and Fiat

*7 May European Central Bank cuts rates to record low of 1 per cent

*1 June General Motors files for bankruptcy, becoming the largest manufacturing bankruptcy in US history

*3 June Q1 data shows UK GDP fell by 2.4 per cent, the largest fall in 50 years

*10 July New GM emerges from bankruptcy in record 40 days

*14 July Quarterly earnings at Goldman Sachs surge 33 per cent; average bonus at bank hits $904,624

*24 July Dow Jones, US benchmark stock index, regains 9,000, a level first passed in 1998

*6 August Bank of England expands quantitative easing plan to £175bn to kick start lending

*12 August FSA bans guaranteed bonuses for more than a year in crackdown on risk-taking at banks

*13 August Second-quarter data show French and German economies have emerged from recession

*20 August Switzerland sells stake in UBS for $5.1bn

*25 August France imposes limits on bank bonuses

*5 September G20 target excess bank pay and risk-taking and insist economic support will be needed for some time

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