European leaders are now keenly aware of the myriad strands that bind together the world’s financial system. And they say they are determined not to commit the same mistakes that, in their view, the Bush administration and the Federal Reserve made when they did not prevent Lehman’s bankruptcy in September 2008.
The ghost of Lehman has been ever present at the negotiations among top European officials, Europe’s central bank and investors in bonds issued by cash-strapped countries such as Greece over how to prevent a catastrophic default.
“Remember in 2008, when the U.S. let Lehman Brothers fail, the global financial system paid the price,” French President Nicolas Sarkozy said last month. “For both economic reasons and moral reasons, we can’t let Greece fail.”
German Chancellor Angela Merkel drew the same parallel late last month in a television interview, saying, “What we can’t do is destroy the confidence of all investors mid-course.”
Jean-Claude Trichet, the president of the European Central Bank, says he warned U.S. officials three years ago that allowing Lehman to go bankrupt would be “something which is exceptionally grave,” and is now pressing to avoid a similar upheaval in Europe on his own watch.
One of the main lessons of Lehman is that even relatively small failures — the Wall Street firm was only the fourth largest U.S. investment bank at the time of its bankruptcy — can cause devastating ripple effects.
In the lead up to its collapse, Lehman had suffered billions of dollars in losses on commercial real estate loans, including for hotels and office buildings. As investors became more worried about the scale of those losses, they became reluctant to provide any of the short-term loans that Lehman and other investment banks use to finance themselves. Without access to that money and no lifeline from the government, Lehman filed for bankruptcy on Sept. 14, 2008, the victim of an old-fashioned run on the bank.
The failure caused a series of unforeseen ripple effects. For example, a large money market mutual fund that had invested heavily in short-term loans to Lehman lost so much money that its shares fell below $1. That prompted fearful withdrawals from other money market funds, leading them to sell off the corporate IOU’s they own. That in turn made it hard for the companies that rely on those loans, such as industrial giant General Electric, to finance their day-to-day operations. Markets around the world seized up.
In the Lehman episode, the other major banks it did business with were exposed to losses due to the bankruptcy. That was bad enough. But the impact was greatly magnified because no one knew which other banks were facing such large losses that they, too, were at risk of failing. No longer could anyone tell who else was a good risk so lending between banks froze up entirely. The basic trust that underpins the financial system evaporated.
A Greek default could have similar effects. Banks around Europe would suffer significant losses, because they hold significant amounts of Greek government bonds. But no one would know exactly how bad the losses were or which banks, if any, were in danger of failing. Again, lending could dry up.
If Greece could fail, investors would fear that other European nations with shaky finances — first Portugal and Ireland, and then potentially the much larger economies of Spain and Italy and even France — could follow suit. Depositors in those nations’ banks might pull out their money. It could turn into a run — in which people’s fears become self-fulfilling, causing banks to fail and economies to collapse.
Fearing such a dynamic, politicians and bankers have gone to great lengths to prevent Greece, a nation with an economy the size of Massachusetts, from defaulting on debts it can’t repay on its own.
“The Lehman case has alerted people to the huge costs associated with contagion,” said Kjell G. Nyborg, a finance professor at the University of Zurich. “If there was no fear of contagion we’d be finished with this now. Greece would have defaulted and that would have been it.”
U.S. officials tend to see Lehman as one chapter in the larger financial crisis that began in 2007. By contrast, in the halls of European finance ministries and central banks, the financial meltdown is more routinely described as the “Lehman crisis,” and a common view is that the Bush administration’s unwillingness to bail out the Wall Street bank was an underlying reason for the global downturn.
Now, the roles are reversed. Treasury Secretary Timothy F. Geithner and other U.S. officials fear that a weak response by European leaders to the continent’s debt problems could spark a new financial crisis, which would damage an already-struggling U.S. economy. The Obama administration has been applying public and private pressure to European officials, urging them to aggressively address the debt crisis.
“In the same way that with Lehman a U.S. event ricocheted around the globe, Geithner knows a European Lehman-style event could profoundly affect the U.S. banking system,” said Desmond Lachman, a resident fellow at the American Enterprise Institute.
The recognition that an all-out Greek default must be avoided has, ironically, made it harder to rescue Greece. Investors in Greek bonds, which include major European banks, know that government officials in Germany, France and elsewhere are determined to avoid the kind of disorderly default that could cripple global markets and will ultimately have to bail Greece out. So the investors have less reason to make concessions of their own, for instance by agreeing to accept only a fraction of the payments they’re owed on the bonds. This has bogged down negotiations over a plan to resolve the Greek crisis.
“The banks have every incentive to have German taxpayers take the loss, rather than themselves,” Lachman said.