Okay, folks. It’s been five years since Lehman Brothers failed, setting off a chain of unanticipated consequences that came within inches of melting down the world’s financial system. Had the Federal Reserve, other central banks, and the U.S. government not intervened and thrown trillions of dollars at the crisis to keep financial markets afloat, we would be talking about Great Depression II.
But rather than offering the conventional wisdom about what’s happened since Lehman filed for bankruptcy on Sept. 15, 2008, which is readily accessible in a zillion places, I’d like to offer some unconventional wisdom — at least, I hope it’s wisdom — based on my 40-plus years of writing about business. My specialty is fiascoes and failures, which is why there’s a toy vulture hanging from my office ceiling, a mid-1980s Father’s Day present from my children.
The true lesson I take from Lehman is that a simple move that was praised by free-market types at the time — letting Lehman fail — set off unanticipated consequences that brought the financial world to its knees within days. It was an object lesson about how things that seem simple on the surface can come back to bite you in unanticipated places in unanticipated ways.
Lehman failed six months after the Fed and the Treasury bailed out Bear Stearns — actually, they bailed out Bear Stearns’s creditors and counterparties; its shareholders were largely wiped out. There was grumbling at the time that the government should have let the market take down Bear and instill discipline by inflicting heavy pain on Bear’s creditors.
But when Lehman went under, two horrible, unanticipated things happened. One was that a big money-market fund, the Reserve Fund, had to take losses because it owned Lehman paper. Reserve’s “breaking the buck” ignited a run on all money-market funds, forcing the government to guarantee all accounts in order to quell the panic.
Second, some hedge funds that used Lehman’s London office as their “prime broker” found their assets frozen as a result of its bankruptcy. That triggered a mad scramble in the United States as hedgies pulled their accounts out of Goldman Sachs and Morgan Stanley, neither of which had full access to the array of Fed lending programs that commercial banks did. Both firms would have gone under — inflicting catastrophic pain on the financial system by setting off a worldwide cascade of failures — had the Fed not made Goldman and Morgan Stanley bank holding companies and given them access to unlimited cash to meet customer withdrawals. The run promptly stopped.
These two Lehman side effects, which too many people have forgotten, typify the problems of dealing with financial crises. You don’t know where the problem will come from, so you need to have all sorts of resources available.
We’ve forced giant, too-big-to-be-allowed-to-fail financial institutions to beef up their capital relative to their assets, which is a good thing. However, we’ve gravely weakened the ability of the Federal Reserve by taking away key powers that it had used to stabilize things. That’s bad. Really bad. This problem, combined with the unhappy fact that much of the rest of the federal government is dysfunctional, will cost us dearly when the next financial crisis hits. And there always is a next one.