By Steven Pearlstein
Friday, September 4, 2009
We're coming up on the one-year anniversary of the Great Financial Meltdown, and running through much of the retrospective coverage will be the notion that it was far worse than it needed to be because the government mistakenly allowed Lehman Brothers to fail.
Certainly that is the conventional wisdom. Janet Yellen, the president of the Federal Reserve Bank of San Francisco, told an academic conference that the decision not to rescue Lehman caused a "quantum jump" in the magnitude of the financial crisis. Economist Allan Meltzer bellowed on the op-ed pages last week that letting Lehman "fail without warning is one of the worst blunders in Federal Reserve history." French finance minister, Christine Lagarde, called it a "horrendous" decision. Sir John Gieve, who at the time was deputy governor of the Bank of England, told a British newspaper it was a "catastrophic error."
In truth, we'll never really know what would have happened if Lehman had been rescued, but we do know that it wasn't for lack of trying. That weekend a year ago, Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke summoned the heads of all the big Wall Street firms to the New York Fed and spent a long and frustrating time trying to orchestrate a rescue. Paulson and Bernanke claim that, in the end, there simply was no legal way they could commit taxpayer money to bail out a firm that was so highly leveraged and so deep into soured real estate investments that it had become insolvent. Those unwilling to accept that explanation, however, must ask themselves why equal blame shouldn't be assigned to the financiers who foolishly refused to pony up a few billions dollars each to avoid a far more costly calamity, and to Sir John and his British colleagues, whose refusal to bend the rules and offer the government guarantees that could have cleared the way for Barclay's Bank to ride to Lehman's rescue.
There is also some reason to doubt that the financial crisis, and the recession, would have been significantly less severe if Lehman's collapse had been avoided.
It's true that financial markets went into a tailspin in the days after Lehman's bankruptcy filing. Credit and derivatives markets froze, banks hoarded cash, and the government was forced to bail out the country's largest insurance company, American International Group. And after a money-market fund that was holding too much Lehman paper announced that it was "breaking the buck," panicked investors began pulling money out of other money-market funds. Hoping to avoid Lehman's fate, rival Merrill Lynch threw itself into the arms of Bank of America, while the Federal Reserve hastily approved the applications of the two remaining independent investment banks, Goldman Sachs and Morgan Stanley, to become bank holding companies with free access to the Fed's lending window.
But it is also worth remembering that before Lehman's collapse, financial markets were already on edge and a sense of crisis was in the air. Financial stocks were in a free fall, and risk spreads had risen to levels well above historic averages. The government had already taken over Fannie Mae and Freddie Mac and seized one of the nation's biggest mortgage lenders, Indy Mac Bancorp. At that point, the failure or near-failure of any high-profile institution would surely have triggered the panic that eventually engulfed financial markets. Lehman happened to be the one that came along.
Moreover, subsequent events have only confirmed that, if Lehman had somehow been rescued, things would not have turned out a whole lot better for Citigroup, or Washington Mutual or Wachovia or Bank of America, or any of the institutions that eventually needed cash injections from the Treasury. And it certainly would have done nothing to save AIG or Merrill, whose rescues were set in motion during the same Lehman weekend. For the reality is that, underlying the liquidity crisis of last fall was a massive credit crisis -- too many risky loans made on loose terms and based on overly optimistic assumptions. Lehman's failure may have sped up the process by which all this lousy lending was revealed and the losses acknowledged, but the financial reckoning was inevitable.
The final point is a political one. A year ago, in the wake of the Bear Stearns rescue, the public -- left, right and center -- was hopping mad about government bailouts of Wall Street. Paulson isn't just kidding when he says that if he had used taxpayer money to save Lehman, impeachment proceedings would have begun against him the following day. It was only after the public witnessed the post-Lehman financial meltdown that Congress was willing to consider the idea of giving the Fed and the Treasury the money and the authority to launch a comprehensive rescue of the financial sector, and even then it took a second try before the House of Representatives would go along.
Far from being a mistake, letting Lehman fail may have turned out to have been the best thing Paulson and Bernanke could have done. Although they certainly didn't plan it this way, the events of that weekend not only accelerated a financial crisis that was inevitable, but accelerated a global policy response that would eventually prevent the total collapse of financial markets and save the world from a second Great Depression.
Steven Pearlstein can be reached at firstname.lastname@example.org.