Tag: Federal Reserve

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Lehman’s Lasting Legacy on the Federal Reserve

Lehman
Photo: David Shankbone / CC BY-SA (http://creativecommons.org/licenses/by-sa/3.0/). Image has been modified.

It has been only a little over a decade yet it feels like a century ago perhaps because it also feels like the latest iteration of the Gilded Age. On September 15, 2008, Lehman Brothers filed for bankruptcy. In (this summary of) his paper, Laurence Ball (2016) asks, “Why did the Federal Reserve [Fed] let Lehman Brothers fail?” He follows with, “Fed officials say they lacked the legal authority to rescue the firm, because it did not have adequate collateral to borrow the cash it needed.” He (p2) writes, “According to Bernanke (FCIC testimony, 2010): ‘[T]he only way we could have saved Lehman would have been by breaking the law, and I’m not sure I’m willing to accept those consequences for the Federal Reserve and for our systems of laws. I just don’t think that would be appropriate.’”

Ball (p2) disputes the Fed’s official line and Bernanke’s explanation. Instead, Ball concludes “that the explanation offered by Fed officials is incorrect, in two senses: a perceived lack of legal authority was not the reason for the Fed’s inaction; and the Fed did in fact have the authority to rescue Lehman.” He argues that, based on a de novo examination of its finances, Lehman did have enough collateral and that the Fed prevented it from using the Primary Dealer Credit Facility (PDCF).

The sensitivity around this question is that Lehman’s failure was a cataclysmic event for financial markets and for the global economy. If the Fed had allowed it to fail on dubious grounds, it would reflect a gross error in judgment and even incompetence. Ball (p3) states, “The record also shows that the decision to let Lehman fail was made primarily by Treasury Secretary Henry Paulson,” even though this is the Fed’s purview not the Treasury’s, and the decision was made presumably considering political sensitivities. (You might also recall that Paulson was the former chairman and CEO of Goldman Sachs, a competing investment bank, and if there were any ulterior motives, that would have been corruption.)

Therefore, the primary questions are: Why did the Fed not rescue Lehman? Did it have the legal authority to do so? Did Lehman have adequate collateral available? Were there political or other reasons for the decision?

The Complexities  

In fairness to the Fed, it can get sued, and it has. Most notably, it got sued by former AIG CEO Maurice “Hank” Greenberg, who after a fair amount of drama lost his case with the court ruling that he did not have legal standing to pursue it. Instead, AIG did, and it had declined to do so. (In case you are interested in listening to Greenberg’s side of the story.) The prior ruling, in June 2015, had ruled in Greenberg’s favor but awarded no damages, and as Moyer (2017) reports the court stated that “the Federal Reserve had overstepped its authority in taking the stake in A.I.G.”

Thus, if the Fed indeed had legal concerns, the ensuing events would suggest that they were reasonable and legitimate. Also, in the United States, rehypothecation of collateral (repledging) is limited by Rule 15c3-3 of the SEC, but the United Kingdom had no such restriction. Lehman’s bailout would have included its foreign subsidiaries including its UK-based broker dealer. Thus, in terms of the counterfactual, had collateral been posted, it is uncertain who or which institution would have had final claim to it: other holders of the collateral or the Fed.

This potential concern for the Fed seems supported by Ball’s (p5) description of its actions, “The entity that Barclays almost purchased on the 14th, and which famously filed for bankruptcy on the 15th, was Lehman Brothers Holdings Inc. (LBHI), a corporation with many subsidiary companies. Most of these subsidiaries also entered bankruptcy immediately, but one did not: Lehman Brothers Inc. (LBI), which was Lehman’s broker-dealer in New York. The Fed kept LBI in business from September 15 to September 18 by lending it tens of billions of dollars through the Primary Dealer Credit Facility; after that, Barclays purchased part of LBI and the rest was wound down.” Also, LBI was heavily involved in the repo market, with its book still relatively intact perhaps due to access to the PDCF, and LBI’s disorderly unwinding might have been detrimental to the important money market.

Prior to Lehman’s failure, the Fed managed the sale of Bear Stearns, another failed investment bank, to JPMorgan Chase. The Fed subsequently set up the PDCF. (Another question that remains perhaps even more of a mystery is why Lehman did not avail itself of the PDCF earlier when its insolvency would not have been in question.) The Fed’s intervention in AIG involved a considerable equity stake, as the corporation was effectively nationalized. Thus, these two outcomes, managed sale and nationalization were not bailouts in the sense of what was to come.

Lehman – The Lesson Learned

Lehman’s bankruptcy triggered a credit crunch, and the Fed’s reaction was an alphabet soup of “special facilities,” including ones for the money market mutual fund industry, which experienced a run, and commercial paper, which froze. The Fed effectively backstopped trillion-dollar industries and provided trillions of dollars in additional support to various institutions. The knee-jerk reaction suggests that the Fed and others underestimated the impact of Lehman’s failure, and in its aftermath, decided to dramatically reverse course to a “whatever-it-takes” approach.

Lehman – The Lesson to Unlearn

The last lesson needs to be unlearned. As it turns out, what we have really learned is that moral hazard is a serious concern that has not been adequately considered or appreciated. The correct approach is to either allow firms to file bankruptcy or truly nationalize them. The focus of bailouts should be people not corporations. The American people’s tax dollars are not a piggy bank for irresponsible corporations. They are its collective contribution to build a better society for themselves.

Dramatically reversing course from what was once a more free-market ideology to a bastardized version of Keynesian economics takes the American economy and people from one extreme to another. This legacy of Lehman’s downfall is rearing its ugly head as the Fed bails out entire industries and corporations with no restraint and no accountability during this present crisis. It was irresponsible and immoral then, and it still is now. The American people deserve better.

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Symmetric Storm, Asymmetric Shock and the Immorality of Fed Policy

Fed
Photo: Alec Favale on Unsplash

Some have called it “the great equalizer.” In some ways, this is an accurate description. The pandemic does not discriminate, although certainly some people are more vulnerable to the disease. One could also describe the coronavirus pandemic as a symmetric storm, one that is howling across the world so fiercely that some are wondering if they are, in fact, hearing the harbinger of the apocalypse. However, the effects of the pandemic, like previous crises, are not symmetric but instead, have resulted in an asymmetric shock.

The response of the “technocratic class,” in true elitist fashion, has also been anything but symmetric. It has been a moral failure of monumental proportions. However, this is nothing new; it is just a new low. For decades, the elite in the United States and around the world have been more preoccupied with advancing their own political, academic and professional careers than about the people they are privileged with the responsibility of serving, the people whose interests they have a moral obligation to protect and to promote.

Instead, central banks and other institutions around the world have created policies that cater to the powers that be, multinational corporations and the rich. Understandably, monetary policy is difficult for many people to understand beyond basics, such as the lowering and raising of interest rates, its theoretical effects on inflation and unemployment and, perhaps, a general understanding of the mechanisms with which central banks implement the policy, what was, in the United States, known as open market operations.

Fed Response 2008

In response to the financial crisis of 2008/9, the United States central bank, the Federal Reserve (Fed), started using a set of monetary policy tools that fall under the umbrella of unconventional monetary policy. One of these policies is known as quantitative easing. It should be noted that these are experimental policies (the Japanese experience notwithstanding), and the experiment is clearly failing. Prior to the financial crisis, the Fed maintained a balance sheet that was around 800 billion.

After hitting the zero-lower-bound, meaning interest rates could not be lowered any further (aside from negative interest rates, a topic for another day), the Fed resorted to quantitative easing. They began purchasing assets not to target short-term interest rates, money market rates, such as the fed funds and the repo rates, but to lower longer-term interest rates.

Fed – Interest Rates and Morality

The Bible clearly prohibits usury, more precisely, charging interest at all; for example, “If you lend money to one of my people among you who is needy, do not treat it like a business deal; charge no interest,” Exodus 22:25, and “Do not charge a fellow Israelite interest, whether on money or food or anything else that may earn interest,” (Deuteronomy 23:19).

McCleary and Barro (2019, p11) in their book, The Wealth of Religions (support your local bookstore), wrote the following with respect to the secularization hypothesis: “Secularization applied to some aspects of John Calvin’s city of Geneva and its regulation of economic activity, especially the distinction doctrinally made between interest and usury. Interest was an economic necessity for commercial and financial transactions and was allowed by the authorities. The maximum interest rate, set at 5 percent, was regulated by the Genevan government and the Consistory, a corporate religious-moral committee of the government whose judgments were enforced by the city council…”.

Interest rates above the regulated rate were considered usurious; however, they explain that this was raised to 6.7 percent while Calvin was still living and to 10 percent after his death. With these and related actions, the city of Geneva apparently liberated itself from the theological restriction and began what they describe as “the secularization of economic activity in Geneva.”

Another way to describe it would be, thus began the unleashing of unbridled capitalism. The immorality of usury is obvious. One only has to look at its modern manifestations, such as Payday loans. Even the actions of the recently deceased former Fed Chairman Paul Volcker who raised interest rates to control inflation, an action which predictably led to a recession, should be reexamined to possibly find a better approach.

The immorality of the opposite of high interest rates, low interest rates, particularly for an extended period of time, has not been adequately discussed or perhaps even considered. Volcker’s successor, former Fed Chairman Alan Greenspan depended on this form of management to prop up financial markets and, arguably secondarily, the real economy, which has had various negative effects, such as asset price bubbles, excessive speculation and crises among others.

Fed – Bailouts

In more recent years, financial markets have become dependent not only on perpetually low interest rates but also on eye-popping amounts of central bank intervention, trillions of dollars, often in the form of “special facilities,” financial/legal vehicles that the Fed has been using to circumvent its requirement to hold only government-issued (T-bills, Treasuries, etc.) or government-backed (Agency MBS) securities. (The exact totals of “bailout” money, regardless of whether it is on the balance sheet or in special facilities, depends on how one counts it and what the Fed has been willing to disclose. It should be required to disclose it all.)

Not only are the Fed’s policies causing imbalances and other issues, but the key question is: why are the very corporations that have been causing our economic and financial problems being bailed out with trillions of dollars while the American people are suffering and being abandoned by the institutions that are supposed to be serving them? These central bank actions (both here and abroad) are exacerbating the asymmetric shock on the rich and the poor, on richer and poorer countries.

The Fed will attempt to provide pacifying, pseudo-intellectual arguments to justify these grossly immoral actions. They cannot obfuscate the truth. The institution is failing the American people whose taxes are being used in ways that are detrimental to their interests and contrary to how they should be used. This exploitation of the American people and corruption of the Fed needs to stop. The American people and people around the world deserve better from their institutions, their leaders and the “technocratic elite.”            

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