We were on a train from London to Edinburgh when the financial crisis erupted in September 2008. The newspaper headlines were downright lurid and the detailed stories provided little comfort. A financial catastrophe was about to descend on all of us.
As relatively recent retirees, we felt particularly vulnerable. There’d be no time or opportunity to recoup losses and rebuild savings. Getting back into the workforce at anything resembling our previous levels would be difficult. Businesses would likely be shedding staff rather than hiring.
It made for anxious dinner conversation with our Edinburgh hosts that evening. They’d been following the BBC’s news bulletins all day and we all looked for whatever reassurance we could find in the reports of forthcoming decisive action on the part of the relevant authorities.
Now, 10 years later, economist Laurence M. Ball’s The Fed and Lehan Brothers argues that some of those authorities were part of the problem. While they didn’t create the underlying toxic situation, they botched the initial handling of it, thus inadvertently magnifying the subsequent panic.
Another economist, N. Gregory Mankiw, has succinctly described the two key tasks of a central bank: “The first is to adjust the money supply and interest rates as economic conditions change. The second is to help ensure the safety and soundness of the financial system. As part of this second task, central banks sometimes need to act as a lender of last resort.”
Even solvent financial institutions – where assets exceed liabilities – are susceptible to panics. Assets may not be immediately liquid and if all depositors or short-term liability holders suddenly demand their cash, the institution will be unable to pay. So the lender of last resort provides temporary funding to bridge the gap and arrest the panic.
But America’s central bank – the Federal Reserve System, or the Fed – didn’t step in as lender of last resort. Lehman Brothers, the country’s fourth largest investment bank, was allowed to fail, formally going bankrupt in the early hours of Monday, Sept. 15. The reverberations were felt around the world.
Like many other institutions, Lehman had bad real estate investments, the losses from which began to show up in 2007. However, these losses weren’t the direct cause of Lehman’s collapse. Instead, the problem was that lenders lost confidence and refused to renew the short-term loans on which Lehman’s operational model depended. It was, in Ball’s description, the 21st century version of a bank run.
The Fed’s stated rationale is that it lacked the legal authority. Lehman, the Fed says, didn’t have the requisite collateral to secure the loan.
By his calculations, Lehman was either solvent or almost so. And as these calculations are based on mark-to-market valuations – defined as the prices at which the assets could be currently sold – Lehman was “probably solvent based on its assets’ fundamental values.”
But selling assets in an orderly fashion takes time, which was a luxury Lehman didn’t have. With short-term lenders refusing to roll over Lehman’s debt, there wasn’t sufficient cash on hand to open for business on Sept. 15.
Why then was Lehman allowed to go under?
Ball can think of at least two reasons.
One was political. Treasury Secretary Henry Paulson was stung by criticism of the Bear Stearns rescue the previous March and didn’t want to be seen as the guy favouring messed-up banks. In his own words, “I can’t be Mr. Bailout.”
And the other was an error in judgment. Although “Paulson and Fed officials worried about the effects of a Lehman failure, they did not fully anticipate the severe damage to the financial system that it would cause.”
If it’s true that Paulson and the Fed made a bad situation worse, it’s also true that they didn’t create it. Nor, for that matter, can Wall Street be blamed for everything that went wrong globally. The experience of countries as disparate as Ireland, Iceland and Greece demonstrates that misplaced financial exuberance has many pedigrees.
For us, things eventually turned out fine.
Granted, there was an extremely uncomfortable six months as the equity portion of our retirement savings seemed to steadily melt away. But we made two early calls.
First, the particular businesses we’d invested in were fundamentally sound. And second, much of what was happening was indistinguishable from a mass panic attack and would thus subside.
Fortunately, we were right on both counts.
Troy Media columnist Pat Murphy casts a history buff’s eye at the goings-on in our world. Never cynical – well, perhaps just a little bit.