Asking the Wrong Question about the Lehman Brothers Collapse

Asking whether we should have bailed out Lehman Brothers is the wrong question

On the 5th anniversary of the start of the 2008 financial crisis, Andrew Ross Sorkin is one of many people wondering “What if the U.S. had rescued Lehman?“. People keep asking this wrong-headed question for two reasons, one of which is entirely forgivable and the other of which is not.

Begin with the facts: Government’s reaction to the financial crisis did not start with the decision to let Lehman fail. It began six months earlier when the government chose to bail out a similar institution with similar financial problems: Bear Sterns. This signaled to Lehman that they could continue with business as usual and the taxpayer would be there to rescue the lions of capitalism whenever called upon.

Government policy was thus to bail out one investment bank and then six months later refuse to bail out a similar investment bank. Why do so many people only ask why the government didn’t bail out Lehman and so few ask why it bailed out Bear Stearns?

Let’s deal with forgivable reason first. Psychologically, it is easier to speculate about “what might have been” regarding something that did not happen than something that did. We know what happened when the government bailed out Bear Stearns; we will never know what would have happened if the government had bailed out Lehman. The absence of certain knowledge gives our imagination more running room. ‘Twas ever thus in the human mind, and therefore not to be castigated.

But the other reason is less forgivable: The sense of entitlement of the people who run Wall Street. In their world view, when they take risks for profit and end up losing, a taxpayer bailout is only right and just. The bailout of Bear Stearns thus requires no explanation, Indeed, second-guessing it would be an act of lese-majesty. On the other hand, if the government dares to hold the masters of the universe responsible for their stupidity and cupidity as it did at Lehman Brothers, then the bankers deserve an immediate explanation (accompanied of course with a forelock-tugging apology).

Author: Keith Humphreys

Keith Humphreys is the Esther Ting Memorial Professor of Psychiatry at Stanford University and an Honorary Professor of Psychiatry at Kings College Lonon. His research, teaching and writing have focused on addictive disorders, self-help organizations (e.g., breast cancer support groups, Alcoholics Anonymous), evaluation research methods, and public policy related to health care, mental illness, veterans, drugs, crime and correctional systems. Professor Humphreys' over 300 scholarly articles, monographs and books have been cited over ten thousand times by scientific colleagues. He is a regular contributor to Washington Post and has also written for the New York Times, Wall Street Journal, Washington Monthly, San Francisco Chronicle, The Guardian (UK), The Telegraph (UK), Times Higher Education (UK), Crossbow (UK) and other media outlets.

43 thoughts on “Asking the Wrong Question about the Lehman Brothers Collapse”

  1. “…if the government dares to hold the masters of the universe responsible for their stupidity and cupidity as it did at Lehman Brothers…”

    I’m glad I’m not holding my breath on that one. AFAIK, no one at Lehman Bros has been held legally accountable, at least per the NY Times:
    http://dealbook.nytimes.com/2013/09/08/inside-the-end-of-the-u-s-bid-to-punish-lehman-executives/

    Why no perp walk for Lehman Bros execs when a $10 bag of weed all but guarantees that in many states in the Union? Well, that’s the face of justice — and injustice — in America. Steal a little and you go to jail. Steal a lot and you merely get the opportunity to do it again while enjoying the fruit of your ill-gotten gains. And don’t steal at all, but just prefer a smoky buzz to the alcohol jangle and — well you need locked up because you’re a real threat to public order.

    So these Lehman Bros execs may indeed have a case for why the government should have stepped in and bailed them out. They’re apparently no more criminal than anyone else on Wall St, so why should the government start picking winners and losers that way and leave them out of being rewarded for their behavior? It’s just not fair, don’t ya know?

      1. Maybe. Six or seven generations back, according to dad, who keeps the family genealogy. But my greatest influence is from deceidely more red-necky regions of the country. I just like to go colloquial when things get stuffy in here.

        BTW, pity the hard times that former Lehman Bros execs have fallen on…
        http://www.nytimes.com/reuters/2013/09/17/business/17reuters-lehman-gregory-auction.html?hp

        I’ll bet they still don’t quite qualify for foodstamps…oh wait, nevermind, no one else will either if Congress gets its way.

  2. I thought it was telling that the moral hazard so many pundits fretted about was that people who took loans they shouldn’t have might get bailed out. The real moral hazard was the bankers seeing that TBTF was real and there were no consequences for their actions beyond a decline (possibly temporary) in their portfolios. Their behavior during the bubble years was largely validated. Their expectation that they could go to Uncle Sammy for help was confirmed. Lehman was an exception (and one many bankers will see as unjust, because the rest of them got bailed out).

    THAT is moral hazard.

    Saving the financial system had to be done. I’m still torn as to whether the best way would have been: a) bailout similar to the one that was done, coupled with aggressive investigation and prosecution by the SEC and/or other regulators; or b) nationalize the failed banks temporarily, coupled with aggressive investigation and prosecution. I’m leaning toward b. That would have really sent a message to the bankers. Screw up monumentally and not only will you suffer financially and possibly legally, but you will be further humiliated by having the government take over your bank. Given how ego-driven these guys seem to be, I think that last bit actually has bite.

    1. Until the passage of Dodd-Frank the government didn’t have the legal authority to nationalize the failed banks. It could only do so with commercial banks or S&Ls. Bear Stearns was a pure investment bank with no commercial operation. The same was true of Lehman. AIG was an insurance company. So your option B was not possible.

      The problem with your option A is that proving financial crimes is hard. As the link Mike provided goes through, the threshold of materiality is difficult to define and, in the case of Lehman, quite possibly was not met. Holding an individual responsible is even more difficult as you have to be able to prove that that individual had specific knowledge and intent.

      As I point out frequently it’s not true that the feds never prosecuted anyone over the financial crisis. The problem is that they did prosecute a few people and they lost the cases. That caused the regulators to overhaul the requirements a case had to meet before they would file it. Evidence that we would consider damning turned out not to satisfy juries. In one particular case, prosecutors presented emails in which the defendants discussed the fact that they were ripping off their customers. It didn’t matter; they were acquitted anyway.

      1. The power of eminent domain is an inherent power of the sovereign state. There’s no need for any legislation at all for the government to simply take over a failed business with a fair market value of 0$, such as Lehman was at the time. You only need authorizing legislation if takeovers are going to be allowed without fair market compensation as part of a broad regulatory scheme.

        1. THAT would require a constitutional amendment, not just legislation, I should think. The 5th amendment doesn’t appear to make any exception for “broad regulatory schemes”, and you’d be hard put to argue that simply taking a business over wasn’t a taking.

          Even failed businesses usually have some sort of salvage value.

        2. All I can say is that you have no concept of the legal issues involved. Had the feds tried this they would have been sued and had their heads handed to them by any judge hearing the case.

          1. In which case don’t bail them out. I understand that the government can generally just not step in and seize businesses; again you are missing the actual issue here, which is what the government can do in return for a check.

          2. The problem is that the people whose approval you would need in order to take the business, namely the shareholders, are not the same ones who would be receiving the check you posit. They have no incentive to agree to your plan.

      2. “Until the passage of Dodd-Frank the government didn’t have the legal authority to nationalize the failed banks. It could only do so with commercial banks or S&Ls. Bear Stearns was a pure investment bank with no commercial operation. The same was true of Lehman. AIG was an insurance company. So your option B was not possible.”

        ‘You want the money, you sign this contract’.

        “he problem with your option A is that proving financial crimes is hard. As the link Mike provided goes through, the threshold of materiality is difficult to define and, in the case of Lehman, quite possibly was not met. Holding an individual responsible is even more difficult as you have to be able to prove that that individual had specific knowledge and intent.”

        Wrong. It’s not the case that *not everybody* was convicted, it’s the case that *nobody* was convicted, a 100% failure rate.

        1. Well, yes. The DoJ had a 100% failure rate in the cases they took to court. And the cases they prosecuted were the ones that they thought were the strongest.

          So, what is it that you think an ethical prosecutor should do with the cases that he doesn’t think are as strong after the first ones led to acquittals?

          1. “And the cases they prosecuted were the ones that they thought were the strongest.”

            That’s a strong statement, and assumes that the prosecutors were trying.

      3. Thanks for the info. I didn’t know that (regarding nationalization). I do understand that proving financial crime is hard, but this:

        In one particular case, prosecutors presented emails in which the defendants discussed the fact that they were ripping off their customers. It didn’t matter; they were acquitted anyway.

        is all sorts of depressing. Well, we’re screwed then.

        What did they do in the 1930s? Called folks before Congress and grilled them, right? This time, they called them before Congress and Congresscritters volunteered for ball washing duty.

        1. BTW, (Matt Taibbi?) had an article in the Rolling Stone about the revolving door between the SEC and the financial legal defense industry; they’re openly in bed together. The article stated that moving multiple times between the two allegedly antagonistic groups was the norm.

          ” The problem is that they did prosecute a few people and they lost the cases. That caused the regulators to overhaul the requirements a case had to meet before they would file it. Evidence that we would consider damning turned out not to satisfy juries. In one particular case, prosecutors presented emails in which the defendants discussed the fact that they were ripping off their customers. It didn’t matter; they were acquitted anyway.”

          You do understand the difference between ‘a few’ and ‘many’?

          1. Matt Taibbi likes to pretend that he understands any subject that he decides to write upon. In the case of finance, he was mistaken. He really has no idea what is involved.

  3. Why do so many people only ask why the government didn’t bail out Lehman and so few ask why it bailed out Bear Stearns?

    Because the Bear Stearns bailout “succeeded” (for certain values of success).

    Moral hazard was baked into the cake long before the Bear Stearns bailout, and the Lehman non-bailout didn’t do anything materially to change that – but the failure to deal with Lehman had a really bad effect on the overall economy.

    “Too big to fail” is a phrase that has a real meaning. If you let an institution’s survival become crucial to the health of the economy, you can’t let them fail. Of course, as Professor Humphreys says, the sense of entitlement of those bailed out is offensive and shouldn’t have been accommodated. Lehman needed to be resolved in some kind of orderly fashion, and the malefactors needed to be jailed.

    1. “Too interconnected to fail” is preferred by some observers to “too big to fail.” Lehman was connected to so many other financial institutions that its failure was certain to affect them as well in an avalanche-like manner. This usage frames the question differently and suggests different remedies. Size and interconnectedness are correlated but not identical. When no one can map the connections accurately you have the potential for panic.

      1. Yeah, I think “interconnected” is a better word. I am actually skeptical of the “too big to fail” concept, and was using it as shorthand here. The financial system itself is too big to fail, no matter the size of the individual components in that system.

        The problem with “too big” is a problem of political economy. I think it’s possible the financial system would not have become so screwed up if the actors in it were more fragmentary, and thus less politically powerful.

  4. the malefactors needed to be jailed

    Thankfully, losing money when everyone else thought you were a sure thing to make money isn’t (yet) a crime.

    1. Losing money isn’t a crime. Fraudulent accounting, insider dealing, and failing to disclose materially relevant information, however, can be.

        1. I’ve noted here as well that I’m an insurance professional; it’s certainly no secret.

          I don’t think, though, that my attraction to the idea that being mistaken about the future is not a crime has a great deal to do with that fact.

          1. Sam, if you knew *anything* about the Crash, you’d know that vast quantities of instruments were sold as AAA, even though they’d be worthless in the case of the housing bubble leveling off, and that *massive* numbers of documents were fraudulently notarized, in some instances with the same handwriting as the seller, buyer and notary. And by ‘massive’ I mean thousands per company.

  5. Government’s reaction to the financial crisis did not start with the decision to let Lehman fail. It began six months earlier when the government chose to bail out a similar institution with similar financial problems: Bear Stearns. This signaled to Lehman that they could continue with business as usual and the taxpayer would be there to rescue the lions of capitalism whenever called upon.

    I don’t think this is actually true. The collapse and bailout of Bear Stearns, whether good or bad, was felt by Bear Stearns personnel as a personal and professional calamity. Is there any evidence that anyone in Lehman saw what happened to Bear Stearns and said, in effect, “Oh, that would be fine” and then acted on that basis?

    For what it’s worth, my understanding is that Lehman’s 2008 collapse was caused by its substantial long position in subprime mortgage securities, a position which it had built up well before the collapse of Bear Stearns in 2007-2008. In other words: the risk taking that led to the Lehman collapse happened well before the Bear Stearns collapse, and could not have been affected by the government’s response to the Bear Stearns collapse.

    1. I am travelling and can’t find it alkali, but Lehman executives were quoted as saying they expected a government bailout and that is part why they held out when suitors contacted them to buy them out.

      1. That might be right, but that decision was a different issue from the bad decisionmaking that got them in trouble

  6. Your understanding is correct in its essence, but overlooks the overwhelming factor–leverage. From Wikipedia:

    Lehman borrowed significant amounts to fund its investing in the years leading to its bankruptcy in 2008, a process known as leveraging or gearing. A significant portion of this investing was in housing-related assets, making it vulnerable to a downturn in that market. One measure of this risk-taking was its leverage ratio, a measure of the ratio of assets to owners equity, which increased from approximately 24:1 in 2003 to 31:1 by 2007. While generating tremendous profits during the boom, this vulnerable position meant that just a 3–4% decline in the value of its assets would entirely eliminate its book value or equity. Investment banks such as Lehman were not subject to the same regulations applied to depository banks to restrict their risk-taking.

    Wikipedia has a pretty good summary of the whole sordid affair:
    http://en.wikipedia.org/wiki/Bankruptcy_of_Lehman_Brothers

  7. This bears repeating: “While generating tremendous profits during the boom, this vulnerable position meant that just a 3–4% decline in the value of its assets would entirely eliminate its book value or equity. Investment banks such as Lehman were not subject to the same regulations applied to depository banks to restrict their risk-taking.”

    How hard is it to have a 3-4% decline in asset value? The people running it (and most of Wall St) basically pushed it until it broke, because until then, the more they pushed it, the more they made.

  8. J. Michael Neal says:

    “Matt Taibbi likes to pretend that he understands any subject that he decides to write upon. In the case of finance, he was mistaken. He really has no idea what is involved.”

    I wouldn’t be surprised, but the major fact was the revolving door, and any competent journalist should be able to get that right. Again, you don’t seem to be able to spot key issues, do you?

    1. Actually, the main issue was not the revolving door. Taibbi was factually wrong, to the point that I suspect he was being dishonest rather than merely mistaken, in several of the articles he wrote about the lack of prosecution. If you want another take on Matt Taibbi, find some of the things Mark Ames has said about him.

        1. You are correct. No CEOs were prosecuted*. Exactly how many times do I have to explain this? The way that the rules of evidence work in the American legal system it is very difficult to tie top executives to specific acts. It is difficult to prove fraud (which as a legal term differs fairly dramatically from its colloquial usage) to begin with. After that you need to prove beyond a reasonable doubt that the CEO both knew about specific actions and knew that they were fraudulent. It is not enough to prove that he was in charge of the company. It is not enough to prove that he suspected or even knew that fraud in general was taking place. You must tie him concretely to specific acts.

          In the case of Lehman, which was the company mentioned at the top, you don’t get past the first hurdle. As goofy as it sounds, Repo 105 wasn’t accounting fraud. They found a loophole in the rules for accounting for debt. The problem is that it is a very complicated subject and it’s next to impossible to write rules that don’t have openings someone can find. Filling all of these holes would require a complete change in how accounting rules work under GAAP. IFRS, the international standards, is more principles based and so more flexible in preventing loopholes. Before anyone gets excited about that, though, not only would it take an act of Congress to change the basis of U.S. accounting rules, a principles based system has plenty of downside of its own.

          So Lehman is out. As I said, the DoJ tried to prosecute traders that were involved in concocting some of the bonds that went bad. These were the people who directly made the decisions that you consider to be fraudulent. These are the ones that have a paper trail directly linking them to the actions. This is the paper trail in which the traders talked to each other about how they were misleading their customers. These are the guys that were acquitted. The jury was of the opinion that deliberately misleading their customers did not meet the legal standards to constitute fraud. This was basically due to questions of materiality; essentially, the government was unable to prove that the customers wouldn’t have bought the bonds had they known the true information.

          In the case that Goldman settled for several hundred million dollars, the weakness in the government’s case (and why I was kind of surprised that they got a settlement at all) was that there was evidence that the primary customer, a German bank, wouldn’t have cared had they known the true origin of the security. That’s because their primary concern was fitting through a loophole in German banking regulation that required a very specific kind of security that they could treat as Tier 1 capital. They were also buying bonds that they knew were crappy, and so there’s a big chance that decent defense lawyers (of which Goldman has a few) could have broken the case on materiality had it ever gone to trial.

          All told, there’s no reason to think that prosecutions would lead to convictions. I don’t care how convinced you are that crimes occurred. I’m pretty damned sure they did, too. That has nothing to do with whether any of it can be proved to a jury’s satisfaction.

          *That sort of depends upon how broadly you define “financial crisis”. At around the same time, Justice prosecuted Henry Samueli, the CEO of Broadcom, for backdating options. This was another case in which they had emails in which Samueli discussed what he was doing. When the jury came back with an acquittal despite evidence in which the defendant admitted to committing the crime he was charged for it changed the attitude towards prosecution at both the SEC and the DoJ. The sorts of events that they would prosecute for narrowed drastically because they didn’t think they could get convictions on anything complicated. And that’s what ethical prosecutors are supposed to do; if you don’t think you can convict, do not prosecute.

          1. A tip of my cap to J. Michael for a coherent explanation.

            I believe a lapse in strict application of the rules of fiduciary responsibility leaves the government essentially powerless in many cases. Here’s a short paragraph from the Cornell University Law School:

            A fiduciary duty is a legal duty to act solely in another party’s interests. Parties owing this duty are called fiduciaries. The individuals to whom they owe a duty are called principals. Fiduciaries may not profit from their relationship with their principals unless they have the principals’ express informed consent. They also have a duty to avoid any conflicts of interest between themselves and their principals or between their principals and the fiduciaries’ other clients. A fiduciary duty is the strictest duty of care recognized by the US legal system. Examples of fiduciary relationships include those between a lawyer and her client, a guardian and her ward, and a director and her shareholders.

            I believe when we began tearing down the barriers between banking and insurance, and the barriers between banking and brokerage, we began weakening our ability to enforce that “strictest duty of care,” and that the resulting chaos in banking was the inevitable result of allowing the bankers, brokers, and insurers, to have conflicting objectives.

          2. Ken Rhodes–can you expand a bit on this point? It’s intriguing, but I’m having a hard time making sense of how the mixture of (traditional/commercial)banking, security brokerage, and insurance–none of which had fiduciary duties to my knowledge–weakened the ability to enforce fiduciary duties of care.

          3. I misremembered the Samueli case a bit. That case never reached a jury. Samueli pleaded guilty but a judge tossed out the plea and dismissed the case.

          4. There are definitely cases where I think the standards of fiduciary responsibility should be applied. On mortgage brokers is one. On the whole, though, that wouldn’t have prevented the financial crisis.

            One thing that I don’t think enough people realize is that the outright lying about the quality of mortgage securities was mostly a feature of the late stages before the bubble burst. Even without it the collapse would have been pretty severe.

            For most of the buildup period, the people involved at all levels weren’t lying. Instead, they were badly, badly mistaken. They really believed their own bullshit. I remember a meeting with some guys from New York while I worked for Citi in the summer of 2005. They were out trying to tell us how to use information about corporate bonds to help us hedge positions. (I was a trader in the options market making operation at the time.) Along the way they explained how they were using nickel puts to eliminate the risk of low rated corporate bonds going bad. Their claim was that they had found an arbitrage opportunity in that the puts completely insulated them from bankruptcy risk while costing so little that it locked in junk bond rates.

            That was the moment I realized that everything was going into the tank at some point in the not-to-distant future. I didn’t take the time to figure out what was wrong with their strategy. I still haven’t bothered. All I knew was that the company was full of people who thought that they’d eliminated risk and were left with huge profits. When looked around I kept finding people who thought they’d done the same within whatever niche they worked in.

            When they tried to sell these products to people they really thought they were safe. Not all of them, but by far the majority until late in the process. One of the things that means is that there was no fraud in these instances. To be fraud, you have to deliberately say something that you know to be false. These idiots thought they’d found the risk-free Holy Grail that all of their finance professors had told them doesn’t exist.

            The really depressing thing is that the finance industry seems to do this every ten years. The 1987 crash was the result of thinking they’d found the Grail with portfolio insurance. The 1997 crash was the result of LTCM thinking that they’d found it in correlations. And the 2008 insanity was the result of lots of people finding lots of different ways to eliminate risk.

            Again, this isn’t true of everyone involved but this is very much a case where stupidity is a better explanation than malice.

  9. Ken Rhodes: “I believe when we began tearing down the barriers between banking and insurance, and the barriers between banking and brokerage, we began weakening our ability to enforce that “strictest duty of care,” and that the resulting chaos in banking was the inevitable result of allowing the bankers, brokers, and insurers, to have conflicting objectives.”

    I think that this is what’s happened (guess what – the Federalist Society’s project of changing laws through the judiciary has been successful). I recall a case where Goldman Sachs played both sides of a game with a client, brokering a deal while working with the third party to screw over the second party, and it didn’t matter. People like G-S aren’t under the law.

    1. I’m pretty sure that the Goldman case you are referring to is the same one I mentioned above where the customer was the German bank. As I said, this probably wasn’t fraud in the legal sense anyway and trying to prove that it was once good defense attorneys were involved would likely have been a waste of time.

  10. The premise of this post confused me.

    I could not recall, nor find any evidence that the Federal Reserve or the US Treasury *put any money* into Bear Sterns.

    The ‘bailout’ a la Long Term Capital Managmement, consisted of arranging its quick sale to JP Morgan.

    With Lehman Brothers the same situation: the Treasury tried to arrange a purchase by Barclays. The sticking point was the 3 week rule (Barclays, by UK Law, needed to consult its shareholders, giving them 15 working days to reply, and first pass (preemptive rights) at any equity issuance to make the purchase). Barclays demanded price protection for those 3 weeks– normal in a corporate finance situation (ie if Lehmans piled up huge losses, Barclays would not have to carry those). The US Treasury refused, arguing it had no legal right so to do– neither could the Fed, because Lehmans was not a commercial bank and part of the Fed system.

    What evidence is there that the US government put money into a Bear Sterns bailout? (genuine question)

    Because if it did not, then that undermines the whole premise of this post and thus the whole argument.

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