How Global Financial Crisis of 08 was fueled by the US administration

Fed could have saved Lehman Brothers from failing under Section 13 (3) by extending PDCF that it did to other banks, and a different long-term resolution of the firm would have helped the global financial crisis from worsening.

The views below are based on my understanding of The Fed and Lehman Brothers by Ball. The article reviews the book and tries to draw conclusion from the stated facts.

The Fed and Lehman Brothers book by Laurence M. Ball shows that Lehman’s failure could have been avoided, and the policymakers weren’t restricted to provide liquidity support under Section 13 (3). Section 13 (3) in 2008 provided the Federal Reserve bank with greater flexibility to make a loan to non-depository institutions. In 2008, the board could allow a loan if the following three agreements were met[1]:

• The Board must find that “unusual and exigent circumstances” exist.

• The Reserve bank must “obtain evidence that [the borrower] is unable to secure adequate credit accommodations from other banking institutions.”

• The loan must be “endorsed or otherwise secured to the satisfaction of the Reserve Bank.”

The book asserts that the Lehman met the first and second requirements and the tricky part was the third criterion–the criterion that Fed officials often quote. Fed Officials in many settled arguments mention that the financial institutions fulfilled the last criterion for all the lending they provided in 2008, such as rescuing Bear Stearns and AIG.

The book categorically points out two other significant features of Section 13 (3) as it stood in 2008. The first is related to “solvency” and the second is related to “authority”. This section didn’t require that the borrowers be solvent, and the author uses the point to further argue that the concept of solvency is not the same as the satisfaction of the Fed. The authority over the Fed’s lending decisions to make a loan under this section was with the Fed’s Board of Governor.

The book examines the financial condition of Lehman by analyzing its balance sheet and makes a note of bankruptcy destructing the valuation of the bank. The author argues that the bank was solvent contrary to Fed official’s claim that Lehman insolvency was a factor in their decision not to rescue the firm.

The book counters evidence from Valuka’s report that uses “market-based solvency analysis” by the accounting firm of Duff and Phelps[2] in place of comprehensive value analysis.

Solvent if market value of equity > [book value of liabilities] — [market value of liabilities]

The author stresses the accepted definition of solvency as a condition in which assets are greater than liabilities. Duff and Phelps report argues that the firm is solvent as long as the market value of equity exceeds the difference between the book and market value of its liabilities. The book considers that as a flawed analysis because the prospect of bankruptcy may drive down the market value of equity to be zero and the value destruction associated with the bankruptcy will erode the market value of liability, thus making the right-hand side positive.

The book analyzes the balance sheet of the Lehman Brothers, considers overvaluation, and uses analysis of Lehman’s valuation by other financial institutions such as Bank of America and Barclays to claim that the bank was solvent.

As per Federal Reserve act in 2008, the sole authority to land or not land as per Section 13 (3) rested with the Fed’s Board of Governor. The book describes various events and quotes to make a point that Treasury Secretary Henry Paulson, who had no legal authority in the subject, took the decisions to let Lehman Brothers fail. The incidents of Secretary Geithner’s insistence on the Treasury support during Bear Stearns crisis and his acknowledgment “[w]hile it merely stated fiscal facts, I thought it gave us some cover implicating Treasury in the risk we were taking” also counters the argument made by Fed officials in the legal explanation of the third Point of Section 13 (3). If they handed out support to Bear Stearns on the pretext assets covered that the loans or arrangements, then what was the need for that letter? And if the underlying assets not covered risks, then why the same reasoning didn’t apply for Lehman? The book mentions as per Secretary Geithner’s account that “Hank forcefully repeated his no public money stand…” and “he did not want to be known as Mr. Bailout”. All the above accounts hint that the decision to not bail out Lehman was political and suggest that Fed officials needed Paulson’s approval to assist Lehman.

The book states various accounts of Lehman executives and Fed officials covered during the inquiries. Fed officials understood the severity of the crisis and were worried about liquidity challenges in the market. They broadened the acceptable PDCF collaterals on Sunday evening to help ease liquidity but ensured that the terms were not extended to Lehman. It’s stretching to accept General Counsel Baxter’s version of the chronology for PDCF as executives at Lehman gave a different version. Also, Lehman could have used the relaxed PDCF collateral to at-least save the bank from filing bankruptcy on Sunday evening. That LBI but not LBIE or LBHI used PDCF to borrow meant that the decision-makers understood the new provision of the PDCF. We saw later that Goldman Sachs and Morgan Stanley’s London broker-dealer similar to LBIE could borrow money from the facility.

LBI could have internally funded LBHI by using their assets as collateral in the PDCF but the Fed’s imposition of the Friday criterion limited company’s collateral to only those assets that were on its balance sheet on Friday, September 12th thwarted that option. The evening phone call to the board by the chairperson of SEC Christopher Cox and the event leading to it signal that the Fed officials were implementing a plan in which the Lehman brother calls for bankruptcy and then they advanced the PDCF relaxed guidelines.

The book mentions the motive behind those decisions such as fear of political backlash, political shielding, media coverage, etc. but the most striking evidence is from David’s Wessel “In Fed We Trust” quoting Paulson “I’m being called Mr. bailout. I can’t do it again”. Later in the aftermath of the Lehman crisis Sorkin relates[3]that Secretary Geithner was successful in persuading Paulson to change his mind this time and that led to the rescue of other banks.

[1] The website of the Board of Governors describes in its section on “Credit and Liquidity programs and the Balance Sheet”

[2] Valukas, pp. 1570–1587 and Appendix 21

[3] Sorkin, p. 396