Friday, August 19, 2016

Lehman Brothers should have been saved

One of the biggest controversies around the financial crisis of 2008 is about the decision to let the investment bank Lehman Brothers fail.

The moment that happened, it was as though somebody had dropped a bunker-busting bomb on a shaky and dilapidated building. The money market mutual funds, on whom the banks depended for short-term funds, withdrew their funding raising the prospect of the collapse of the financial system. It required a series of bailouts, including that of insurance giant AIG, and the guaranteeing of money market mutual funds' investment in banks, to rescue the system.

One argument trotted out at the time was that the US Treasury Secretary Hank Paulson wanted to send out a clear message on moral hazard to big players: no more rescues. However, since further rescues followed the failure of Lehman, that argument has worn thin. The official position since has been that the Fed simply could not provide liquidity to Lehman because it was not solvent and could not provide the necessary collateral. The Fed would violated the laws applicable to it had it tried to save Lehman.

Larry Ball of Johns Hopkins has done a brilliant analysis of the Lehman failure and he finds that the arguments don't stand up to scrutiny. He believes that Lehman was allowed to fail because the US Treasury and the Fed didn't quite anticipate the disastrous consequences that would follow. He also contends that the Fed has failed to provide the necessary documentation to substantiate its contention that Lehman wasn't solvent at the time.

More in my article in the Hindu, The cost of political interference

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