Books: The Fed And Lehman Brothers By Lawrence M. Ball

(Drivebycuriosity) - In some weeks we will commemorate the 10th anniversary of Lehman Brothers` bankruptcy.  The fall of the huge investment bank started a financial panic, destroyed trust into global financial institutions and send stocks in a downwards spiral which turned the recession into a global crisis. Lawrence M. Ball analyses the fall of Lehman in his book "The Fed and Lehman Brothers" (amazon). His message: The Fed could have helped Lehman survive and so would avoided the panic.

Lehman`s bankruptcy on September 15, 2008 was the moment when growing stresses in financial markets exploded into the worst financial crisis and deepest US recession since the 1930s. Ball claims that Lehman could have avoided a bankruptcy if the bank had received a sufficient loan from the Fed, he also asserts that the firm had plenty of collateral to secure such a loan. So Lehman`s rescue wouldn`t have cost the taxpayers anything.

According to Ball the fundamentals of Lehman´s finance did not dictate a bankruptcy because the bank had enough assets which could have been mortgaged. So Lehman was a viable firm that could eventually have regained the market`s confidence if it had been able to weather its 2008 crisis.

The book describes that Lehman only needed the kind of well-secured liquidity support that the Fed provided liberally to other financial institutions like Bear Stearns & AIG, Lehman´s bankruptcy was caused by a liquidity crisis driven by self-fulfilling expectations. Short sellers borrowed Lehman stocks and sold them immediately as a bet on further falling stock prices. Their sales - and accompanying comments - accelerated the fall of Lehman stocks and eroded confidence in Lehman Bros and other banks and so worsened the crisis. "In a speech he gave in May 2008, the prominent hedge fund manager David Einhorn criticized Lehman`s valuation methods, saying "I suspect that greater transparency on these valuations wold not inspire market confidence". Einhorn was, at the time, shorting Lehman`s stocks.

Falling confidence in Lehman was also exacerbated by negative press coverage. On June 11 2008, for example, Bloomberg published an article titled "Lehman independent for How Long?`In concluded wit a quote from an analyst : ´Lehman is next. when you have a pack of dinosaurs, the slowest get picked off". Journalists also expressed strong opposition to a public rescue of Lehman including Financial Times & Wall Street Journal. Influential politicians were against rescuing Lehman as well. Senator Obama and the Republican presidential nominee, John McCain, both expressed outrage about public rescues of private.

Lehman probably could have survived if the Fed had merely not taken actions to restrict its access to her own credit facility on September 14. The author explains that many so-called bailouts - including, the liquidity assistance that Lehman Brothers needed - are short-term loans from the Fed that are very likely to be repaid with interest. Even if a borrower like Lehman were to default, the collateral posted for the loan would protect the Fed and taxpayers from significant losses. Most important, Fed assistance can prevent a run from quickly destroying a financial institution, so the firm can either survive or be wound down in a controlled way that minimizes the damage to the economy. Such interventions by the Fed can prevent or mitigate recessions, and more people can keep their jobs.

To make it worse the Fed official did not merely stand by and allow Lehman to fall but intentionally took actions to force the bank into filing a bankruptcy decision. Finally Treasury Secretary Paulson, who was clearly in charge of policy deliberations, decided on September 14 that Lehman should declare bankruptcy and dictated that decision to Fed officials.

What could we learn from the financial panic? When a major financial institution experiences a run, but has collateral, the Fed should lend it the cash it needs to avert a sudden and disorderly bankruptcy. Unfortunately regulation - the Dodd-Frank Act from 2010 - significantly limits the Fed´s lending authority. According to Dodd-Frank the Fed cannot lend to an institution deemed "insolvent" or "failing"; any lending program must be designed for a substantial number of firms, not just one (like the rescues of Bear Stearns and AIG); and all lending must be approved by the Secretary of the Treasury. Under these rules, future Fed leaders may be helpless to counter runs on financial institutions and prevent unnecessary financial disasters.