Lehman Brothers: How Good Policy Can Make Bad Law

As we approach the 10-year anniversary of the failure of Lehman Brothers, the news is again awash in a debate about whether policymakers could have saved the investment bank.  That the issue remains so deeply contested reflects how fundamentally flawed the current legal regime is.  Although embodying ideas that are sensible in the abstract, the regime makes the authority to act contingent on facts that policy makers cannot readily discern during periods of systemic distress.  Making matters worse, subsequent events, including other actions by those same policy makers, can further skew the critical facts on which legal authority rests.  This is no way to design a crisis management system.

According to longstanding central bank folklore, roughly codified in today’s legal regime, central banks should help to contain financial panics, but they should provide support only to solvent institutions and only against good collateral.  Most of the time, these guidelines work well, helping to guard against moral hazard and protect central banks from credit risk.

The challenge is that crises usually do not erupt in regulated banks about which central banks have a good deal of information.  Precisely because banks are so heavily regulated, activity tends to migrate to less regulated domains, colloquially known as shadow banking systems.  For example, prior to the Crisis of 1907, which led to the creation of the Federal Reserve, activity moved from banks to bank-like trust companies.  It was in these trust companies that the crisis first erupted.  Similarly, all three of the systemically important institutions that sought aid from the Federal Reserve during the early phases of the 2007-2009 financial crisis—Bear Stearns, Lehman Brothers, and AIG—were not primarily banks.  Instead, they were part of the 2000s version of the shadow banking system, a massive system of market-based intermediation that had come to play a critical role in providing financing to households and firms and issuing deposit-like liabilities.  Hence, when each of these firms got into trouble, the Federal Reserve had only limited information about the health of that  firm and the quality of the collateral it could post.  This is bad news for a legal rule that places such a premium on making  determinations based on that information.

What’s more, hindsight here is not 20/20, a problem reflected in the ongoing debate about whether regulators had the legal authority to save Lehman Brothers.  Then-Federal Reserve Chairman Ben Bernanke and then-Treasury Secretary Hank Paulson have been steadfast in their claim that the firm lacked adequate collateral, and so they had no choice but to allow it to fail.  That Lehman Brothers’ creditors have received only 44 cents for each dollar they were owed would seem to support the notion that the firm was insolvent. The challenge is that forcing a large financial institution into bankruptcy during a crisis is a value-destroying proposition.  That Lehman’s creditors have not been made whole tells us little about what the firm would have been worth had it been able to continue operations.  This helps explain how esteemed economist Lawrence Ball, who painstakingly reviewed all available evidence, concluded that Lehman was indeed solvent when it failed, and the Fed could have saved it had it chosen to do so.

Turning the lens on firms that the Federal Reserve did help save, Bear Stearns and AIG, further illuminates the problem of using collateral quality and solvency as conditions for lawful action.  The core challenge here is that subsequent developments can have a first-order impact on both the value of assets accepted as collateral and the apparent health of the firms needing support.  More troubling still, the Fed’s own actions can be among the most critical determinants of the value of those assets and apparent firm health.

In the years following support for Bear and AIG, the Fed engaged in aggressive and creative actions to spur economic recovery.  Near-zero interest rates became the new norm, as did a ballooning central bank balance sheet, which included quantities of mortgage-backed securities.  Although there is little sign that the Fed took these actions to deflect scrutiny from its earlier decisions to help Bear and AIG, that was a side benefit.  The Fed’s subsequent monetary policy inevitably affects the value of existing debt instruments, and its program of quantitative easing provided particular support to the housing market and hence the value of existing housing-backed instruments.  We will never know what Bear Stearns’ assets posted as collateral would have been worth had the Fed not pursued such an aggressive policy.  Nor can we make any pronouncements about AIG’s solvency independent of the economic recovery the Fed helped make possible. In short, the actions that the Fed took after rescuing AIG and Bear may have been critical to making the collateral posted by those firms seem adequate to justify the central bank’s earlier actions.

If all of this seems complicated, it is.  Trying to figure out whether a federal regulator has legal authority to act during a time of crisis should not rest on facts that the regulator is unlikely to have and could later manipulate.  The current system encourages regulatory gamesmanship and undermines democratic accountability.

Crises inevitably require difficult decisions.  If regulators are too quick to provide support, they can invite moral hazard and unfairly enrich the very firms that brought on the crisis.  If they allow all panics to continue unabated, they can bring the real economy to its knees, wiping out wealth and driving up unemployment.  Rather than pretending to draw bright-line rules that break down in the real world, policy makers should focus on how to devise processes that ensure that regulators can be held to account no matter what.  Only when regulators know that they will have to answer for their decisions will they have adequate incentives to consider the long-term consequences of those decisions.

Better options are possible.  In a new paper, I outline a more appropriate legal scheme for preserving accountability and improving regulatory incentives while ensuring regulators have the capacity to contain a growing crisis.  In a subsequent post, I will provide more details about the benefits of an appropriately empowered guarantor of last resort.

This post comes to us from Professor Kathryn Judge at Columbia Law School.