As reflected in the title of the new memoir by Former Federal Reserve Chairman Ben Bernanke, The Courage to Act: A Memoir of a Crisis and Its Aftermath, Bernanke clearly believes that he and other Fed policymakers demonstrated exceptional courage in their handling of the 2007-2009 financial crisis.[1] In a new paper forthcoming in Columbia Law Review and available here, I suggest otherwise. I agree with Bernanke that if one narrows the lens to the Fed’s actions after Lehman Brothers failed in September 2008, the Fed and other financial regulators often displayed great courage and creativity and the economy benefited from their bold actions. Nonetheless, as Bernanke readily concedes, the financial crisis started more than a year prior to Lehman’s failure, in August 2007. My paper, The First Year: The Role of a Modern Lender of Last Resort, uses the same transcripts of the Federal Open Market Committee (FOMC) that undergird Bernanke’s memoir to paint a very different picture of the Fed’s handling of that first year of the Crisis. Beyond casting doubt on Bernanke’s claim to courage, the account suggests that far less courage may have been required had the Fed used available tools to gather critical information in a timely fashion and responded accordingly.

The focus of The First Year is the appropriate role of a lender of last resort in today’s financial markets. The conventional wisdom, which Bernanke invokes throughout his memoir to explain the Fed’s actions, is that a central bank should flood the market with liquidity, subject only to constraints designed to reduce the inevitable credit risk and moral hazard. I argue that this is the wrong approach when liquidity shortages persist despite countervailing efforts by a central bank. While too little liquidity can exacerbate financial distress and the provision of liquidity can play an important role preventing shocks, like the terrorist attacks of 9/11, from triggering a crisis, liquidity alone will never resolve a crisis once panic takes hold. In order to quell ongoing dysfunction, markets require credible information about how risks are distributed and how great those risks actually are. Moreover, when that picture reveals the need for more capital—as will often be the case when liquidity shortages persist—policymakers cannot hope to restore financial stability without identifying and rectifying those shortfalls.

For these reasons, in the face of persistent liquidity shortages and a growing financial crisis, how a central bank should use its lender-of-last-resort authority changes dramatically. Continuing to flood the market with liquidity without simultaneously addressing the underlying problems causing the market dysfunction to continue allows those problems to fester and can render the financial system as a whole more fragile. Instead, a central bank should complement its efforts to provide liquidity with aggressive efforts to gather critical information and, working with others as needed, it should seek to address the challenges causing liquidity shortages to persist.

The paper establishes the importance of updating the paradigm for how a central can best use its lender-of-last-resort authority by revisiting the first year of the Crisis. Using FOMC transcripts and other primary materials to remain true to what Bernanke and other policymakers actually knew and believed and various junctures in the Crisis, the paper reveals a host of missed opportunities that are downplayed or ignored in Bernanke’s (and former Treasury Secretary Timothy Geithner’s) account of the critical events.

To appreciate policymakers’ mishandling of the early stages of the crisis, a little context is helpful.  A “perfect storm” of factors, triggered a financial crisis that few saw coming. I do not fault Bernanke or others for being blindsided when the trouble first hit. However, as Bernanke, Geithner and others readily concede, that storm hit ground in August 2007. From then on, liquidity conditions and market functioning remained strained. As Bernanke acknowledged at an FOMC meeting in January 2008, empirical evidence suggested that the country already was in the midst of one of “the five largest financial crises in any industrial country since World War II.”[2]  By August 2008, Fed Governor Frederic Mishkin reminded his colleagues “that in the Great Depression, when… ‘something’ hit the fan, it actually occurred close to a year after the initial negative shock….  We are now a year into this.”[3]   Fed officials thus had more than a year to prepare for the potential demise of Lehman Brothers and AIG, and more than a year to help market participants prepare for such events. Hence, the critical question is: what did Fed officials do with this time?

My answer, which is largely consistent with Bernanke’s own account, is not flattering. In short, the Fed provided just enough fresh liquidity to allow the financial system to become increasingly fragile without taking the complementary actions that might have enabled the Fed and others to acquire the information it needed to understand and to develop a plan for addressing the underlying problems causing the financial crisis to continue.

The magnitude of the disparity between how the Fed used the time and authority available to it and how it may have best used those resources comes to life in the six months following the near-failure of Bear Stearns in March 2008. Fed officials were aware throughout the Crisis that if any major financial firm faced possible failure, that firm would seek support from the Fed. And, when the Fed decided to help Bear Stearns, the Fed demonstrated to itself and everyone else that the Fed would be willing to put taxpayer money at risk to save even a non-bank financial institution. Bear Stearns’ status as an investment bank, rather a commercial bank or a bank holding company, meant that it was not regulated by the Fed or any other bank regulator. As a result, the Fed had little high-quality information about the institution’s solvency and the value of proposed collateral that was going to be used to secure the loan from the Fed.  Nonetheless, as Bernanke explained then and subsequently, Fed officials believed that the credit risk and moral hazard arising from the intervention were justified because Bear Stearns was so interconnected with other financial firms that its failure could jeopardize the health of the financial system as a whole.

At the same time the Fed agreed to bail out Bear Stearns, the Fed expanded its emergency lending facilities to provide all of the leading investment banks and other primary dealers access to Fed liquidity. These facilities put the Fed in a position of potentially being directly exposed to these institutions, but it also gave the Fed critical leverage—the capacity to use its status as a creditor to demand information about the financial condition of Lehman Brothers and the other investment banks and the interconnections among these firms and other financial institutions. Given the Fed’s decision to save Bear and its rationale for doing so, this information would seem critical. Nonetheless, the Fed chose to obtain far less information than it could have obtained, less information than the on-site examiners seemed to believe was needed to understand the health of the institutions they were monitoring, and less information than the Fed needed to prepare for events that—at that stage—were entirely foreseeable, even if not probable.

Lehman’s bankruptcy did not come out of the blue. All of the leading policymakers have stated that after Bear failed, they believed that Lehman could be next. The little information they did gather confirmed their fears.[4] Fed policymakers also knew that other market participants were allowing Lehman to operate with more leverage and less liquidity than they would otherwise demand because of Lehman’s access the Fed’s newly created lending facilities. Nonetheless, the on-site monitoring remained extremely modest.  The Fed failed to work with Lehman’s primary supervisor to address known deficiencies, and the Fed failed to gather the information it needed to understand and potentially help to contain the effects of allowing Lehman to fail. Fed officials were thus woefully ill-prepared when Lehman finally hit the rocks. Bernanke confirms much of this in his memoir, acknowledging that as soon as other banks started to undertake due diligence, they quickly discovered massive discrepancies between the actual value of Lehman’s assets and the values that Lehman had been reporting. Bernanke also admits that Lehman was engaged in other accounting trickery that helped it to disguise its financial health. Nonetheless, Bernanke says nothing to explain why all of this seemed to be “news” to the Fed and does not seem to believe that anything was amiss even though the Fed had been providing Lehman access to liquidity for six months leading up to its failure.

The missed opportunities are equally striking with respect to AIG. In January 2008, the Fed’s leading policymakers were provided detailed information about the ways that insurance-like products covering AAA-rated MBS created a web of interconnections among banks and insurance companies. While focused on the monoline insurers, the discussion revealed that insurance regulators had only a minimal understanding of the risks to which insurance companies were exposed and that a rating downgrade of an insurance company could have significant ripple effects irrespective of the company’s financial health. AIG itself even tried to warn the Fed. Twice in July 2008, AIG’s CEO went to the New York Fed to meet with its then-President, Timothy Geithner. In Geithner’s own telling, AIG “danced around the issue of whether we might be able to help if AIG’s liquidity ever dried up,” and a subsequent meeting between Fed staff and the bank regulators overseeing AIG, left Fed staff “alarmed.”[5]

Despite the red flags suggesting AIG might run out of liquidity and would seek help from the Fed if it did, and despite the fact that the Fed was providing liquidity to Goldman Sachs and many of AIG’s other major counterparties, giving it a mechanism through which it could have learned about AIG’s risk exposures and financial health, the Fed made virtually no effort to better understand AIG. According to Bernanke, the Fed had been monitoring the situation at AIG over the summer of 2008, but he does not explain why, given the Fed’s concerns, it did not use the mechanisms available to acquire better information about AIG’s health and the nature of its interconnections to other financial firms. Because of the Fed’s failure to avail itself of viable mechanisms for gathering such information, as the government itself has highlighted, the Fed, “and therefore ultimately taxpayers, took on significant credit risk” when it extended the loan to AIG.[6]  This risk was not inherent to AIG, but rather was a byproduct of “the Federal Reserve’s prior unfamiliarity with AIG” and “uncertainty [regarding] AIG’s solvency, financial condition, and funding needs.”[7] In other words, the government’s capacity to make money on the loan to AIG and get out clean was largely a matter of luck, and it didn’t need to be.

There is little that the Fed could have done to avoid the 2007-2009 financial crisis and the Fed’s aggressive use of its monetary policy to help mitigate the effects of that crisis on the broader economy merits applause. Moreover, given the widespread belief that advanced economies were beyond financial crises, perhaps Bernanke and his colleagues should be forgiven for failing to do more to prepare during the first year of the Crisis. Nonetheless, Bernanke’s willingness to act boldly after the disastrous events of September 2008 can largely be attributed to the decades that he and others had spent studying the Fed’s response to the Great Depression. The only way to help the Fed and other central banks improve their capacity to contain the next financial crisis is by using the benefit of hindsight to figure out how the Fed’s handling of the crisis might have been improved upon. Close inspection of the first year of the crisis suggests significant room for improvement.

ENDNOTES

[1] Ben Bernanke, The Courage to Act: A Memoir of a Crisis and Its Aftermath (2015).

[2] Transcript of the Federal Open Market Committee Conference Call on January 21, 2008, at 9.

[3] Transcript of the Federal Open Market Committee Meeting on August 5, 2008, at 90.

[4] After installing a team of on-site examiners at Lehman in March 2008, Fed officials learned that Lehman would fail if faced with a run akin to that on Bear, Lehman would fail even if facing a less adverse scenario, and Lehman’s risk management systems overestimated the firm’s capacity to withstand further adverse developments.

[5] Timothy F. Geithner, Stress Test: Reflections on Financial Crises 176, 184 (2014).

[6] Defendant’s Statement of Contested Facts at 20, Starr Int’l Co. v. United States, No. 11-00779C (TCW) (Fed. Cl. Aug. 18, 2014).

[7] Id.