What the 2008 Financial Crisis Can Teach Us Today
With a potential recession around the corner, it is worth remembering how regulators contained the last panic.
As the United States weighs concern about another recession, it is worth remembering how three U.S. financial regulators helped keep the 2007 to 2009 financial crisis from becoming another Great Depression: Ben Bernanke, the chair of the Federal Reserve; Henry Paulson, the treasury secretary as crisis erupted under President George W. Bush; and Timothy Geithner, the president of the New York Fed under Bush and treasury secretary under President Barack Obama. It is also worth reflecting on one critical decision: letting the investment bank Lehman Brothers collapse on Monday, Sept. 15, 2008. They didn’t have to. And if they hadn’t, they might well have prevented the worst of the crisis in the first place.
But except for the case of Lehman, the regulators’ efforts to rescue the financial system were incredibly broad. By March 2009, the Fed had deployed $7.77 trillion dollars, more than half of U.S. GDP, to lend to financial institutions on the brink, buy assets plummeting in value, or otherwise forestall disaster. Congress also authorized the Treasury to spend another $700 billion to buy toxic assets. The regulators used these funds to support, among other firms, Fannie Mae and Freddie Mac, government-sponsored but privately owned corporations that owned or guaranteed half of U.S. home mortgages; American International Group, the insurance giant with 76 million customers; and the largest U.S. banks, including JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley. But not Lehman.
The three regulators have insisted that they lacked legal authority to lend to Lehman. The story is so riddled with holes that it’s hard to know where to start. They say in their recent co-authored book, Firefighting: The Financial Crisis and Its Lessons, that a 2013 study, not identified in any way that would let you find it, claims that Lehman’s “capital hole might have been as big as $200 billion.” But that isn’t borne out by the fact that other banks were willing to invest in Lehman. The very weekend before it folded, Barclays offered to buy Lehman if it could avoid possible losses on $40 billion of assets—assets that a group of Wall Street executives agreed to buy. The sale would have gone through but for British financial regulators.
Besides, the relevant Section 13(3) of the Fed’s enabling act didn’t in fact bar lending to an insolvent institution but only required that the loan be secured “to the satisfaction of the Federal Reserve bank.” The borrower would put up collateral that the Fed could seize in a bankruptcy. To protect the Fed, the collateral could have a higher face value than the amount of the loan. Loans to Morgan Stanley and Goldman Sachs shortly after Lehman’s collapse were no safer, Laurence Ball of Johns Hopkins has carefully argued.
The tale gets weirder still. On Thursday before the fateful weekend, Paulson leaked a statement to the press that there would be no government support for Lehman. Bernanke and Geithner excuse this as a bargaining gambit gone awry. But if you want to save a firm, it’s not a bargaining gambit—it’s nuts. Then, over the weekend, the government carefully excluded Lehman from a program to borrow funds that Morgan and Goldman were quickly allowed to tap.
What was going on? There are two theories, one personal and one political. Probably both contributed. Although the Fed had authority to lend, Paulson took up managing the matter. “Paulson simply didn’t like Dick Fuld,” the CEO of Lehman, said Bryan Marsal, who managed the firm’s bankruptcy, in an interview with the Washington Post. As well, bailouts of Bear Stearns in March and Fannie and Freddie in September had put the regulators under intense political pressure. “I’m being called Mr. Bailout. I can’t do it again,” the forceful Paulson announced to Bernanke and Geithner, according to David Wessel in his book In Fed We Trust. Meanwhile, Sens. Obama and John McCain, contending for the presidency, equally lambasted the rescues.
If the regulators had resisted political pressure and organized a controlled bankruptcy, events might have gone very differently. Alan Blinder, a Princeton University economist and former vice chair of the Fed, has written: “Lehman’s failure precipitated a near cataclysm in the financial markets and shattered confidence everywhere. It literally changed everything—for the worse.” Macroeconomics is rarely subject to proof—you’d have to change one out of countless factors that affect an economy and rerun history—but backstopping Lehman would surely have significantly limited the crisis.
In financial markets, perception can hardly be separated from fact. A commercial bank borrows short-term funds by accepting deposits from retail customers and lends those funds out at higher interest rates in long-term mortgages, business loans, or other instruments. Why do banks borrow short-term and lend long-term? Well, it’s what banks have done since the Renaissance, filling an essential role in the emergence of capitalism. But there’s a problem. Even if the long-term loans are sound, in that the debtors will pay the agreed principal and interest in time, the bank has no immediate access to funds it has borrowed from depositors. If a stampede of retail customers suddenly lose faith in the bank for some reason (or no reason at all), it lacks the cash to return all their deposits. Absent central bank support, it fails. The Bank of England learned in the 19th century to lend to troubled banks against sound collateral, the same authority the Fed had in 2008.
A contemporary financial institution also takes out short-term loans, often borrowing from money market funds, commercial banks, or other institutional sources, rather than just taking retail deposits. It then ties up the borrowed money by investing it in higher-paying, longer-term assets. These assets might be complicated packages—far too complicated—of mortgages, student loans, credit card debt, and other promises to pay interest and principal. As long as creditors supplying the short-term loans have faith in the institution, they keep rolling their loans over, and all is well. But if they lose faith—perhaps panic causes assets the institution has invested in to fall in value on the market—the creditors may balk at rolling over short-term loans. Just as if retail customers of a commercial bank withdrew deposits, the institution runs out of cash to repay its creditors and goes bankrupt.
In this situation, financial players race to anticipate what everybody else will do, the economist John Maynard Keynes observed during the Great Depression, driving erratic herd behavior. Panic from Lehman caused mayhem. The Reserve Primary Fund, a money market fund, owned $785 million of Lehman commercial paper, a form of short-term loan. Loss of that paper forced the firm to inform customers they would only get back 97 cents for every dollar they had stashed in the fund. Over the next several days, a panicked public withdrew $350 billion from money market funds—much more than the value of the bad Lehman paper. Blue-chip companies such as General Electric and Coca-Cola had relied on such funds to maintain inventories and make payroll, so some had to cut production and lay off workers.
Panic shot across financial sectors and around the world as perceptions changed overnight from serious concern before Lehman to all-out dread. But, oddly, the underlying impetus for the crisis was remarkably limited. Of course, there was plenty of fraud and “toxic waste” in U.S. mortgages, but the default rate on them in 2009—in the worst year and the sector at the heart of the crisis—was under 3 percent. Though higher than the historical average, it was hardly what you’d would expect to bring down the global economy.
More broadly, Fed and Treasury programs to buy assets nobody else wanted and to support teetering institutions ultimately made billions of dollars in profit. The reason they did is that most of the underlying mortgages, business loans, credit card debt, and other promises to pay did in fact make promised payments. If private institutions had only held those assets, and creditors had continued rolling over short-term loans, they would have made money in the end, and the crisis would have been nowhere near as bad as what actually erupted.
In short, if nobody had panicked, there wouldn’t have been a crisis. Panic was the crisis.
As it proved in wide-ranging actions after Lehman, the Fed can buy assets falling in value, lend to weak institutions, and limit economy-wide panic. But it is not exempt from politics. Political pressures on Bernanke, Geithner, and Paulson to let Lehman collapse—from Democrats to Republicans, from the liberal New York Times editorial page to the conservative Wall Street Journal editorial page—were fierce. Only after Lehman went down, showing all too vividly how a major financial institution’s collapse can fuel disaster, could they secure the political commitment to launch an all-out fight against crisis.
Unfortunately, political decisions have further encroached on Fed authority. Angry that banks were bailed out and homeowners weren’t, Democratic Sen. Elizabeth Warren, who is now campaigning to be president, and Republican Sen. David Vitter introduced the Bailout Prevention Act of 2015 to restrict the Fed’s ability to backstop firms like Lehman. It didn’t pass, but despite helpful measures to reregulate finance, the 2010 Dodd-Frank bill dangerously limits the Fed’s legal lending authority and politicizes it by requiring Treasury approval. Ball meticulously shows in The Fed and Lehman Brothers that the Fed had legal authority to lend to Lehman in 2008, but he warns that Dodd-Frank would, in fact, have deprived it of that authority. Bernanke, Geithner, and Paulson share his concerns that this bill and other regulations will undermine the Fed’s ability to fight the next crisis.
Financial malfeasance should be punished, but letting major financial firms fail is the wrong way. Obama’s Justice Department didn’t start serious investigations until mid-2012, by which time the statute of limitations on ordinary criminal fraud had run out. Banks paid billions of dollars to settle civil fraud complaints, promising not to commit the same fraud again—and then proceeded to commit it again once, twice, and even three times.
It’s as sure as death and taxes that crises will erupt again, and almost as sure that nobody can be certain how bad they will be. A key reason for that uncertainty is that crises are largely contingent. The last global financial crisis was the worst since the 1930s, but if the Fed had handled Lehman better and quelled financial fears, it could have avoided being nearly so bad. Precisely because crises are so powerfully driven by panic, it is concerning that Dodd-Frank and other regulations have weakened the Fed’s ability to stop such dread—and that the institution will be subject to even more political pressure than before.
Jonathan Schlefer is a senior researcher in the Business, Government, and International Economy Unit at Harvard Business School.