Looking Back at Lehman

I haven't yet opened Andrew Ross Sorkin's new book, but Yves Smith has, and walks us through some of the juicier details of the Lehman collapse:

But three things are striking about the Sorkin-provided details:

First, Fuld (and presumably the underlying business) was desperate as of early July. Sorkin has Fuld arranging for contacts to be made to possible buyers like Bank of America on a Saturday. Huh? He was clearly flailing about, yet not offering a price or deal terms commensurate with his obviously panicked state.

Second, Paulson and Geithner were aware of Fuld's desperation. The Wall Street Journal reported earlier that Fuld was calling Paulson almost daily (and suggested Paulson was somewhat puzzled). The Sorkin excerpt shows Fuld petitioning the Fed via Geithner to become a bank holding company:

Mr. Fuld's outside lawyer, Rodgin Cohen, chairman of Sullivan & Cromwell, had recently suggested an idea to help stabilize the firm: to voluntarily turn itself into a bank holding company. The move, Mr. Cohen had explained, would make it easier for Lehman to borrow money from the Fed "just like Citigroup or JPMorgan."

Mr. Cohen, a 64-year-old, mild-mannered mandarin from West Virginia, was one of the most influential and yet least well-known people on Wall Street. Pacing in his hotel room in Philadelphia before the wedding of his niece that night, he joined the call between Lehman and the New York Fed.

"We're giving serious consideration to becoming a bank holding company," Mr. Fuld started out by saying. "We think it would put us in a much better place." He suggested that Lehman could use a small industrial bank it owned in Utah to take deposits to comply with the regulations.

Mr. Geithner, who was joined on the call by his general counsel, Tom Baxter, was apprehensive. "Have you considered all the implications?" he asked.

Mr. Baxter, who had cut short a trip to Martha's Vineyard to participate, walked through some of the requirements, which would transform Lehman's aggressive culture, minimizing risk and making it a more staid institution, in league with traditional banks.

Regardless of the technical issues, Mr. Geithner said, "I'm a little worried you could be seen as acting in desperation," and the signal that Lehman would send to the markets with such a move.

Mr. Fuld ended his call deflated. Later that evening, Mr. Fuld called Mr. Cohen, finding his lawyer in the waiting room of a hospital, attending to a cousin who had become ill at the wedding.

Yves here. If Geithner and his colleagues didn't get that Fuld was at the end of his rope, they were choosing to ignore an elephant in the room. Now they may have been completely unwilling to consider the petition and this was the easiest way to signal their opposition (taking Fuld through a long list of requirements, some of which presumably would have been pretty painful, was another message).

But this speaks to a question we have raised again and again: why was there no serious assessment of what a Lehman bankruptcy would mean? After Bear went down, everyone knew Lehman was next on the list, with Merrill and UBS also known to be wobbly. Why didn't the Fed, Treasury, and SEC together demand certain types of information from all big US regulated capital markets players (including JP Morgan and Goldman, perceived to be the healthiest, so as not to be singling out the weaker members of the herd?). This is a massive oversight. Relying on luck, which is what assuming all would be well after the Bear debacle, is no substitute for having a strategy. There was clear urgency in July. Even a month of assessment and evaluation of options (it probably would have taken two weeks to orchestrate the information requests among the agencies) would have been better than nothing. But the Freddie/Fannie unwind was moving to front burner, that probably consumed a lot of available bandwidth.

And we have the third, and peculiarly most obvious point to anyone who has had some exposure to deals, but one that Sorkin does not bring forward: what the hell was Fuld doing trying to negotiate his own deals? This is a mistake CEOs make all the time, and it never ceases to amaze me.

Reading between the lines of conversations I've had with Fed and Treasury officials--though they never quite actually say it--both were well aware that Lehman (and Merrill) were on the rocks.   They had also decided that they were not going to take any extraordinary measures to bail them out, because they believed that the banks were in the grip of a serious case of moral hazard.  Indeed, this is possibly the most plausible explanation of Dick Fuld's unwillingness to make the kinds of deals that could have kept his firm from a catastrophic collapse--he thought his BATNA* was a bailout-backed fire sale, not the implosion of the company and his own probable personal bankruptcy as his shareholders filed suit.

So Treasury and the Fed spent the time between Bear and Lehman building contingency plans for the bankruptcy, rather than working as hard as hard could be to ensure that one didn't happen.  Then Lehman's collapse had an effect no one had anticipated:  the Reserve Primary Fund, a money market fund that held a lot of Lehman's commercial paper, broke the buck, triggering a general run on the money markets that only stopped when the government stepped in to backstop the losses.  Most of their contingency plans worked as intended, which is why the Lehman bankruptcy wasn't an even bigger disaster.  But the run in the money markets made it clear (or at least, made them fear) that they just weren't capable of planning their way around the failure of a systemic institution; the markets were too complicated, and trouble forestalled in one sector would just pop up somewhere else.  After Lehman, they stopped trying to orchestrate an orderly transition, and started pumping as much money into the system as they could without much worrying about the effect that this might (did) eventually have on banker psychology.

You can argue about whether this was the right decision, and certainly the current banker attitude towards the resulting profits is pretty galling.  But ultimately, I think they made the right decision in both cases.  In September, moral hazard seemed like a huge problem that was actually making the crisis worse, and would certainly make the likelihood of another one much higher.  After September, we knew better, but there was no way to find that out ahead of time.  Once we did, though, it made sense to try to shepherd the system through the crisis, and reform it later. You can always slap down bankers at some later date (though whether we will, of course, remains an open question).  But the families that lose their homes when unemployment spikes to 15% and the banks collapse take a long time to get back on their feet.

* Best Alternative To Negotiated Agreement