38: The Fed Made a Massive Mistake Letting Lehman Go

Tracy Alloway (0:07)

Hello, and welcome to Odd Lots. I'm Tracy Alloway, executive editor of Bloomberg Markets.

Joe Weisenthal (0:11)

And I'm Joe Weisenthal, managing editor at Bloomberg Markets.

Tracy Alloway (0:15)

So Joe, I was away for a few days earlier this month, and while I was away, this paper was published with the very intriguing title of The Fed and Lehman Brothers. Did you read it?

Joe Weisenthal (0:30)

If I'm gonna be completely honest, I haven't read the entire thing, but I know that it's making quite some waves in the world of law and economics and banking because it has a provocative thesis about how Lehman was led to fail and whether the official story really matches what happened.

Tracy Alloway (0:51)

Right, so it was penned by Lawrence Ball. He's a professor of economics over at Johns Hopkins University. He's also a research associate at the National Bureau of Economic Research and a visiting scholar at the IMF. He is going to be our guest for today. But just before we start, let's talk about the paper a bit because yes, you're right. The thesis here is that the Fed essentially had a choice when it came to letting Lehman Brothers go back in 2008 And that when it decided to let Lehman Brothers go, that ended up being a massive mistake for the financial system, which is provocative because you'll remember that people like Ben Bernanke were quite adamant at the time that they did not have an option here. They had to let the bank fail.

Joe Weisenthal (1:38)

That's right. The basic argument at the time that the Fed said was our hands were tied, there are clear laws about when we can lend to a bank that's in distress, Lehman wasn't solvent and so forth. And they've stuck to that line after several years, even though we know what a huge disruption the collapse of Lehman caused.

Tracy Alloway (2:01)

Exactly.

Joe Weisenthal (2:01)

So it's a big deal if you go back and say, actually, they could have potentially bailed them out.

Tracy Alloway (2:07)

And there's one other short thing I want to say about this paper before we begin. It is 218 pages long.

It doesn't have an abstract, the summary that normally comes with these kinds of academic papers. And it's also kind of unusual in that when you think about academic research, especially in finance and economics, there's usually a lot of mathematical formula, regression analysis, things like that. This one is different because it kind of relies on a lot of information that's already out there. Things like the Lehman Brothers bankruptcy examiner report, the government inquiry into the financial crisis, things like that. It doesn't read like your usual academia.

Joe Weisenthal (2:49)

Right, it's almost more of a piece of investigative journalism, isn't it?

Tracy Alloway (2:52)

Yeah, exactly. So I'm really excited to have Lawrence on the show. Let's bring him in now.

Hi, Lawrence, thanks for joining us today.

Joe Weisenthal (3:09)

Thank you for joining us, Lawrence.

Laurence Ball (3:11)

Oh, you're welcome. I'm happy to talk.

Tracy Alloway (3:13)

All right, so let's start at the beginning. What prompted you to choose this particular topic for research, given that, you know, it's now almost a decade from Lehman Brothers collapse, and a lot of people would be happy just forgetting that it ever happened.

Laurence Ball (3:30)

Well, first of all, I started it four years ago, so it's four years less far in the past when I started. And the basic motivation, like most macroeconomists, I was interested in what caused the great recession, and the answer is the financial crisis. What was the big event in the financial crisis? Lehman Brothers, so why did Lehman Brothers fail? And like a lot of people, I had some doubts about the story that we couldn't save them, even though we couldn't save everybody else.

So I just started looking into that. And you mentioned the bankruptcy examiner's report and the Financial Crisis Inquiry Commission report. There's quite a bit of easily accessible information from these investigations.

A lot of people give opinions about the crisis without knowing there's actually a lot of facts out there that you can look up.

Joe Weisenthal (4:25)

So you mentioned that you were skeptical of the original story that was told. Give us your succinct summary of that story and what tip do you offer earlier on, or early on, that may not fully explain what happened?

Laurence Ball (4:42)

Well, the story is fairly simple. The law, section 133 of the Federal Reserve Act, says the Fed could only lend if there is satisfactory security, which is generally interpreted to be enough collateral so that the Fed is protected, even if the load is not paid back.