Speaker 1: Hello, and welcome to add thoughts. I'm Tracy Alloway, executive
Speaker 1: editor at Bloomberg Markets, and I'm Joe wasn't all managing
Speaker 1: editor at Bloomberg Markets, so Joe. I was away for
Speaker 1: a few days earlier this month, and while I was away,
Speaker 1: this paper was published with the very intriguing title of
Speaker 1: the Fed and Lehman Brothers. Did you read it? Uh?
Speaker 1: If I'm going to be completely honest, I haven't read
Speaker 1: the entire thing, but I know that it's making quite
Speaker 1: some waves in the world of law and economics and
Speaker 1: banking because it has a provocative thesis about how Lehman
Speaker 1: was let to fail and whether the official story really
Speaker 1: matches what happened. Right. So it was penned by Lawrence Ball.
Speaker 1: He's a professor of economics over at Johns Hopkins University.
Speaker 1: He's also research associate at the National Bureau of Economic
Speaker 1: Research and a visiting scholar at the I m F.
Speaker 1: He is going to be our guest for today, but
Speaker 1: just before we start, you know, let's talk about the
Speaker 1: paper a bit, because, yes, you're right, the thesis here
Speaker 1: is that the FED essentially had a choice when it
Speaker 1: came to letting Lehman Brothers go back in two thousand
Speaker 1: and eight, and that when it decided to let Lehman
Speaker 1: Brothers go, that ended up being a massive mistake for
Speaker 1: the financial system, which is provocative because you'll remember that
Speaker 1: people like Ben Bernanky were quite adamant at the time
Speaker 1: that they did not have an option here. They had
Speaker 1: to let the bank fail. That's right. The basic argument
Speaker 1: at the time that the FED said was our our
Speaker 1: hands were tied. There are clear laws about when we
Speaker 1: can lend to a bank that's in distress. Lehman wasn't
Speaker 1: solvent and so forth, and they've stuck to that line
Speaker 1: after several years, even though we know what a huge
Speaker 1: disruption the collapse of Lehman cause. So it's a big
Speaker 1: deal if you know, you go back and say, actually,
Speaker 1: they could have they could have potentially build them up.
Speaker 1: And there's one other short thing I want to say
Speaker 1: about this paper before we begin. It is two hundred
Speaker 1: eighteen pages long. It doesn't have an abstract, you know,
Speaker 1: the summary that normally comes with these kinds of academic papers.
Speaker 1: And it's also kind of unusual in that when you
Speaker 1: think about academic research, especially in finance and economics, there's
Speaker 1: usually a lot of mathematical formula regression analyses things like that.
Speaker 1: This one is different because it kind of relies on
Speaker 1: a lot of information that's already out there, things like
Speaker 1: the Lehman Brothers bankruptcy examine or report of the government
Speaker 1: inquiry into the financial crisis, things like that. It doesn't
Speaker 1: read like your usual academia, right. It's almost more of
Speaker 1: a piece of investigative journalism, isn't it. Yeah, exactly. So
Speaker 1: I'm really excited to have Lawrence on the show. Let's
Speaker 1: bring him in now, Hi, Lawrence, thanks for joining us today. Hello,
Speaker 1: thank you for joining us, Lawrence. Oh, you're welcome. I'm
Speaker 1: happy to talk, all right. So let's start at the beginning.
Speaker 1: What prompted you to choose this particular topic for research,
Speaker 1: given that you know, it's now almost a decade from
Speaker 1: Lehman Brothers collapse, and a lot of people would be
Speaker 1: happy just forgetting that it ever happened. Well, first of all,
Speaker 1: I started it four years ago, so it's four years
Speaker 1: less uh far in the past when I started. And
Speaker 1: there's a basic motivation. Like most macro economists, I was
Speaker 1: interested in what caused a great recession? And the answer
Speaker 1: is the financial crisis? What was the big event and
Speaker 1: the financial crisis Leman Brothers? So why did Lehman Brothers fail?
Speaker 1: And like a lot of people, I had some doubts
Speaker 1: about the story that we couldn't save them, even though
Speaker 1: we couldn't save everybody else. So I just started looking
Speaker 1: into that. And you mentioned the Bankruptcy Examiners report and
Speaker 1: the Financial Crisis and Greek Commission report. There's quite a
Speaker 1: bit of easily accessible information from these investigations. A lot
Speaker 1: of people give opinions about the crisis without knowing that's
Speaker 1: actually there are actually a lot of facts out there
Speaker 1: that you can look up. So you mentioned that you
Speaker 1: were skeptical of the original story that was told. Um,
Speaker 1: you know, give us yours to sink summary of that
Speaker 1: story and what tipped you off earlier on or early
Speaker 1: on that um you know, may not fully explain what happened. Well,
Speaker 1: the story is fairly simple. The the law Section three
Speaker 1: in the Federal Reserve Act says could only land if
Speaker 1: there is satisfactory security, which is generally interpreted to be
Speaker 1: enough collateral so that the fat is protected even if
Speaker 1: the loan does not take back and the position the
Speaker 1: Fed officials is that that condition was not met, that
Speaker 1: the amount of collateral that Lehman had was much less
Speaker 1: than the amount of money they would have needed to
Speaker 1: borrow to survive, So they didn't have satisfactory security. So
Speaker 1: it wasn't legal in that sense, their hands were tied.
Speaker 1: And I guess what made me wonder is just having
Speaker 1: read a fear amount about it that they that was
Speaker 1: never backed up with any numbers or any analysis. It
Speaker 1: was just given on authority that these other firms had
Speaker 1: plenty of collateral and Lehman had not nearly enough collateral.
Speaker 1: So I just started to look to look into that.
Speaker 1: So how did you actually go about calculating how much
Speaker 1: collateral Lehman would have had? Because I mean, Joe and
Speaker 1: I both know having covered markets in finance for a
Speaker 1: long time, that valuing a bank's balance sheet, particularly in
Speaker 1: September two thousand and eight, when a lot of this
Speaker 1: stuff was very liquid, is incredibly difficult and relies on
Speaker 1: a whole bunch of subjective assumptions. Right, It's hard in
Speaker 1: normal times, let alone in a period of extreme acute crisis. Well,
Speaker 1: in terms of valuing assets, I used the best available,
Speaker 1: but I think it's probably the best available evidence, which
Speaker 1: is analyzes done at the time by Barclays and by
Speaker 1: Bank of America, which we're both considering acquiring Lehman and
Speaker 1: so looked over its balance sheet very carefully and um
Speaker 1: and then also by the constortium of Wall Street firms
Speaker 1: that was famously gathered at the New York FED to
Speaker 1: analyze the situation. They all looked very carefully at the
Speaker 1: balance sheet and came up with different numbers about how
Speaker 1: much Leman overvalued their assets, and the numbers were remarkably
Speaker 1: consistent and in the range of fifteen the thirty billion
Speaker 1: dollars of overvaluating, which puts them on the borderline of
Speaker 1: solvency and insolvency. So one interesting in these papers you
Speaker 1: actually come up with the number for the amount of
Speaker 1: assets that would have been acceptable as collateral for FED liquidity,
Speaker 1: and you put it at a hundred and thirty one
Speaker 1: billion worth of assets, which means that Lehman probably could
Speaker 1: have stayed in business if it had received a loan
Speaker 1: of something like eight billion. Walk us through how you
Speaker 1: how you made that calculation? Okay, So, so that calculation
Speaker 1: the hundred and thirty one billion came primarily from looking
Speaker 1: at financial statement, which is again all the original documents
Speaker 1: are on the websites of both the Financial Requests Inquiry
Speaker 1: Commission and Bankruptcy Examiner. A financial statement of Lehman, which
Speaker 1: I believe was intended for their quarterly report for the
Speaker 1: third quarter, which never got issued because they declared bankruptcy.
Speaker 1: And actually that the hundred thirty one billion dollars were
Speaker 1: assets that were specifically eligible to be collateral that the
Speaker 1: fends lending facility and the primary deal or credit facility,
Speaker 1: and those were actually not the same that the assets
Speaker 1: with the questionable evaluations were things like private equity and
Speaker 1: real estate projects. There's a lot of subjectivity. One billion
Speaker 1: dollars were primarily securities where valuation was reasonably straightforward based
Speaker 1: on market prices. So I got that from the essentially
Speaker 1: uh Lehman's financial statement that they were preparing, and then
Speaker 1: I estimated that they would need billion dollars of support.
Speaker 1: That is pretty speculative, but it's based on a mixture
Speaker 1: of what had happened in the last week, how many
Speaker 1: WE purchase agreements they had lost and so on, and
Speaker 1: various in colonel forecasts at what was going to happen
Speaker 1: the next week. Also the Federal Reserve did there's no
Speaker 1: evidence of the FAT booked very carefully at the issue.
Speaker 1: Over the last weekend in the summer. They did stress
Speaker 1: tests what would happen if there was a run on Lehman,
Speaker 1: and they had numbers for, well, what if a bunch
Speaker 1: of the prime brokerage customers flee, how much catually lose,
Speaker 1: how much casually lose if there's this kind of collateral call,
Speaker 1: and so on. So I relied on that. Also in
Speaker 1: your research, you pointed out that there were some a
Speaker 1: couple of voices at the FAT. I believe we said,
Speaker 1: actually Lehman probably would be solvent, they do have enough
Speaker 1: collateral to merit a bailout, but that they weren't really
Speaker 1: listened to what happened there. So that is something that
Speaker 1: I don't know firsthand. That there was a very interesting
Speaker 1: article in two thousand and fourteen by James stewar Or
Speaker 1: in another New York Times reporter, which was based on
Speaker 1: anonymous sources from the New York Fed. And again there,
Speaker 1: if you want to be careful about it, there are
Speaker 1: actually two distinct issues, one about how much collateral they
Speaker 1: had per a loan, and the second about their asset
Speaker 1: over evaluation and solvency, which are related but different questions,
Speaker 1: And the way this New York Times article was reported,
Speaker 1: the New York Fed people were looking at the over
Speaker 1: evaluation and solvency issue and seemed to have can't counter
Speaker 1: roughly the same conclusion that I did of that it
Speaker 1: was a close call whether they're net worth was a
Speaker 1: little bit positive or a little bit negative. The New
Speaker 1: York Times article also reports that this that this analysis
Speaker 1: never made it to senior policymakers. So one of the
Speaker 1: more striking things I thought in the paper was you
Speaker 1: actually look at other bank bailouts undertaken by the FED
Speaker 1: and the US front, including you know, Bear Sterns earlier
Speaker 1: in two thousand and eight, and then later on Morgan
Speaker 1: Stanley and Goldman Sachs also got some liquidity access from
Speaker 1: the FED, and you point out that those operations were
Speaker 1: actually done on far more favorable terms than what we're
Speaker 1: potentially being asked of Lehman Brothers. At the same time, Yes,
Speaker 1: absolutely so. In my reading of the evidence, Lehman Brothers
Speaker 1: just needed overnight, well collateralized lending through the FED lending facilities.
Speaker 1: But I guess what Morgan Stanley and Goldman Sachs received
Speaker 1: in large quantities was what also needed and that and
Speaker 1: that was quite safe. Again, it was lending one day
Speaker 1: at a time with big haircuts on the collateral. The
Speaker 1: loans to the I G and too Maiden Lane, which
Speaker 1: brought the bear stret certains assets were risk here. I
Speaker 1: mean a I G is quite striking. The collateral or
Speaker 1: the a I G loan consisted largely of stock equity
Speaker 1: ownerships and a I G S insurance subsidiary, and Fed
Speaker 1: River officials have said things like that was good collateral.
Speaker 1: It guaranteyed every penny of the money we lent. But
Speaker 1: I've never seen evaluation of that. And they're actually in
Speaker 1: again looking at the publicly available documents. There's some fragment here.
Speaker 1: There's some fragmentary evidence in the form of power point
Speaker 1: presentations of the New York Fed which seemed to call
Speaker 1: in the question how healthy these insurance companies are and
Speaker 1: how much they're really worth. As I say, it's fragmentary,
Speaker 1: but they've they're they've never given an account. Actually, another
Speaker 1: side story is that I repressed some documents about the
Speaker 1: I G loan under the Feet of Information Act, and
Speaker 1: the FED declined to provide them, and I them in
Speaker 1: federal court and I lost. So uh so we said,
Speaker 1: we don't have very much information about how valuable so
Speaker 1: a i g. Was lent eighty five billion dollars and
Speaker 1: whether the collateral was worth more or less than eighty
Speaker 1: five billion dollars. We have very little idea. So why
Speaker 1: didn't the FED bailout Leman? I mean you say they
Speaker 1: theoretically or for your research, they had the numbers could
Speaker 1: have backed it up. What ultimately was the reason? Yeah,
Speaker 1: why didn't they do it? That? Well? So I think
Speaker 1: based on my research is easier to say why they
Speaker 1: did not do it, what's not the reason and what
Speaker 1: is the reason. So my main point is that was
Speaker 1: not an absence the legal authority. They had the legal authority.
Speaker 1: And also in the extent of real time record, there
Speaker 1: was no discussion that do we have legal authority or
Speaker 1: don't we have legal authority? What way? What they were discussing,
Speaker 1: and this is not an original point with me, was
Speaker 1: politics of the matter. So, in particular, Henry Paulson, who
Speaker 1: seemed to have been in charge of the decision making,
Speaker 1: has been quoted by many people are saying, I can't
Speaker 1: do it again, needing a bailout. I can't be mr
Speaker 1: bailout again. In the record of emails between government officials
Speaker 1: over that weekend, there are things like, we can't do this,
Speaker 1: the press will kill us if we if we do
Speaker 1: this so again. This is not an original point with me,
Speaker 1: but the the idea that there was political pressure against
Speaker 1: bailouts is consistent with the evidence that I've seen, along
Speaker 1: with not fully appreciating how damaging the bankruptcy would be.
Speaker 1: I think nobody was an unprecedented event and they were
Speaker 1: worried about it, but there was hope that maybe they
Speaker 1: could contain the damage and it wouldn't be so bad.
Speaker 1: Do you think that was an objectively wrong judgment that
Speaker 1: should have been known at the time, or that something
Speaker 1: okay in retrospect. Clearly the Lehman failure was economically damaging,
Speaker 1: but it wasn't necessarily obvious that it was going to
Speaker 1: be so bad. That's a good question. I would say
Speaker 1: it was not necessarily obvious because it was an unprecedented event,
Speaker 1: but there was the fact that markets had already seen
Speaker 1: the Bear Stearn's problem and seeing problems that Lehman and
Speaker 1: UM and the FED was taking various measures to trying
Speaker 1: to contain the damage, increasing their lending to other investment banks,
Speaker 1: and several other things. So I I can imagine in
Speaker 1: real time arguing it either way. So I don't think
Speaker 1: it was obvious at the time that it was going
Speaker 1: to be as disastrous as it actually was. Actually, just
Speaker 1: for example, some specific things that happened the whole episode
Speaker 1: with the Reserve primary fund breaking in the box and
Speaker 1: that leading to the run on a market funds and
Speaker 1: the breakdown of the commercial paper market. That was very
Speaker 1: damaging and that was a big surprise to everybody. So
Speaker 1: this paper has been four years in the making, it's
Speaker 1: been out for um, I guess a little over a week. Now,
Speaker 1: what reaction have you gotten. Have you received angry phone
Speaker 1: calls from Ben Burnanki or Hank Paulson that sort of thing. Uh? No,
Speaker 1: Ben Brankian Hank Paulson have not shared their thoughts at
Speaker 1: any about the paper with me. To be honest, the
Speaker 1: reaction that received is similar to reactions I've received other
Speaker 1: papers critical of the Federal Reserve that people I know
Speaker 1: with the Federal Reserve don't like it, and most other
Speaker 1: people do like it. It's interesting vote on the left
Speaker 1: wing of the political spectrum and the right wing of
Speaker 1: the political spectrum, there's a lot of suspicion of the
Speaker 1: Federal Reserve. And actually, much as I'd like to say
Speaker 1: that my people have read my paper carefully and it's persuasive,
Speaker 1: obviously people's actions are based on their preconception. So I
Speaker 1: think a lot of people who were skeptical the FAD
Speaker 1: have have appreciated that people who work for the FAD
Speaker 1: or are very close to the fans felt like you
Speaker 1: mentioned some people at the FED and how they've reacted
Speaker 1: to the paper. I think when I was discussing this
Speaker 1: with some of my contacts who used to work at
Speaker 1: the New York FED in particular, one of the main
Speaker 1: criticisms they had was that you rely on sort of
Speaker 1: third party sources journalistic research, some of which full disclosure
Speaker 1: was mine back in two thousand and ten. About the
Speaker 1: Maiden Lane portfolio. My former New York FED contacts, they
Speaker 1: say things like that Maiden Lane analysis could have benefited
Speaker 1: from a regression analysis that would have actually revealed that
Speaker 1: the FED was buying very low grade collateral inflated prices. So,
Speaker 1: if anything, the paper could have been more forceful had
Speaker 1: it done some of the more traditional things that you
Speaker 1: find in macroeconomic papers. Okay, well that's interesting. So there
Speaker 1: are a couple of points there. I mean, I think
Speaker 1: both my paper and you're reporting on me in lane,
Speaker 1: if I may say so, I mean uses direct evidence
Speaker 1: about facts, and you actually had data on which securities
Speaker 1: exactly we're in the portfolio and what their ratings were,
Speaker 1: and that's just data. So I think, actually, um, again,
Speaker 1: there's lots of primary material out there that was gathered
Speaker 1: by the Financial Crisis Inquiry Commission, and I grew for
Speaker 1: the examiner of both of whom had subpoena power, and
Speaker 1: I think that's what I rely on mostly. I mean,
Speaker 1: as far as the point about regression analysis, I guess
Speaker 1: the simple answer to that is that one can add
Speaker 1: up numbers about what assets they have and add up
Speaker 1: numbers about what liquidity drains they would have had based
Speaker 1: on information about those things, and I'm not sure that
Speaker 1: high power statistics would add very much. Is there any
Speaker 1: particular lesson for policy makers now from your research, or
Speaker 1: is this something that was kind of hyper specific to
Speaker 1: an event and important for the historical record but may
Speaker 1: not necessarily be applicable in situations going forward. I would
Speaker 1: say that there are some lessons. I think for any
Speaker 1: any historical episode of this magnitude that understanding what happened
Speaker 1: is almost sure to have some lessons. In this case,
Speaker 1: a lessons at a couple of different levels. I think
Speaker 1: the fact that, or the my view that there could
Speaker 1: have been a better resolution of the crisis is important.
Speaker 1: What one reason is that, as I'm sure you know
Speaker 1: that dot Frank Act limits effectibility to rescue financial institutions,
Speaker 1: and it's actually, again, this would be complex, but but
Speaker 1: it's possible that what they could have done for Lee
Speaker 1: men actually there there would actually be legal barriers in
Speaker 1: the future. So I think it's relevant us. It's relevant
Speaker 1: for that. It's also in terms of Fed governance or politics.
Speaker 1: The Federal Reserve talks a lot about how they are
Speaker 1: independent of politics, and in this episode that doesn't completely
Speaker 1: ring true because of Kenry Paulson, the Treasury Secretary's role
Speaker 1: and dictating policy. The Federal Reserve officials also talk a
Speaker 1: lot about the principle of transparency about their policy actions
Speaker 1: and the reasons for their policy actions, and I don't
Speaker 1: think they were very transparent in this episode. Alright, So
Speaker 1: tell us what you're working on now or are you
Speaker 1: taking a break after penning this two d page report,
Speaker 1: which is quite hefty. Well, when we're you know now
Speaker 1: is largely did different things that I put off by
Speaker 1: they're going put off because of this project. I do
Speaker 1: mainly spend my professional life doing more traditional research, So
Speaker 1: I run regressions to estimate the philips current relationship between
Speaker 1: insolation and unemployment and things like that, like a regular macroeconomist.
Speaker 1: So I'm going back to that for a while. I
Speaker 1: don't I'm not sure what if anything, I might do
Speaker 1: related to the financial crisis in the future, you know,
Speaker 1: on on this question real quickly about sort of macroeconomics.
Speaker 1: I know it's always tough to talk about counterfectuals, but
Speaker 1: when I think of like that period, I see the
Speaker 1: Layman collapses sort of being a catalyzing force for some
Speaker 1: of the actions taken by both Congress and the Fed
Speaker 1: to start to turn the economy around. And so we
Speaker 1: had this massive collapse, but then we got TARP, and
Speaker 1: then we got you know a few months later, we
Speaker 1: got QUEI one and so forth. Had Layman been saved?
Speaker 1: Do you have any sort of vision of what the
Speaker 1: economic trajectory would have been would have been shallower, but
Speaker 1: a longer uh declined down something like that. Like, what
Speaker 1: is the sort of in your view alternate history scenario
Speaker 1: had they billed out Layman? Good question question, What would
Speaker 1: a kind of factual history like in in this in
Speaker 1: an alternate history novel if you were writing it, and
Speaker 1: and in that history they had bailed out Layman, how
Speaker 1: do you see things having played out? Because there was
Speaker 1: obviously still deep problems with all the bad mortgages that
Speaker 1: a Layman um a Layman rescue wouldn't have changed that.
Speaker 1: So how do you see the next several quarters and
Speaker 1: years playing out had they not let Lehman fail? So
Speaker 1: with with the obvious qualiplication that nobody knows, my guests
Speaker 1: would be. I think my guess would be it might
Speaker 1: be the latest. It might be like the collapse of
Speaker 1: the tech bubble, or like the savings and loan crisis
Speaker 1: of the nineteen eighties. I mean, it was a real
Speaker 1: problem in financial markets and people lost money in it,
Speaker 1: who would have had a dampening effect on the economy.
Speaker 1: But I think the scale the financial collapse and the
Speaker 1: scale of the Great Recession UM could have probably been avoided.
Speaker 1: All right, Lawrence Paul, we're going to leave it there.
Speaker 1: Thank you so much for joining us today. Than thank
Speaker 1: you very much. All right, Joe. So, I think that
Speaker 1: was a really good summary of what would otherwise probably
Speaker 1: take a good hour or so to read. What do
Speaker 1: you think? Oh? I thought I thought that was a
Speaker 1: fascinating conversation. I like anything that involves multiple years of
Speaker 1: meticulous research until one event to really shed light on
Speaker 1: something that, you know, it's probably just sort of hazy
Speaker 1: in people's mind. It's probably hazier in my mind than yours,
Speaker 1: because you have you did, you did reporting that got
Speaker 1: cited in the research. No. I love any work like
Speaker 1: this type of thing. Yeah, and I'm surprised that this
Speaker 1: paper has you know, it's been making some waves up
Speaker 1: but I'm surprised it's not getting more attention because it
Speaker 1: really synthesizes basically all the criticisms UM you could level
Speaker 1: at the FED or at US Treasury over that time era.
Speaker 1: And I think it's important to bring it up again now,
Speaker 1: specifically the point about how officials might have misjudged the
Speaker 1: impact of a Lehman Brothers collapse, because nowadays, as you know, Joe,
Speaker 1: we're facing so many more unknowns, right. Lehman Brothers collapse
Speaker 1: was a complete unknown back in two thousand eight, and
Speaker 1: now it seems like we're facing a throwing laundry list
Speaker 1: of unknown macroeconomic risks that no one really knows how
Speaker 1: they'll play out either. Yeah, I tend to, you know,
Speaker 1: when I think back about the decisions made in summer
Speaker 1: of two thousand and eight and early two thousand nine,
Speaker 1: I sort of, you know, there was this sort of
Speaker 1: fog of war type feeling where you're right in the
Speaker 1: middle of it and you don't know what decisions are
Speaker 1: going to prove correct, and you don't know what's going
Speaker 1: to um have been a mistake. But it really is
Speaker 1: worth examining in detail, even if it's several years later,
Speaker 1: the exact choices that were made. And I think he
Speaker 1: was spot on that any sort of his proper historical
Speaker 1: record of this stuff does potentially have, um have lessons
Speaker 1: for the things that we face today. Right, There's nothing
Speaker 1: better than financial crisis hindsight, isn't that in your Twitter bio? Yeah,
Speaker 1: I'm quoting myself. All right, let's go all right, Well,
Speaker 1: on that note, I'm Joe Wisenthal, there has been another
Speaker 1: episode of Odd LODs. You can find me on Twitter
Speaker 1: at the Stalwart and I'm Tracy Alloway. I'm on Twitter
Speaker 1: at Tracy Alloway. Thanks are listening. M