It's conventional wisdom on Wall Street that the biggest government mistake of the last year was letting Lehman Brothers fail. I guess the barons of capitalism still don't get it.
Here's how the Wall Streeters see it: The March 2008 government bailout of Bear Stearns—if you can call a $2-per-share fire sale a bailout—sent a signal that the feds would not let a big investment bank go down. When Lehman started to sink in early September, the presumption was that the government would prevent an all-out liquidation because of the collateral damage it might cause throughout the financial system. By that logic, when the feds stepped aside and Lehman filed for bankruptcy on September 15, investors were so shocked that credit froze worldwide and the stock markets went into a record plunge from which we still haven't recovered.
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There's obviously some truth to that. But as historians unravel the intricate cause-and-effect correlations of the 2008 meltdown, it's quite possible that a different view will emerge. We know now that Lehman Brothers in the summer of 2008 had many of the hallmarks of a firm destined for failure. It had violated the rules of its own business, taking poor risks and accumulating astounding levels of debt. An incisive New York magazine story details how Richard Fuld, Lehman's headstrong CEO, turned down offers to buy his firm when there was still a chance to salvage it. A Wall Street Journal exposé shows how Fuld and his Lehman chums, convinced that their firm was impervious to market forces, basically vaporized $75 billion worth of assets by failing to plan for an orderly bankruptcy. "Lehman was a recklessly run company," says financial historian James Grant, editor of Grant's Interest Rate Observer. "It was hugely leveraged. Management was arrogant. This was a bad firm."
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Lehman was also an egregious example of corporate greed. Fuld earned about $240 million between 2005 and 2007—$80 million per year—while making the very decisions that would doom his firm. On average, the CEO of a public company listed on the S&P 500 index earns about $15 million a year, according to the Corporate Library—and most of them run companies that earn a profit and stay in business. Fuld and his Wall Street brethren believe they deserved such lavish earnings because they're smarter than everybody else and can spin a derivative on the head of a pin. Out in the real world, we're still puzzling that one over.
So, why should the government have saved Lehman Brothers? Oh, right—because the government saved a bunch of other floundering companies, like Citigroup and AIG and, later, General Motors and Chrysler, that happened to employ a lot of people and do a lot of business. And because Lehman was so vital to the financial system that it held the world's economy hostage.
Except maybe it didn't. What we learn from 2008 will help shape major reforms sure to come in the Obama administration and transform the financial system in ways that could last for decades. So, as the Lehman Brothers postmortem begins to solidify, here's some new thinking on why it may have been perfectly legitimate to let Wall Street's oldest investment bank fail:
Bear Stearns was the real mistake. There's clearly a disparity in the way the government handled Bear Stearns and Lehman Brothers. Bear Stearns was smaller, yet the government stepped in to broker the sale of that firm to JPMorgan Chase and take over $29 billion worth of bastardized securities that nobody would buy, at any price. The Federal Reserve and the Treasury Department did, in fact, send a strong signal that they would intervene to prevent one firm's problems from setting off a financial chain reaction. So six months later, with even more at stake, it stood to reason that Lehman would get the same treatment.
But what if the feds had never set the precedent? "Maybe the mistake was rescuing Bear Stearns," says Mary Miller, director of the fixed income division at investing firm T. Rowe Price. "The Bear bailout gave a false sense of security to the markets. Lehman was the wake-up call." If the government had let Bear fail completely, there might have been a credit freeze and market plunge in the spring instead of the fall. But it probably would have been less severe. And as Lehman's troubles mounted, Fuld and his minions almost certainly would have acted differently if they knew that oblivion was a real possibility.
As it turned out, Lehman came to embody the risks of "moral hazard"—the notion that decision makers will behave recklessly if they don't believe they have to bear responsibility for their own actions.
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Lehman may not have triggered the financial meltdown after all. There were so many cataclysms in mid-September that it's easy to forget who else was reeling. But one day after the Lehman Brothers bankruptcy, the government granted the huge insurance company AIG an $85 billion emergency loan to prevent it, too, from going belly-up. AIG had nearly twice the revenue of Lehman, four times as many employees, and a massive web of investments that the feds clearly thought could trigger a global catastrophe if the firm collapsed.
It wasn't all that surprising that Lehman, a deeply indebted investment bank, got into trouble when too many risky bets went sour. But the spectacle of a huge insurer like AIG—part of the institutional safety net that's supposed to prevent widespread catastrophe—suddenly faced with collapse itself was deeply unnerving. "The real surprise wasn't Lehman Brothers, it was AIG," Frederic Mishkin, a Columbia Business School professor and former member of the Federal Reserve Board, said in a recent speech. "Who would have thought that an insurance company would have been affected by all this? When that happened, all bets were off."
If it turns out that AIG's near-death experience was the most powerful trigger for the financial freeze-up that followed, then Lehman's failure looks tolerable by comparison. And the bank looks a lot less vital than its Wall Street apologists believe.
Somebody has to fail. Maybe there are a few institutions that are truly "too big to fail." But most aren't, and the failure of unsuccessful firms used to be capitalism's way of clearing the decks for smarter entrepreneurs with fresher ideas and better products. "Success stories are almost always preceded by failure," says Sydney Finkelstein, a professor at Dartmouth's Tuck School of Business and author of Why Smart Executives Fail. "It's like the way nature needs forest fires. It's nature's way of regenerating growth. There's something equally fundamental about the need for failure in a capitalistic society."
Pure free-market capitalism can be ruthless and volatile, which is why we have thousands of government regulations to protect workers and consumers and promote stability. But that doesn't give companies a license to screw up and then beg for forgiveness—and a taxpayer bailout. As the Category 4 winds of 2008 recede, Lehman Brothers looks increasingly like a firm that we're better off without. Now that it's out of the way, maybe somebody with better ideas—and a bit more decency—might take its place.