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Fed transcripts: Bernanke chose to let Lehman fail

February 21, 2014

Ben Bernanke on Capitol HIll

FORTUNE — September 15, 2008 was a watershed moment for the financial crisis that consigned much of the world to an economic malaise from which we are still recovering. That day, government officials hastily arranged a sale of investment bank Merrill Lynch to Bank of America (BAC), while another bank — Lehman Brothers — was allowed to file for bankruptcy.

The failure of Lehman Brothers sent shockwaves through the global financial system, accelerating the crisis until leaders of the seven largest economies met on Oct. 10 and pledged to not let any more systemically important financial institutions go under. This promise led to the eventual passage of TARP and the much-maligned bank bailouts that, while politically unpopular, helped the world avoid a Great Depression-style meltdown.

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Here’s a slide from Ben Bernanke’s 2012 lecture on the Federal Reserve’s response to the crisis. It shows just how much this concerted action helped calm financial markets and dampen the severity of the crisis:

The chart shows the interest rates banks required to lend to each other overnight, an excellent measure of overall stress in the financial system. While they were at elevated rates going back to the middle of 2007, it was really Lehman’s failure that sent financial markets into panic mode and the promise of government backstops that calmed the markets and set the stage for a recovery.

Given this picture, the decision to not even attempt to use whatever government powers were available to save Lehman Brothers is questionable. Ben Bernanke and other officials have claimed that they did not have the necessary tools to save Lehman. In the case of the Treasury Department, this may be accurate. TARP had not yet been passed and Secretary Hank Paulson didn’t have a huge pot of money to pump into Lehman, as it later would with other major banks.

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The Fed’s claim that it didn’t have the power to save Lehman is much more dubious, and is further weakened by transcripts released Friday morning of the central bank’s 2008 meetings. The standard excuse for its inaction on Lehman is that central banks should be the lender of last resort to banks that are in a liquidity crunch, but are still solvent. That is, the Fed should lend money to any bank that has collateral to offer. When defending his decision to not intervene with Lehman, Bernanke has claimed that he could not offer anything because the bank was insolvent:

Lehman Brothers was in itself probably too big to fail, in the sense that its failure had enormous negative impacts on the global financial system … But there we were helpless, because it was essentially an insolvent firm.

But the difference between a firm being insolvent and illiquid isn’t cut-and-dried, and it hinges on how you value a bunch of inscrutable assets. Based on the opinions of Federal Reserve Open Market Committee members revealed in the recently released minutes, the decision to let Lehman fail seems to have much more to do with an ideological aversion to government intervention than anything else. Here’s St. Louis Fed President James Bullard on Sept. 16, the day after the Lehman bankruptcy:

My policy preference is to maintain the federal funds rate target at the current level and to wait for some time to assess the impact of the Lehman bankruptcy filing, if any, on the national economy … By denying funding to Lehman suitors, the Fed has begun to reestablish the idea that markets should not expect help at each difficult juncture. Changing rates today would confuse that important signal and take out much of the positive part out of the previous decision.

Hindsight is 20/20, of course, but it is stunning that Fed members thought that the Lehman bankruptcy could conceivably have no effect on the economy. Notice as well that Bullard paints the decision to not save Lehman as not one of necessity but of choice.

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Boston Fed President Eric Rosengren was perhaps the most insightful member of the Fed Board in 2008, as he was one of the few in favor of lowering interest rates as early as September, and questions the wisdom of the decision to let Lehman fail:

I think it’s too soon to know whether what we did with Lehman is right. Given that the Treasury didn’t want to put money in, what happened was that we had no choice. But we took a calculated bet. If we have a run on the money market funds or if the nongovernment tri-party repo market shuts down, that bet may not look nearly so good.

Rosengren’s statement is a bit murky here. He calls letting Lehman fail a “calculated bet” but then says that the Fed had “no choice.” This waffling has the whiff of justification, however. In e-mails unearthed by the Financial Crisis Inquiry Commission, we can see that the Fed was clearly considering a $200 billion loan to help keep Lehman afloat. These emails called that approach “a gamble” that might be worth taking.

But the Fed never took it, and it appears they did so at least partly for ideological reasons. This is all the more confusing because the federal government had spent the last 30 years intervening in crises to prevent destructive financial system meltdowns. In light of this, economist Alan Meltzer has called the decision “one of the worst blunders in Federal Reserve history.” Five years later, the recently released transcripts give us no reason to disagree with Meltzer’s assessment.