Notice & Comment

Lehman the Lemon, or Lehman the Forsaken?, by Philip Wallach

Peter Conti-Brown says that the Fed’s official explanation for its failure to rescue Lehman Brothers, which blames the Fed’s legal limitations, is “pure spin,” and that “the Fed reached for legal cover when the Lehman bankruptcy turned out very differently than they had hoped. It was a political decision, not a legal one.” Under his reading of the Fed’s emergency lending authority in § 13(3) of the Federal Reserve Act, it is obvious that the Fed could have acted to save Lehman and clear that their strenuous protestations to the contrary are old-fashioned tail-covering.

I disagree, and hopefully in an edifying way: I think Peter’s understanding of § 13(3) leads to a kind of reductio ad absurdum—not in the sense of being facially illogical, but in a political economy sense if we keep an eye on legitimacy. That is, I think that Peter makes life too easy for the Fed’s lawyers when he imagines that they can read the law outside of any political context. As I see it, the decision not to save Lehman was political and legal both. The content of the law was hugely important in dictating what kind of choices the Fed would be willing to seriously consider, and thus acted as a crucial constraint—which isn’t to say it was an apolitical constraint. I’ll clarify this claim after going through some of the elements of Peter’s argument in greater detail.

Peter’s framing is that the Fed’s resistance to helping Lehman was actually political. Reading between the lines a bit, the claim is that the Fed was wary of being portrayed as the savior of financiers getting their just comeuppance, which is how many saw their rescue of Bear Stearns back in March 2008. Fear of creating moral hazard was the watchword in early September 2008, and so the Treasury and Fed refused to help Lehman. They somewhat shared concerns about moral hazard themselves, but just as importantly felt that political prudence demanded that they put these concerns front and center. Only after that decision blew up did the Fed frame its non-bailout of Lehman in exclusively legal terms.

To me, this account seems to badly oversimplify. First, as Lehman’s failure went from a hypothetical worry to an imminent possibility, the Fed hardly remained aloof. It was drawn into the search for a solution immediately, and (especially given its involvement with Bear Stearns) that meant it was effectively a party to negotiations. That means we shouldn’t take its own statements at face value: when it represented itself as unwilling to help Lehman (as indeed it did), the Fed was hoping to produce a certain kind of response from Lehman itself and its many Wall Street counterparties. It succeeded: the heads of Wall Street’s leading banks convened to try to work out a private solution, a la Long Term Capital Management.

When that ad hoc consortium failed to act, the Fed’s initial opposition to all direct involvement in Lehman’s problems was revealed as a bluff. If consistency is the hobgoblin of small minds, Treasury Secretary Paulson’s deal-making mentality positioned him to be a hobgoblin slayer many times over during the crisis. In this case, working in close cooperation with Paulson, the Fed expressed some willingness to play a role in helping Barclays complete its contemplated purchase of Lehman (see Paulson’s memoir, Chapter 9, Kindle loc. 3220). That might well have been the result but for Barclays’ UK regulators deciding that there was no way the bank could do the deal without a shareholder vote—which, given the time frames involved, was tantamount to saying that the deal couldn’t be done at all. So the Fed’s “political” desire to avoid becoming an all-purpose bailout vendor wasn’t so strong as to preclude significant help. That help might have been forthcoming if an appropriate buyer had been lined up, but the search for one ran out of time after Barclays’ jarring withdrawal.

What the Fed did not see was a way it could simply make a § 13(3) loan to Lehman directly. Here is where Peter’s rather unusual reading of the law comes in: he thinks that the right way to read the statute’s requirement that any loan be “secured to the satisfaction of the Federal Reserve Bank” is that the Fed can make any loan it likes. The “satisfaction” requirement, in this reading, is just an obligation to weigh the question of security (collateral) in the decision to make a loan. Then, having so reflected, the Fed may make the loan even if it has no expectation that it will ever get repaid.

If that reading is correct, then in the “unusual and exigent circumstances” during which § 13(3) becomes operative, the Fed can become a de facto fiscal authority, channeling money into the markets through the conduit of a failing firm. The only legal constraint is the Fed’s own general sense of right conduct in financial crises—as Peter reveals when he notes, “There’s no obvious hook for judicial review (and no independent mechanism for enforcement), and the authority given is completely broad.” With no serious prospect for having its decisions reversed on legal grounds, the Fed is legally unconstrained as a financial crisis responder.

In the context of republican government, given that we do not have an Article 48 in our Constitution, that strikes me as a misreading of the law. I (and most observers) read the “satisfaction” requirement as meaning that the Fed can only lend against what it genuinely believes to be sound collateral—i.e., it must act as a (central) bank, and not as a stand-in fiscal authority. The Fed’s assessment of Lehman Brothers as deeply insolvent at the time of the crisis meant that it did not have the legal power to lend. Years later, we have some indication that this assessment may have been flawed, but I don’t take the evidence uncovered as anything like dispositive. As I note in the book, the Fed’s defenders make a strong substantive case that the Fed was right to see Lehman as beyond helping as AIG (rescued days later) was not. Financial historians digging through the remains of Lehman and doing some serious accounting will have to take up those claims. But, contra Peter’s suggestion, the need to lend only to solvent borrowers becomes a solid legal constraint to be reckoned with.

Now, having made the case that law stayed in the picture in a very important way, let me hasten to concede that “solvency” is not a terribly well-defined concept, and the difference between well-secured loans and inadequately-secured loans is a murky one. The “satisfaction” requirement obviously cannot mean that the Fed should make only those loans it is certain will be repaid in full with interest, because such a reading would render it useless during the chaos of crises. That means that when the Fed interprets its own statutory responsibilities under § 13(3), it is necessarily making a discretionary judgment. This is a legal obligation not in the sense that if they don’t proceed in good faith they’ll lose in court—Peter is right, that seems highly improbable—but in the sense that the law decisively structures the Fed’s thinking. In doing that thinking, the Fed, like any government institution, must consider its legitimacy. In this case, the Fed decided that, to save Lehman, it would have to stretch its legal powers well beyond what its institutional legitimacy could support, and pulled back. Legality and legitimacy—not either/or. (I will concede that the Fed’s explanations of its Lehman decision, which sometimes tried to blame everything on clear legal limits, have considerably obscured these issues. The Fed’s lawyers do not have a preference for making their thinking transparent, to say the least.)

Peter might react to the last paragraph by saying: “call it what you will, you’ve just described politics in action, not law.” I would want to rebut that by digging still deeper into the meaning of those concepts…but let’s skip that for now. Here I’ll just make a more modest point. Normally, when people (and especially lawyers and legal scholars) say that something was decided because of “politics,” the connotation is that good substantive reasoning was overruled by a desire to please certain irrational parties (that pesky demos again…).

But if we insist on saying the Fed’s thinking in constructing its § 13(3) powers was fundamentally political, we ought to simultaneously acknowledge the propriety and even necessity of thinking in this political kind of way. By its own reckoning, in deciding whether to make a loan to Lehman the Fed had more at stake than just the principal lent out—it also had its institutional legitimacy to think about. It was far from crazy to think that serious political repercussions would have followed if it adopted Peter’s way of thinking only to watch its loans to Lehman go bad. And—whether you call it political or not—that seems entirely appropriate! We have good reasons to reject a Fed conceiving of itself as an unbounded savior, and thus no reason to wish for a world where it operates entirely above the fray of politics and legitimacy.

Likewise, whether you call it political or legal, appreciating this way of thinking allows you to understand why the Fed’s calculus could be so different when it came to AIG—because the insurance firm’s available collateral was very different, and because the dramatic fallout from Lehman’s bankruptcy changed the political environment very fast. What a difference a day makes: saving the world suddenly looked far more important than preventing moral hazard.

It was in that climate that the Treasury Department undertook its most legally audacious and substantively effective crisis maneuver: the guaranteeing of money market funds with the Exchange Stabilization Fund. Onto that in my next post.

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