Felix Salmon

How miscommunication caused Lehman’s collapse

By Felix Salmon
September 3, 2009

Larry Elliott and Jill Treanor have a big story today, although I’d love to see it re-reported elsewhere. Remember the tick-tock on why Lehman Brothers was allowed to fail: although there was a bid on the table from Barclays, it required government funds, and neither the US nor the UK government were willing to provide them.

One hurdle remained: To ink a Lehman deal, Barclays needed a shareholder vote. There was no way to get one on a Sunday. Barclays would need the U.S. or British government to back Lehman’s trading balances until a vote could be held.

Government approval never came, though there are diverging views on why. Some blame the U.S. government for refusing to commit resources. Others say the British government refused to entertain a deal they worried would expose England to unnecessary risk.

From the other side of the pond, it seems that the Brits were convinced all along that the US money was there for the asking:

In London, the Treasury, the Bank of England and the Financial Services Authority all believed that the US government would step in with a financial guarantee for the troubled Wall Street bank…

The UK tripartite authorities – the FSA, the Bank of England and the Treasury – had expected the US government to stand behind Lehman in the way that it had backed two crucial mortgage lenders the previous week and helped to orchestrate the bailout for Bear Stearns in March.

No explanation has ever been given for the lack of government funds offered in the final weeks of the Bush administration, which had to step in to prop up the insurance company AIG days after Lehman’s demise.

That final paragraph is not strictly true. An explanation has been given, repeatedly: that Treasury had no legal authority to provide such funds. It’s just that nobody really believes it. In any event, it’s pretty clear that no one in Treasury was making its inability to provide funds clear to anybody in the UK. Treasury should have been saying “look, gents, we’ve saved the world three times now, but we’ve come a bit unstuck on this Lehman thing, we’re not going to be able to do it ourselves, do you think you could step up this time, give those Barclays chaps a bit of a helping hand, we’ll owe you one, it’s rather urgent”.

Instead, there seems to have been a complete breakdown in communication, with the UK team convinced that the US could and would bail out Lehman. After all, the Yanks had given them every indication that they were perfectly capable of dealing with such things on their own, and didn’t need any help from abroad:

The UK tripartite authorities were concerned about the financial system in the spring of 2007 and asked their American counterparts to participate in a “war game” to prepare for the collapse of a major US bank and develop a response to a financial crisis. However, the war game, which was to have included the UK, Switzerland, the Netherlands and the US, never took place because of a lack of willingness to participate by the US regulatory bodies.

The enormous global costs associated with the chaotic Lehman bankruptcy were entirely avoidable, and to my knowledge no one in power has ever apologized for letting it happen. Maybe Hank Paulson could be the first, in his upcoming memoir.

7 comments so far | RSS Comments RSS

I disagree in that global costs were entirely avoidable. The systemic risk was lurking even if Lehman had been either saved or Ch.11 was staved off. Lehman’s collapse just brought everything to the fore with an immediate urgency.

“Was Lehman the cause or was it the manifestation”

It was the manifestation of Richard Fuld’s failed strategy, holding onto the last lifeboat while his Titanic slowly sank under. LEH also had access to short-term collateralized borrowing via different FED facilities, and they chose not to use them accordingly.

Posted by Griff | Report as abusive

Guys dont forget the Uk had its hands full with RBS and Bradford and Bingley,

Also i doubt that the US couldnt handle the situation and needed the UK’s help

And Barclays were pretty damn close to bankrupcy at the beginning of this year, owning lehmann’s book would have made its situation even worse

Posted by samba | Report as abusive

Indeed an orderly process would have been much better.

Still, the way the financial system was gummed up through and through with bad debt, nasty delevering was on the way, Lehman or no Lehman. Our present troubles are primarily due to years of malinvestment in the distorted environment of the bubble.

Posted by Dan | Report as abusive

I’m I the only one amused by Felix Salmon’s September morning quarterbacking? Salmon was one of the leading cheerleaders for letting Lehman fail and I’m sure if the government had done something to prop them up he would have been the lead tut-tutter.

Instead we get a blog post a year later saying how easy it would have been to solve the problem. Pretty easy to solve the world’s problems from behind a keyboard a year after the fact.

Posted by harry | Report as abusive

The fundamental error was bailing out Bear Stearns, Fannie Mae, and Freddie Mac. It would have been far better for the government to have pushed them all under rather than to have bailed them out. But the very worst thing was for the Treasury to act in inconsistent and unpredictable ways and to generate hysteria in the financial markets.

This “too big to fail” fallacy is setting the stage for the next financial crisis. And the losses will be too big to dump on the taxpayer.

Posted by Charles R. Williams | Report as abusive

You wrote:

“An explanation has been given, repeatedly: that Treasury had no legal authority to provide such funds. It’s just that nobody really believes it.”

At this point, shouldn’t you or someone name the specific authority that Treasury could have used? It’s not enough to say “we don’t believe it, you could have done something.” What was the available authority?

As you know, the TARP legislati9on that authorized Treasury to buy assets and equity was not passed until October, following Lehman’s bankruptcy.

Posted by reader | Report as abusive

Have you not read the papers – academic, not press – which showed the governments were unaware of certain crucial factors because London’s light-touch regulatory regime was designed to attract capital flows by allowing secrecy. It’s been demonstrated that Euro banks were much more dependent on short-term dollar financing than anyone understood, certainly much more than Treasure and the Fed thought. This financing flowed through London – hidden information flows come back to bite – and relied on the US money markets. Remember that Lehman was a huge money market instrument provider so when it collapsed the money markets needed every available dollar so they yanked what they could and that caused an instantaneous cascade in the linked markets in which Euro banks suddenly found they had no dollars and thus no short-term funding. The Fed recognized this immediately and made something like $600B available to the ECB – repaid, btw – but the absolute lack of dollars caused the system to lock up like an engine with no oil. That lack of knowledge of capital flows, a classic information sink, was the basic precipitating cause of the credit lock-up. I would say if Treasury and the Fed knew what the heck was going on with the Euro banking demands for short US money, they would have acted differently, maybe allowing Lehman to fail but with money safeguards in place beforehand.

These papers are not exactly a secret.

Posted by jonathan | Report as abusive

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