How the Fed slept through Lehman

By Felix Salmon
March 16, 2010
Andrew Ross Sorkin today notes that the Fed and the SEC didn't do anything about Lehman Brothers, despite the fact that they knew full well that there were problems.


" data-share-img="" data-share="twitter,facebook,linkedin,reddit,google" data-share-count="true">

Andrew Ross Sorkin today notes that the Fed and the SEC didn’t do anything about Lehman Brothers, despite the fact that they knew full well that there were problems.

Where was the government while all this “materially misleading” accounting was going on? In the vernacular of teenage instant messaging, let’s just say they had a vantage point as good as POS (parent over shoulder)…

Indeed, it now appears that the federal government itself either didn’t appreciate the significance of what it saw (we’ve seen that movie before with regulators waving off tips about Bernard L. Madoff). Or perhaps they did appreciate the significance and blessed the now-suspect accounting anyway.

Yves Smith found the most telling part of the report on Thursday: it’s on page 1,488 of the report, which is page 445 of this PDF.

Liquidity was an important factor in the stress testing that Lehman was required to run under the CSE Program. After March 2008 when the SEC and FRBNY began on‐ site daily monitoring of Lehman, the SEC deferred to the FRBNY to devise more rigorous stress‐testing scenarios to test Lehman’s ability to withstand a run or potential run on the bank. The FRBNY developed two new stress scenarios: “Bear Stearns” and “Bear Stearns Light.” Lehman failed both tests. The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed. However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed. It does not appear that any agency required any action of Lehman in response to the results of the stress testing.

The CSE program, which stands for Consolidated Supervised Entities, was the SEC’s way of trying to supervise too-big-to-fail banks from the inside. But even the SEC didn’t think it was qualified to actually do that, which is why the SEC brought in Geithner’s New York Fed as a partner — note the bit above about the SEC “deferring” to the Fed to put together stress tests.

Clearly the CSE program was an abject failure: it could put together stress tests, but then the SEC and the NY Fed ignored the results. There’s obvious bad news here: that the Fed is such an incompetent regulator of systemically-important institutions that it can’t even get alarmed when one of those institutions fails its own stress tests. But there’s a possible glimmer of good news too: that the Fed had people capable of putting together a decent stress test, and that the SEC sensibly deferred to those people in terms of stress test design. In other words, the Fed has the ability to regulate; all that’s needed now (and was missing in 2008) is the willingness to do so and to bare teeth once in a while.

A good way to institutionalize that is to implement what David Merkel calls “dumb regulation” — once you put simple rules in place, it becomes much more difficult (although never, of course, impossible) to override those rules or to ignore them. The problem with Lehman was that there were no simple rules, and that no one at the Fed or the SEC felt comfortable making up new ones on the spot, like “you’ve got to be able to pass the stress test which we invented five minutes ago”. I, for one, wouldn’t want to be the regulator who had to receive the phone call from Dick Fuld after implementing a rule like that, using dubious legal authority.

One of the problems with giving lots of supervisory authority to the Fed is that the Fed is run by economists who care primarily about setting monetary policy, as opposed to being run by bankers who care primarily about bank regulation and systemic risk. The base-case scenario is that unless and until we start staffing the Fed with a bunch of poachers-turned-gamekeepers, the biggest banks are likely to be able to smooth-talk their way past the Fed’s regulators. The Fed is still the least bad institution to do this: any other alternative would be even worse. But that doesn’t mean that I have any confidence in it.

Comments
5 comments so far

“But there’s a possible glimmer of good news too: that the Fed had people capable of putting together a decent stress test, and that the SEC sensibly deferred to those people in terms of stress test design. In other words, the Fed has the ability to regulate; all that’s needed now (and was missing in 2008) is the willingness to do so and to bare teeth once in a while.”

Are you really saying that the fact that Lehman failed the Fed’s stress tests is evidence that “the Fed has the ability to regulate”? From this one incident we can tell that “the Fed had people capable of putting together a decent stress test”?

Those conclusions, and the supposed good news they imply, do not follow at all. What the Fed did is the equivalent of getting an easy question right on a very long test. This says nothing about their ability in other areas of regulation, and its not even safe to conclude from this isolated incident that their stress tests will be be correct in the future.

So no, this does not mean the Fed has the ability to regulate, but is just lacking the willpower. At all.

Posted by Claremont1 | Report as abusive

Maybe the Fed and the SEC didn’t do anything about Lehman or any other incompetently run bank because the Bush administration did not believe in regulation. We had an administration and a congress that believed the market would take care of everything, and there was no need for the federal government to get involved. Net result: the people running the financial industry did what was best for themselves.

This attitude still persists today, as the feckless majority Democrats defer (cower is probably a better word) to the minority Republicans, whose rejections of all calls for new regulations are just facades for their ideology-based objections to regulation of any kind. I guess they still haven’t seen the email about how the self interests of executives (especially those in the financial industry) do not align with the self-interest of the firms they run, let alone the best interest of the nation.

You can have all the rules you want, if nobody is there to enforce them, it’s not going to matter.

Everybody needs to lower their expectations. Republicans want nothing from government, and the Democrats are going to cave.

Posted by OnTheTimes | Report as abusive

Surely the most plausible explanation for the delay in allowing Lehman to fail is that September 2008 was the drop dead date for the major dealers to be online for centralized submission and confirmation of CDS trades.

The regulators successfully prevented a collapse of the CDS market (which was very much at risk in March 2008 because so much trading was done via email, etc), but wrongly assumed — because everybody had plenty of time to hedge a Lehman failure — that there would not be chaos in the money markets.

Posted by csissoko | Report as abusive

Confidence or no, Felix, here is a model of how that could look:

http://epicureandealmaker.blogspot.com/2 010/03/poachers-turned-gamekeepers.html

Posted by EpicureanDeal | Report as abusive

The Fed didn’t sleep through Lehman. They were wide awake and as active as ever they get, which is why rendering the Fed unconscious once and for all is becoming an ever more attractive proposition.

Posted by HBC | Report as abusive
Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/