Washington & Wall Street: Lehman Brothers and the Failure of Regulation

 Albert Einstein

The fifth anniversary of the failure of Lehman Brothers is generating a lot of comment, mostly of the sort that blames the largest banks for their evil ways. But when considering the lessons learned from the collapse of this large broker-dealer into bankruptcy in 2008, it is important to recognize the role of politicians and regulators in creating this mess in the first place.

The first key point to make about Lehman Brothers concerns the constant refrain from economists that the firm should not have been “allowed to fail.” The fact that my old employer, Bear, Stearns & Co., was rescued earlier that year by JP Morgan had created the false impression that the Fed and large banks were going to clean up the mess short of an outright failure. And if you know the history of Wall Street, the large clearing house banks had historically taken over the weaker players in times of market stress. The rescue of Long Term Capital Management in 1998 was the most recent example.

Unfortunately, neither the Fed nor the other regulators understood the scale of the disarray and absence of internal controls inside Lehman. The firm’s assets were undocumented and could not be sold, a fact that surprised federal officials who tried to bail out the crippled institution. Why was this a new revelation? Because in the early 1990s, then-New York Federal Reserve Bank President Gerald Corrigan had ended surveillance of primary dealers. As my friend David Kotok, Chairman of Cumberland Advisors, wrote in July of 2012:

Somehow, the insanity of the present unsupervised system involving the Federal Reserve’s primary dealers continues. The Fed had “surveillance” in place during the Drexel Burnham failure and the Salomon Brothers affair. There were no market meltdowns attributed to either event. Then, in the early 1990s, under the Corrigan initiative and with the approval of the FOMC and Chairman Greenspan, the Fed ceded the surveillance issue to the other regulators. Since this policy change, the toll of primary dealer casualties has grown to include Lehman Brothers, Bear Stearns, Merrill Lynch, MF Global, Countrywide, and now Barclays.

Corrigan, lest we forget, left the Fed shortly thereafter to join Goldman Sachs, where he has continued to run interference for the Wall Street dealer community. I addressed the nefarious role played by Corrigan and his mentor, former Fed Chairman Paul Volcker, in enabling the worst behavior of the Wall Street banks in my 2010 book Inflated: How Money and Debt Built the American Dream. Volcker, never forget, is the father of “Too Big to Fail.”

The abdication of responsibility by federal regulators like Corrigan for the increasingly risky behavior of the large banks and dealers is the untold story of the Lehman debacle. Keep in mind that Lehman owned a federally insured depository, Lehman Brothers FSB, which was supposedly regulated by the Federal Deposit Insurance Corp once the Fed ended dealer surveillance. The SEC was likewise supposed to be the regulator of Lehman’s dealer operations but was ill-equipped to act as a prudential regulator. Martin Mayer wrote in his 1993 book Nightmare on Wall Street: Salomon Brothers and the Corruption of the Marketplace:

Neither in Washington nor in New York did the Fed seem aware that the dangers of failure to supervise this market had grown exponentially in 1991. Like the Federal Home Loan Bank Board in its pursuit of making the S&Ls look solvent in 1981-82, the Fed had adopted tunnel-vision policies to save the nation’s banks. And just as excessive kindness to S&Ls in the early 1980s had drawn to the trough people who should not have been in the thrift business, Fed monetary policies in the early 1990s created a carnival in the government bond business.

The withdrawal of surveillance by the Fed in the early 1990s created the circumstances for the explosion in unsafe and unsound behavior by the Wall Street dealer community in the mortgage market a decade later. Keep in mind that the federally insured bank owned by Lehman Brothers was the conduit for that firm’s mortgage backed securities, a very deliberate move meant to give the firm a legal “safe harbor” for selling its toxic waste to investors.

By 2005-2006, when Lehman Brothers FSB was reporting 50% equity returns (making it the most profitable bank in the US at the time), the regulators did nothing to investigate what was clearly an anomaly among US banks. In the world of finance and risk management, it is axiomatic that any bank or company which is several times more profitable than its peers has to be doing something wrong. Since then, President Barack Obama and the same regulators at the SEC, Fed, and other agencies have actively avoided bringing charges against the individuals who caused the firm’s demise. As The New York Times reported this week:

Five years after Lehman’s collapse hastened a worldwide economic panic, the government faces lingering questions about the decision to spare executives like Richard S. Fuld Jr., who ran Lehman for 14 years until its demise. Not a single senior executive from any Wall Street bank faced criminal charges from the crisis, either. And the government’s deadline for filing most charges will expire this month, the anniversary of Lehman’s collapse, providing a reminder of the case and its unpopular outcome.

So when you think about the lessons from the collapse of Lehman Brothers, don’t forget that the actions and omission of key regulators aided and abetted this calamity. Not only did officials like Corrigan, Greenspan, and many others look the other way while Lehman was creating the circumstances for its own demise, but they did nothing to head off the crisis even when confronted by clear warning signs. 

The moral of the story of Lehman Brothers is that no amount of regulation can prevent acts of wanton stupidity, fraud, and greed in a free society. Expecting regulators to proactively prevent a financial crisis is at best wishful thinking. In the end, the failure and bankruptcy of Lehman Brothers was the best and only outcome for ending this latest nightmare on Wall Street.