Markets & Finance

The Lehman Crisis: An Unhappy Anniversary


In looking at the causes of the panic, Wharton's Jeremy Siegel says the Fed shares some of the blame for its creation—and most of the credit for keeping things from spiraling out of control

One year after the collapse of Lehman Brothers, the causes of the financial crisis have come into focus, and the impact of government policies can be assessed. There's plenty of blame to go around—but we should also note the actions that saved the world's economies from a far greater calamity.

The roots of the crisis, of course, lay in the real-estate frenzy of the early 2000s. At the peak of the housing boom, major financial institutions were seriously overleveraged in real estate and real-estate related assets. These firms, as well as the major rating agencies, ignored the substantial evidence that the real estate market was in a bubble and therefore substantially underestimated the risk in subprime and other mortgage instruments.

Ultimately, responsibility for the fate of many failed financial firms must fall on the CEOs who were blinded by the seemingly high profitability of financing the housing market and failed to control risk and leverage of their institutions.

The Federal Reserve was also seriously at fault for not anticipating the crisis. Alan Greenspan, along with his successor, Ben Bernanke, failed to grasp the danger posed by the excessive build-up of leveraged subprime securities by the major financial institutions. Furthermore, the Fed failed to issue any warnings—or, for that matter, take any actions—to prevent this overleveraging from occurring.

The collapse of Lehman sent the financial markets into a tailspin. A year ago investors asked, "If Lehman's paper isn't any good, whose is?" As a result there was a massive exodus from private capital to safe Treasury securities, paralyzing capital markets, freezing lending, and sending risk premiums on corporate and personal debt to record highs. These convulsions in the credit markets caused the recession from which we are just now emerging.

But if the Fed should shoulder some of the blame for the crisis, it should also receive some credit for its response to the financial panic. Despite its failure to foresee the crisis, the central bank aggressively countered the panic by dramatically lowering the Fed funds rates and generously supplying reserves to the banking system. These massive provisions of liquidity have prevented the recession from turning into a 1930s-style depression. Equity markets around the world, sensing a vigorous economic recovery, have rallied sharply from their March lows.

Decisive Measures Saved the Economy

Bernanke's peers in Europe and Asia also took decisive measures as the crisis unfolded. I believe the actions of the world central banks were by far the most important steps taken to fight the recession. The fiscal stimulus by the both the Bush and Obama Administrations moderately increased spending, but at the cost of increasing our long-run deficits. The Troubled Asset Relief Program was ill-conceived and lending from the Fed provided far more liquidity to the banking system than the capital injections enabled by the TARP.

Looking forward, the most important reform needed to prevent another crisis is to establish procedures for winding down and liquidating large, troubled nonbank financial institutions, such as Lehman Brothers and AIG (AIG). Such procedures should be similar to those used by the FDIC for the banking industry. Large financial firms must have substantial risk capital to prevent these firms from taking excessive risks, hoping to secure a government bailout if they fail.

One aspect of the Treasury's reform proposals that are now circulating is particularly disturbing: Requiring the Fed to obtain advance approval from the Congress for any loan in "unusual and exigent circumstances." It is critical that the Federal Reserve be afforded the maximum flexibility to act in times of crisis when a matter of minutes can mean the difference between an orderly market and one frozen in panic. Imagine what may have happened to the global financial system last year if the Fed had to spend days or weeks seeking approval for its various rescue actions. Congress can always deal with inappropriate Fed lending after the fact, since ultimately the Federal Reserve is a creature of Congress and has no constitutional protection.

What economists learned from studies of the Great Depression has proved critical in preventing a repeat of that economic disaster. Milton Friedman's historical monetary analysis, which earned him the Nobel Prize in Economics in 1976, convincingly argued that the lack of Fed action to prevent the banking collapse was the principal reason for the Great Depression. Bernanke came to the same conclusions and vowed not to repeat the Fed's past mistakes.

Although the government encouraged subprime lending, the excessive risk-taking and leverage originated from the private sector, just as it did the 1920s. But in contrast to the mistakes of the 1930s, central banks around the globe have led a forceful response. The decisive actions by the Fed and its counterparts leave me optimistic that a solid economic recovery is now underway.

Siegel is Russell E. Palmer Professor of Finance, The Wharton School, University of Pennsylvania .

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