In analyzing the causes and effects of the Great Recession, an argument that often arises is that of “moral hazard,” the concept that by having the federal government rescue big banks and financial institutions during moments of crisis, they are actually encouraging reckless, irresponsible behavior. Through perpetual cycles of this type of behavior, the notion of “Too Big to Fail” is established, and given that there no repercussions to their actions, these firms will never learn their lesson and can operate with blissful ignorance of the consequences of their actions. There is a growing notion that if the government would not step in to save big banks from collapse, the rest would radically reform into a more stable structure, and enormous, long economic collapses such as the Great Recession would be less likely, or at least more navigable.

However, no one firm has generated more controversy on the subject of moral hazard than Lehman Brothers. The collapse of Lehman Brothers is often seen as one of, if not the, most important events that led to the Great Recession. However, a question that has often arisen is, why exactly was Lehman Brothers allowed to collapse? Many point out that other high-risk firms, namely Bear Stearns, AIG, Fannie Mae and Freddie Mac, were bailed out by the federal government, despite all being extremely high risk. But, for some reason, Lehman Brothers was still allowed to collapse. This paper serves to analyze the events leading up to Lehman Brothers filing for bankruptcy, as well as both the short term and long-term interpretation of the effects of this collapse, and to determine how to interpret the concept of moral hazard in this situation.

Leading up to their collapse, Lehman Brothers was the fourth largest investment bank in the United States, and one of the top suppliers of commercial paper. In 2006, the Lehman Brothers board of directors agreed to an aggressive growth strategy, whereby the company began taking on dangerous amounts of debt to leverage high-risk investments, sometimes as high as 30 times their equity. Many of these investments were in subprime mortgage bundles and derivatives, similar to most other major banks at the time, but at greater levels.

In 2007, the housing bubble finally burst, and the subprime mortgage market started to collapse. However, Lehman Brothers was slower than other firms to recognize the long-term effects of this collapse. Ignoring many of their own internal risk management practices, they decided to take a gamble and double down on their subprime mortgage investments, with the hopes that these would turn an enormous profit once the market began to climb up again.

Unfortunately, there was no recovery, and Lehman Brothers began to descend quicker and quicker towards bankruptcy. By the summer of 2008, Lehman Brothers was aggressively seeking a merger or sale to another firm to prevent its own demise. The CEO of Lehman at the time, Dick Fuld, approached Morgan Stanley, Bank of America, Korea Development Banka and the UK-based bank Barclays about potential mergers, while speculation grew across the industry of who would collapse next.

At this point, the Secretary of the Treasury, Hank Paulson, was beginning to get involved. He set up a meeting between Lehman Brothers and Bank of America on July 21, 2008, with the hopes of encouraging negotiations. However, Bank of America stalled and eventually backed out. Additionally, it was at this time that Fannie Mae and Freddie Mac were both in danger of going under, and on September 5th their official bailout by the federal government was announced.

In attempts to further promote their own sale, the board of directors for Lehman Brothers met and agreed to a resolution to maintain $42 billion of liquid assets, to show they were still salvageable. Unfortunately, over the next few days many of their major clients, including JP Morgan, began demanding cash for their pulled out investments rather than the collateral insured by the commercial paper market. One week after the bailout of Fannie Mae and Freddie Mac, the CEO’s of all major banks besides Lehman Brothers convened a secret meeting to try and determine how to resolve the situation, now that the vast majority of their liquid assets were gone.

From the meeting, Hank Paulson set up another attempt with Bank of America to try and negotiate a fair purchase of Lehman Brothers. By this point, relations between the too were cold, and they immediately pulled out, claiming the firm simply had to many bad assets for the merger to make sense, that the losses were too great. They would only agree if the federal government would ensure the bad assets. To this point, Paulson refused, and neither side agreed to give any ground. At this point, Bank of America began discussions with Merrill Lynch about a potential merger.

Meanwhile, Paulson was also in talks with Barclays. Eventually, Dick Fuld presented to the board of directors a plan for Barclays to purchase the bank, and Hank Paulson and the CEO’s of the other major banks agreed to raise $30 billion of liquid assets to fund the “bad assets.” The only thing riding on this was approval from the UK Financial Services Authority. Unfortunately, the FSA shot down the deal, claiming they were too concerned with the UK’s own financial system. Eventually, the Chair of the Securities and Exchange Commission called Lehman Brothers and “highly encouraged” them to file for Chapter 11 bankruptcy, and once agreed, Lehman Brothers was no more (Harris, 2012).

The general argument for moral hazard in this case would be that big banks generally assumed that they would be taken care of. From the high levels of involvement by the Treasury Department, Federal Reserve and SEC, to how in negotiations with Bank of America they demanded government backing of the “bad assets.” This attitude is, according to the theory of moral hazard, toxic in and of itself, and is in large part a major contributor to why a massive recession occurred in the first place.

In the case of Lehman Brothers, we see an investment bank that not only engaged in risky behavior and engaged in questionable investments, but they also took a gamble on those bad investments, which resulted in their collapse. As they start to slip, they begin to panic and reach out to everyone, even government interference, for help. The considerations themselves also requested government backing, and the fed even set up many of the negotiations that did not involve them initially. To believers of moral hazard, letting the collapse of Lehman Brothers occur is a just action that they wholly deserved (Wallison, 2011).

However, the situation is far more complicated than that, and moral hazard is somewhat to blame. When Hank Paulson first began to get involved, such as the initial meeting between Bank of America and Lehman Brothers, he was under a lot of scrutiny for his bailout of Bear Stearns. At this point, the argument of moral hazard had already begun to unfold. These criticisms would increase exponentially with the bailouts of Fannie Mae and Freddie Mac, and he began to become subject to increasing political pressures as well, from both sides of the isle (Harris, 2012).

When analyzing the effects of the Great Recession, however, we can clearly see that letting Fannie Mae and Freddie Mac collapse would have been an absolute disaster. Before the collapse of Lehman Brothers, the economy was certainly dipping, but it had not tanked yet. The collapse of the subprime mortgage market hurt all of the investment banks, but to allow all of those to default would have destroyed them. It was not until the collapse of Lehman Brothers that the Great Recession really hit, when all the banks began to panic (Ydstie, 2008).

There is also evidence that there were some sour relationships between Dick Fuld, the federal government, and some of the other banks, namely Bank of America. When Hank Paulson went to the final negotiations with Bank of America, it was described as “chilly at best.” This could have been due to any number of reasons, from unwanted government pressures, to knowledge of the Merill Lynch deal, to awareness that Bank of America was being used to leverage Barclays, to simply stress or mutual disliking of each other, but many of the meetings designed to find solutions to Lehman’s problem resulted more in, as Dick Fuld described it, “chicken fights” (Harris, 2012).

The immediate reaction to Lehman’s collapse was that it was the catalyst that sparked the worst of the Great Recession. Immediately following their bankruptcy, the government came under widespread scrutiny. Hank Paulson admitted that he never considered bailing out Lehman Brothers, but many people agreed that it might have slowed or curbed the Great Recession otherwise. It is widely agreed that when Lehman went under, the Great Recession really began. And that this was mostly due to political pressures to avoid moral hazard.

However, the immediate reaction was that letting Lehman Brothers collapse actually increased moral hazard rather than prevent or discourage it. Only days after Lehman’s collapse, when the stock market had completely crashed, the government decided to bailout AIG, which was equally risky, if not more. Previous decisions to bailout a smaller firm like Bear Stearns but to let one with a meaningful global presence such as Lehman, the fourth largest investment bank in the US, were brought to question. The concept of Too Big to Fail is unappealing to most people, but there are clearly certain firms that are more important than others for global stability, and to let them go bankrupt out of principle does not really prove anything. Rather, the government needs to pick and choose who they let fail more carefully, to make examples of firms but know the proper time and place.

As for worsening moral hazard, it has been argued that since the collapse of Lehman Brothers, instead of providing insurance on certain investments, the government has directly infused capital into firms. Instead of providing a buffer, they are becoming directly interested. Whereas moral hazard was once a concept to detach the federal government from major banks, by trying to clean up the mess after the collapse of Lehman Brothers, the argument of moral hazard has now become even worse as the government becomes even more intertwined with Wall Street (Ydstie, 2008).

Later analyses of the Lehman Brothers case seem to agree with this view as well. As mentioned before, the collapse of Lehman Brothers is agreed as the beginning of the worst of the Great Recession. It was at this point that all of the other major banks began to panic. According to the American Enterprise Institute, this is due to the fear of not knowing who would be saved. To most of the other banks, Lehman’s allowance to collapse seemed comparatively unjustified, especially since the other firms had even agreed to raise money to help save it. In an industry entirely based on speculation, when outside forces act at random (according to them), there is no way of predicting the future. Therefore, they begin to liquidate themselves as much as possible, and the system collapses.  It is argued that although Lehman Brothers was rife with systemic risk, by letting them fail the government actually inserted even more systemic risk into the economic system.

However, what is also interesting is that in 2011 the Federal Deposit Insurance Corporation issued a report claiming that the federal government might have made a mistake in letting Lehman fail. At the time, the reasoning behind their policy of non-government intervention, assuming we ignore the very real political pressures behind the move, was that the federal government would not be able to support such a large amount of high-risk debt. It was argued that Lehman Brothers did not have enough liquidity to support the large number of bad investments the government would take on, and this is why they were allowed to collapse.

As mentioned before, we know that other banks were willing to collaborate in an attempt to generate the amount of liquidity needed to support Lehman Brothers. On top of this, in the 2011 report the FDIC claims that it would have been able to support government intervention and eventually spin off the firm with much smaller losses than they initially anticipated back in 2008, as little as 3%. Why this analysis was so misinterpreted at the time could have simply been due to the urgency of the situation, but it seems that Lehman Brothers might have indeed been savable (Wallison, 2011).

Between political pressures to keep the government out of another bailout and the sour relationships developing between the banks and the government, it would seem that the moral hazard argument actually created more problems rather than setting a good example. In attempts to prevent any further government interference and to let Wall Street solve its own problems, the Great Recession might have, in fact, been made worse by making an example of Lehman Brothers. The fact that many still speculate why only Lehman was allowed to fail, and the uncertainties this caused in the financial industry, certainly call into question the entire argument of moral hazard, which allows people to dismiss it.

But I would argue that this is due to our definition of moral hazard in this instance. Generally, moral hazard is to stop passively encouraging bad behavior, to stop stepping in when things go bad and to let things run their due course. But given the complex modern-day relationship between the federal government and major banks, and after seeing the effects of letting Lehman go under, I would say that this definition is ineffective.

Rather, the real moral hazard issue is that the federal government is too involved in the first place. Moral hazard would not involve bailing out major banks if the government was not directly involved in leveraging political pressures to influence the system. With no outside buyers, the government decided to let Lehman fail because it was under heavy amounts of political pressure to avoid moral hazard, even though it probably knew that letting one of the largest investment banks in the world would have resounding effects on the global economy. They also knew other banks were highly concerned, given their willingness to help in the final days of Lehman’s legacy. But by succumbing to political pressure, it actually made the situation worse, and also worsened the level of its moral hazard by becoming even more entangled in future bailout efforts, such as AIG.

Lehman Brothers provides an invaluable example for the study of moral hazards in financial institutions. The systematic encouraging of risky and irresponsible behaviors through continued government intervention is a policy that needs to be stopped. However, Lehman Brothers is far from a black and white case, and it is generally agreed that the collapse of Lehman Brothers was the cause of the worst of the Great Recession. By succumbing to political pressures to stop bailouts, the economy was actually made worse and the threat of moral hazard was worsened by even more comprehensive government intervention. However, if we use the case of Lehman Brothers to help evolve our understanding of what moral hazard truly means, we can use this example to enact policy that not only prevents the “traditional” definition of moral hazard from occurring again, but also begin to take government out of the equation in the first place.

Bibliography

  • Harris, Randall D. “Lehman Brothers: Crisis in Corporate Governance.” Harvard Business School (2012).

This was my primary source that provided most of the factual evidence. It was extremely useful in explaining, in detail, the events leading up to Lehman’s collapse, including numerous attempts to save it, and what factors ultimately led to their demise.

This source was very helpful because it provided evidence from a government             report claiming that the situation could have been much different had they             bailed out Lehman in the first place. I like that it contrasts the other sources             and explains why Lehman collapsing was so significant, as well as offer             solutions for future problems.

Not only is this source from the reputable NPR, but it was also published immediately following Lehman’s collapse. It was interesting to see the short-term perspective on Lehman’s collapse, why it happened, how it affected everyone, and what they think should have happened. I mainly used it to show what people thought of the short term implications, and to evolve the concept of what moral hazard really is.

 

 

 

 

 

 

 

 

 

Writing Goals

  1. Be more clear in intellectual arguments – a heavy criticism of my last paper was that there are ideas that are simply intuitive to me, but might not necessarily be so for the reader. I sometimes have a difficult time fully explaining concepts, because I often feel that they naturally define or explain themselves, so I want to work on making sure that my arguments are comprehensive to all audiences.
  2. Completely but concisely summarize the case – this is a very controversial topic with a lot of research surrounding it, and it could be very easy to ramble. I want to make sure I pick out key facts without leaving any gaps, to prevent myself from over-explaining.
  3. Logical conclusions – this is similar to goal 1, but I want to make sure that when I argue not to excuse moral hazard, but rather to redefine it, that it makes sense to everyone, not just me.

 

 

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