Inside the Federal Reserve Bank of New York, time was running out to answer a question that would change Wall Street forever.
At issue that September, six years ago, was whether the Fed could save a major investment bank whose failure might threaten the entire economy.
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The firm was Lehman Brothers. And the answer for some inside the Fed was yes, the government could bail out Lehman, according to new accounts by Fed officials who were there at the time.
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But as the world now knows, no one rescued Lehman. Instead, the firm was allowed to collapse overnight, a decision that, in cool hindsight, let problems at one bank snowball into a full-blown panic. By the time it was over, nearly every other major bank had to be saved.
Why, given all that happened, was Lehman the only bank that was not too big to fail? For the first time, Fed officials have offered an account that differs significantly from the versions that, for many, have hardened into history.
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Ben S. Bernanke, the Fed chairman at the time, Henry M. Paulson Jr., the former Treasury Secretary, and Timothy F. Geithner, who was then president of the New York Fed, have all argued that Lehman Brothers was in such a deep hole from its risky real estate investments that Fed did not have the legal authority to rescue it.
But now, interviews with current and former Fed officials show that a group inside New York Fed was leaning toward the opposite conclusion — that Lehman was narrowly solvent and therefore might qualify for a bailout. In the frenetic events of what has become known as the Lehman weekend, that preliminary analysis never reached senior officials before they decided to let Lehman fail.
Understanding why Lehman was allowed to die goes beyond apportioning responsibility for the financial crisis and the recession that cost millions of ordinary Americans jobs and savings. Today, long after the bailouts, the debate rages over the Fed's authority to bail out failing firms. Some Fed officials worry that when the next financial crisis comes, the Fed will have less power to shield the financial system from the failure of a single large bank. After the Lehman debacle, Congress curbed the Fed's ability to rescue a bank in trouble.
Whether to save Lehman came down to a crucial question: Did Lehman have enough solid assets to back a loan from the Fed? Finding the answer fell to two teams of financial experts at the New York Fed. Those teams had provisionally concluded that Lehman might, in fact, be a candidate for rescue, but members of those teams said they never briefed Mr. Geithner, who said he did not know of the results.
"My colleagues at the New York Fed were careful and creative, and as demonstrated through the crisis that fall, we were willing to go to extraordinary lengths to try to protect the economy from the unfolding financial disaster," Mr. Geithner said Monday in a statement to The New York Times. "We explored all available alternatives to avoid a collapse of Lehman, but the size of its losses were so great that they were unable to attract a buyer, and we were unable to lend on a scale that would save them."
Mr. Bernanke and Mr. Paulson said in recent interviews with The Times that they did not know about the Fed analysis or its conclusions.
Interviews with half a dozen Fed officials, who spoke on the condition they not be named, so as not to breach the Fed's unofficial vow of silence, suggest some Fed insiders believed that the government had the authority to throw Lehman Brothers a lifeline, even if the bank was nearly broke. The Fed earlier came to the rescue of Bear Stearns, after doing little analysis, and only days later saved the American International Group. The government subsequently saved the likes of Bank of America, Citigroup, Goldman Sachs and Morgan Stanley. Ultimately, whether Lehman should have gotten Fed support was a judgment call, not a matter of strict statute, these people said.
"We had lawyers joined at our hips," said one participant. "And they were very helpful at framing the issues. But they never said we couldn't do it."
As another participant put it, "It was a policy and political decision, not a legal decision."
A Wall Street Watershed
The account from the New York Fed officials provides new insight into a dangerous moment in Wall Street history. Countless financial figures — from Wall Street chiefs to government policy makers — have said that allowing Lehman to die the way it did was a misjudgment that inflicted unnecessary pain.
"There is close to universal agreement that the demise of Lehman Brothers was the watershed event of the entire financial crisis and that the decision to allow it to fail was the watershed decision," Alan S. Blinder, an economics professor at Princeton and former vice chairman of the Fed, wrote in his history of the financial crisis, "After the Music Stopped."
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"The Fed has explained the decision as a legal issue," Mr. Blinder said in an interview. "But is that true or valid? Is it enough? Those are important questions."
Whether the Fed should have tried to save Lehman is still a subject of heated debate. And it is unclear whether the firm could have been rescued at all.
What happened that September was the culmination of circumstances reaching back years — of ordinary people too eager to borrow, of banks too eager to lend and of Wall Street financial engineers reaping multimillion-dollar bonuses. Even so, saving Lehman from complete collapse might have shielded the economy from what turned out to be a crippling blow. And as the subsequent rescue of A.I.G., the insurance giant, demonstrated, a rescue could have included substantial protections for taxpayers.
Back in 2008, the Fed possessed broad authority to lend to banks in trouble. Section 13-3 of the Federal Reserve Act provided that "in unusual and exigent circumstances" the Fed could lend to any institution, as long as the loan was "secured to the satisfaction of the Federal Reserve Bank." In the eyes of the Fed, that means a firm must be solvent and have adequate collateral to lend against, and making that determination was the responsibility of the New York Fed, the regional Fed bank that had begun to assume responsibility for Lehman. On that September weekend, teams from the New York Fed were told to assess Lehman's solvency and collateral.
Whether and how much the Fed could lend Lehman depended on those teams' findings, although the final decision rested with Mr. Geithner, Mr. Bernanke and the Federal Reserve Board.
A Question of Valuation
In recent interviews, members of the teams said that Lehman had considerable assets that were liquid and easy to value, like United States Treasury securities. The question was Lehman's illiquid assets — primarily a real estate portfolio that Lehman had recently valued at $50 billion. By Lehman's account, the firm had a surplus of assets over liabilities of $28.4 billion.
Others had already taken a stab at valuing Lehman's troubled assets. Kenneth D. Lewis, then the chief executive of Bank of America — who, with the government's encouragement, was considering a bid for Lehman — asserted that Lehman had a "$66 billion hole" in its balance sheet.
A group of bankers summoned to the Fed by Mr. Paulson, who was hoping they would mount a private rescue, did not accept Lehman's $50 billion valuation for its real estate and could not decide whether Lehman was solvent. But potential private rescuers had a motive to lowball Lehman's value. Fed officials involved in the valuation stressed that the Fed could hold distressed assets for much longer than private parties, allowing time for those assets to recover in value. Also, because the Fed sets monetary policy, it exerts enormous influence over the assets' ultimate value.
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"There can't be any reasonable doubt that had the Fed rescued Lehman, that very act would have pushed up the value of its assets," Mr. Blinder said.
While the Fed team did not come up with a precise value for Lehman's illiquid assets, it provided a range that was far more generous in its valuations than the private sector had been.
"It was close," a member of the Fed team that evaluated the collateral said. "Folks were aware of how ambiguous these values are, especially at a time of crisis. So it becomes a policy question: Do you want to take a chance or not?"
Argument continues today over the value of Lehman's assets. A report compiled by Anton R. Valukas, a Chicago lawyer, at the behest of the bankruptcy court overseeing Lehman concluded in 2010 that nearly all of the firm's real estate valuations were reasonable. It also suggested that Lehman's chaotic bankruptcy caused many of the losses later borne by the firm's creditors. Other analysts have argued that Lehman was deeply insolvent.
Ultimately, the appraisals of the New York Fed teams did not matter. Their preliminary finding was that Lehman was solvent and that what it faced was essentially a bank run, according to members of the group. Researchers working on the value of Lehman's collateral said they thought they would be delivering those findings to Mr. Geithner that September weekend.
But Mr. Geithner had already been diverted to A.I.G., which was facing its own crisis. In the end, the team members said, they delivered their findings orally to other New York Fed officials, including Michael F. Silva, Mr. Geithner's chief of staff.
On Sunday, Mr. Bernanke was in Washington awaiting the New York Fed's verdict. In a phone call, Mr. Geithner said Lehman could not be saved.
The Fed would be lending into a run, Mr. Geithner told Mr. Bernanke, according to both men's accounts. In a recent interview, Mr. Bernanke said, "Knowing the potential consequences of Lehman's failure, I was 100 percent committed to doing whatever could possibly and legally be done to save the company, as were Tim and Hank." Mr. Paulson has concurred, saying, "Although it was Ben and Tim's decision to make, I shared their view that Lehman was insolvent, and I know the marketplace did."
Those at the Fed who have contended that Lehman was insolvent have never provided any basis for that conclusion, other than references to the estimates of Wall Street firms and other anecdotal evidence. The Financial Crisis Inquiry Commission asked for such evidence several times, but the Fed never provided it. The members of the New York Fed teams said that they did not prepare a formal, written report, and that no one asked them for any notes or work papers or asked them to elaborate on their findings. Scott G. Alvarez, the Fed's general counsel, told the commission that there was "no time" that weekend for a written analysis.
'A Lack of Legal Authority'
Phil Angelides, the crisis commission's chairman, said no one ever mentioned the New York Fed analysis during his hearings. "If in fact the analysis existed and was independent, it would have been in everyone's interest to have that out, even if it were in the form of notes," Mr. Angelides said in an interview. He added, "If you look at the record, there is no legal stopper," meaning a legal barrier.
So why, then, was Lehman allowed to die?
Mr. Paulson has said that politics did not enter into the decision. But he had endured months of criticism for bailing out Bear Stearns in March 2008, and the outcry only intensified after the Treasury provided support to the mortgage finance giants, Fannie Mae and Freddie Mac, in the first week of September. During a conference call on the Thursday before Lehman's collapse, Mr. Paulson declared to Mr. Bernanke, Mr. Geithner and other regulators that he would not use public money to rescue Lehman, saying he did not want to be known as "Mr. Bailout."
In written testimony before Congress that September, Mr. Bernanke made no mention of any legal constraint. Instead, he said, "We judged that investors and counterparties had had time to take precautionary measures."
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It was only on Oct. 7, after early praise for the decision to let Lehman fail had turned into a wave of criticism, that anyone mentioned the legal argument. In a speech that day, Mr. Bernanke said, "Neither the Treasury nor the Federal Reserve had the authority to commit public money in that way." Mr. Paulson first mentioned the claim a week later. In an interview, Mr. Bernanke said, "We made a deliberative decision to be very cautious about publicizing our inability to save Lehman out of concern that it would further worsen the market panic." Mr. Paulson made the same point. Mr. Bernanke was emphatic before the Financial Crisis Inquiry Commission in 2009: "I will maintain to my deathbed that we made every effort to save Lehman, but we were just unable to do so because of a lack of legal authority."
Mr. Bernanke and others have said that a Fed lifeline to Lehman might not have stopped the run on the firm. But others have said the point of Rule 13-3 was exactly that — to stop such panics.
"Of course the Fed can stop a run," said Mr. Blinder, the economist. "That's what it's all about."
Scholars are still struggling with the claim that the Fed could not rescue Lehman but was nonetheless able to save Bear Stearns and A.I.G.
What is clear to Mr. Blinder, he says, is that the decision was a formula for panic.
"The inconsistency was the biggest problem," Mr. Blinder said. "The Lehman decision abruptly and surprisingly tore the perceived rule book into pieces and tossed it out the window."
—By James B. Stewart and Peter Eavis, The New York Times