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Sophia Farrara and Chelsey Kohler

    ECN 272: Financial Crisis

    Professor Cottrell

    December 3, 2010

    An Analysis of the Significance, Cause, and Motives behind Lehman’s Bankruptcy

    During the Financial Crisis of 2008 many factors contributed to the sustained state of economic chaos which ensued in the following months. While many financial institutions were saved by the government and other rescue operations, the collapse of Lehman Brothers remains an outlier in these instances; rather than follow the seemingly apparent protocol of rescue the

    government did quite the opposite in letting Lehman fail. This paper seeks to explain the reason for this decision and investigate the ramifications it had on the economic and political system. Much controversy surrounded the decision to let Lehman collapse and several explanations have developed to justify the actions of the government. Lehman Brothers and its collapse was at the center of a political debate during the Financial Crisis which was based on theories of conspiracy, lessons being taught, and public pressure that was tied to political motives on the part of the Fed.

    There is no doubt that the downfall of investment bank Lehman Brothers was a major contributing factor to the Financial Crisis. There is however doubt regarding exactly why this financial institution was allowed to collapse and what specifically the ramifications were for the financial system as a whole. In the middle of March, 2008, the Federal government working with J. P. Morgan Chase bailed out Bear Sterns, however only several months later in September of the same year, Lehman Brothers was left to file for bankruptcy after the Federal government declined to rescue them. This inconsistency on the part of the government and the Federal Reserve contributed to the uncertainty which the Financial Crisis fostered.

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     Much debate has arisen over the inconsistency in the policies which were applied to Bear Sterns and Lehman in the onset of the financial crisis in 2008. Speculation surrounding these decisions includes conspiracy theories, hopes of sending a message, as well as theories based on public pressure, politics and other external influences from Wall Street. One of the most cited reasons why Lehman Brothers was allowed to file for bankruptcy rather than be saved was the need to enforce the existence of consequences in the banking system. Cassidy pointedly theorizes that “Many people suspect Paulson and Bernanke let Lehman go bankrupt to reestablish the

    principle that irresponsible behavior would be punished” (Cassidy 325). In the months which

    preceded the crisis the financial sector was in a “free-fall-climb” of unchecked wealth,

    unmonitored risk-taking, and un-acknowledged bubbles. Housing prices skyrocketed, new financial services were offered which were meant to bundle risks, and the overall accountability of firm‟s risk taking shrank. By letting Lehman Brothers collapse rather than intervene, the Fed

    sent a message which meant to cause firms to take responsibility for their actions and the risks which they had amassed. Kenneth Rogoff of Harvard University agrees that the decision to not bail out Lehman set a good baseline by establishing that “…we‟re just not going to bail out

    everyone in America” (“Uncertainty Hits Wall Street”). This argument however is flawed if one considers the fact that the Fed had previously agreed to, and succeeded in, bailing out several large firms who had done exactly what Lehman had in that they mismanaged their risk. Why then would the Fed decide to allow the collapse of Lehman Brothers after they had already bailed out Bear Sterns, Fannie Mae, Freddie Mac, and AIG among others?

     The answer to this question comes from an argument based on the inter-connectedness of an institution in determining whether the Fed would step in or not. The argument is based upon the fact that many people said Lehman Brothers wasn‟t big enough to save implying that its

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    failure would not lead to such disastrous consequences as the failure of larger, more inter-connected firms; “…the people behind the Federal Reserve had most probably conducted assessments already which show that the collapse of Lehman [wouldn‟t] bring much chaos to the markets opposed to the collapse of AIG, Bear Stearns, or Fannie Mae or Freddie Mac” (“Why

    AIG was bailed out”). With regards to the inconsistency in the policy decisions in dealing with Bear Sterns and Lehman Brothers the Fed argues that the rescue of Bear was an “extraordinary

    event” and if the Fed then turned around and rescued Lehman as well “it would have repudiated the claim that the Bear rescue was extraordinary…” (“Why AIG was bailed out”). The initial argument that Lehman was not inter-connected enough to save has many dissenters and the evidence for their disagreement is vast; the consequences of Lehman‟s fall did have massive ripple effects in the economy which contributed to the prolonged economic crisis.

    Robert C. Pozen, an economics lecturer at Harvard, recognizes the confusion surrounding the decision why Lehman was not saved and why such controversy has resulted. In discussing the lessons to be learned from Lehman‟s fall, Pozen points out that since many people thought Bear Stearns was “too big to fail, then many investors assumed that the Fed would bail out

    Lehman since it was twice as large as Bear” (Pozen). Pozen describes investors surprise at the decision to not intervene with Lehman as a result of the lack of communication between the Fed and the general public of investors. He specifically says that “The turmoil that followed

    Lehman‟s failure was a direct result of the government‟s failure to clearly explain why the Fed had bailed out Bear Stearns in March of 2008” (Pozen). To rectify this lack of communication,

    Pozen offers the suggestion that the Secretary of the Treasury should “state his reasons for bailing out any financial institution” and then further requiring a report outlining the costs and

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    benefits of any bailout decision (Pozen). This inconsistency in the policy of the Fed led to uncertainty felt by investors and the financial institutions themselves.

    The effects from the collapse of Lehman Brothers were far reaching and affected all aspects of the economy. The global financial community was shocked by the fact that the Federal Treasury allowed Lehman to go bankrupt and as a result “…no one knew who might be next. Bankers stopped lending to each other and credit markets froze” (Baldwin 9). The major result of

    the Lehman collapse, besides the direct negative impact on Lehman Brothers and their investors and assets was a sense of fear which gripped the global financial sector. The “unsteady and ill-

    explained behavior of the US government [led to the formation of] a massive feeling of uncertainty” which worsened the Financial Crisis (Baldwin 10). This fear factor affected

    willingness to borrow, lend, and spend; firms and investors played a game of “wait and see” which led to a “sudden financial arrest” (Baldwin 10). The “sudden financial arrest” led to a

    global credit freeze and many other financial instruments felt negative effects of the same sort (Bladwin 11). These negative effects were only a few of the many that were to come.

    Another result of the Lehman collapse dealt a blow to the safety of other major financial investment firms in the coming months. Help for major financial firms like Lehman had previously been sought from “major sovereign funds in Asia and the Middle East” was increasingly hard to come by… any chance of these large state-sponsored funds coming in…to

    invest in beaten-down financial institutions is for the most part finished” (Thomas Jr.). Additionally the strength of the dollar gave way and investors sold assets choosing instead to seek refuge “…in the safest securities they could find, government bonds” (Thomas Jr.). The effects just mentioned prove that Lehman was in fact significantly interconnected in the financial

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    markets as their collapse led to uncertainty on a global scale and worsened the credit freeze while also negatively impacting other major financial institutions ability to obtain funding.

    In considering the downfall of Lehman Brothers and the policies that were instituted by the Fed many arguments have arisen which tend towards the support of conspiracy theories in which the decisions of the Fed were not objective as they should have been. Investigating the validity of these claims is important in determining the real reason why Lehman Brothers was left to collapse, setting off the negative ripples which affected the rest of the financial community. In the case of Lehman, J.P. Morgan and Goldman Sachs are two of the major financial institutions which have been blamed as culprits of conspiracies (or conspiratorial actions) against Lehman Brothers thus facilitating their downfall.

    Politics and personal relationships between top officials have been cited as the source of the elements which contributed to the so called non-objective treatment of Lehman Brothers. J.P. Morgan is “…alleged to have frozen $17 billion of cash and securities belonging to Lehman on the Friday before it‟s failure” (Dey and Forston). This action has been cited as the cause of “the liquidity crisis that embroiled the firm” (Dey and Forston). In an article for Rolling Stone Matt

    Taibbi makes the assumption that a conspiracy between Treasury Secretary Hank Paulson, the former CEO of Goldman Sachs, was an obvious contributor to the decision regarding Lehman Brothers. In addition to the former loyalties of Paulson which Taibbi cites, he also discusses the negative effect which “naked-short-selling” had on both Bear Stearns and Lehman Brothers and

    how “[these] methods used to destroy these companies pointed to widespread and extravagant market manipulation…” (Taibbi). The possibility that the decision of the Fed in handling the

    failing Lehman Brothers was not made by objective parties and policies had great implications in the preceding months and the unwinding of the financial sector. Uncertainty remained a major

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    factor in the Financial Crisis and the support for conspiracy theories and other public pressures only contributed to the uncertainty.

    The core issue in the fall of Lehman Brothers, which has been proclaimed as a “failure [that will] go down in history as a gigantic misstep,” is whether the Federal Reserve was able to maintain objectivity in its decision (Sorkin). Historically, the Fed has been well-regarded internationally as a non-politicized agent independent from Congressional and Executive pressures. However, one consequence of the Financial Crisis has been the downfall of this reputation. Regarding the issue of Lehman Brothers, it is debatable whether the Fed made the decision to let Lehman fail “in a vacuum.” Although the ex-CEO of Lehman Brothers, Richard

    Fuld, has attempted to place blame on a number of different players in the crisis for the downfall of his firm, the potential conspiracy that this paper will explore involves Goldman Sachs, Congress, and the Fed (Taylor). The claim is as follows: By intentionally spreading rumors and participating in naked short-selling of Lehman Brothers stock, Goldman Sachs largely contributed to the weakening and eventual downfall of Lehman Brothers. Due to the nature of the political atmosphere at the time, the Securities Exchange Commission and the Federal Reserve did not perform the proper due diligence in order to protect Lehman Brothers; furthermore, there is evidence of an underlying motive to let Lehman fail in order to prove to Congress that a dramatic financial crisis was imminent, and proper powers needed to be allotted to the Fed and other authorities in order to manage it. Thus, spurred by Goldman Sachs and exacerbated by the Fed, the fall of Lehman Brothers was not entirely unintended and was, in a way, used as a “means to an end to pass TARP funds through Congress.

     Dramatic public pressure on the Fed was evident through political debates and opinions voiced through media outlets. Public anger towards Wall Street resonated with Congress and

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    President George W. Bush and resulted in heavy scrutiny surrounding bailout debates in regard to using public funds. Therefore, at the time Lehman was struggling, Congress did not have the momentum to support the use of public funds for a bailout of the financial system. Henry Paulson, Secretary of the Treasury during the Financial Crisis, was quoted saying, “I am being called Mr. Bailout. I can‟t do it again” (Nocera). Between March (acquisition of Bear Stearns)

    and September of 2008 (fall of Lehman Brothers), Henry Paulson and Ben Bernanke attempted to persuade Congressional leaders of the impending financial crisis in an attempt to secure the necessary powers to deal with the issues in the aftermath. However, they were met with strong opposition; there was no political will to get anything done. Ironically, once Lehman announced bankruptcy in September of 2008, $700 billion in TARP funds were allotted to the Treasury (Nocera). It is speculated that Paulson and Bernanke realized that something needed to happen in order for Congress to understand the gravity of the situation and pass the necessary bailout. The victim of their strategy, debatably, was Lehman Brothers (Carpenter).

    Richard Fuld, in Lehman Brothers‟ Financial Crisis Inquiry Commission (FCIC) on September 1, 2010, furthered this speculation by arguing that Lehman Brothers was the unfair victim of the Federal Reserve‟s accommodation of public opinion. His argument contained three

    major points. Primarily, he argues that Lehman Brothers was essentially in the wrong place at the wrong time. If the Fed had opened its financing window to investment banks before Bear Stearns failed in March, Bear Stearns could have remained operational, which would have lessened the need for government intervention and kept overall confidence in the market higher than it was otherwise. However, the failure of Bear Stearns and the rescue mission conducted by the Fed set a precedent of intervention, which impacted expectations of financial institutions and public opinion in opposite ways. Almost immediately, the federal government was criticized for using

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public funding to bail out a financial firm, which initiated a wave of debates about “how not to

    handle a bank failure.” Therefore, when Lehman Brothers was the next major institution to be faced with serious issues, it became the victim to Fed appeasement of public opinion (Fuld).

    Secondly, this unanticipated spotlight on Lehman Brothers caused it to be subjected to a disproportionate number of negative, often inaccurate, rumors about the stability and health of the company. This loss of confidence, argued by Fuld to be irrational and unjustified, became a self-fulfilling prophecy; if the public and investors believed Lehman Brothers was going to fail, its likelihood of failure skyrocketed. Lastly, in attempts to save Lehman Brothers, company executives actually suggested many solutions that could be implemented to bolster liquidity for the company. Although these suggestions were not taken at the time, many were ironically used on other investment banks after Lehman declared bankruptcy. This seemingly easy dismissal of and weak attempts to save Lehman Brothers suggests that there may have been other factors involved in the decision to let it fail (Fuld). In conclusion, federal hesitation and resistance to bail out Lehman Brothers was certainly apparent. However, this alone did not cause the institution to fail; questionable activities in the financial sphere, potentially originating with Goldman Sachs, may have played a significant part.

    Speculative accusations of insider trading began against Goldman Sachs when, in the midst of a financial meltdown post-Lehman failure, the company seemed to actually benefit from its bankruptcy. While many investment banks and financial institutions had to sell themselves or look to the government for support, Goldman Sachs got out of the subprime business just before

    ndLehman Brothers went under and managed to attain record profits in the 2 Quarter of 2009

    (Wilson). The major accusation against Goldman Sachs was its involvement in intentional short-selling of Lehman Brothers stocks. By illegally filling the market with misinformation and

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    intentionally spreading negative rumors about the stability of Lehman Brothers, this practice of

    1naked short-selling turned out to be extremely profitable for Goldman and very detrimental to Lehman (Colby, Portilla, Lange). The most damaging rumors to the future of Lehman Brothers speculated that the company was going to be acquired at a discount, and that it was losing two significant trading partners. Evidently, that alone would have strong negative effects on the stock value of the company (Matsumoto).

    To further complicate issues for Lehman Brothers, “abusive short-selling amount[ed] to

    gasoline on the fire for distressed stocks and distressed markets” (Matsumoto). The extent of

    short-selling that was apparent in the market in 2008 before the fall of Lehman and Bear largely contributed to the failure of both institutions. The amount of short sales can be illustrated quantitatively through the number of fails-to-deliver, which is what occurs in a naked short-sell because the security that is traded is not delivered to the buyer. Naked short-selling is detrimental to the company whose stock is traded because it artificially “increases the number of shares, thus

    devaluing the stock” (Matsumoto). Between 1995 and 2007, the number of fails-to-deliver

    multiplied nine-fold; the average daily value of fails-to-deliver went from $838.5 million in 1995 to $7.4 billion in 2007. Although this does not prove that short-sales caused the fall of Lehman, it is estimated that the rapid increase in the number of failed trades of Lehman and Bear Stearns stocks accounted for 30-70% of the decline in the value of the companies‟ stocks. Coupled with

    negative rumors about the health of the institution, such a drastic, immediate decline in the stock value of Lehman Brothers became a self-fulfilling prophecy (Matsumoto).

     1 Definition via web: “Short sellers arrange to borrow shares, then dispose of them in anticipation that they will fall. They later buy shares to replace those they borrowed, profiting if the price has dropped. Naked short sellers don‟t borrow before trading -- a practice that becomes evident once the stock isn‟t delivered. Such trades can generate unlimited sell orders, overwhelming buyers and driving down price” (Matsumoto).

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     Faced with these statistics, an important question to ask is: Why wasn‟t anything done to stop these short-selling practices before they spiraled out of control? In fact, the Enforcement Complaint Center, responsible for financial fraud, received approximately 5,000 complaints between January 2007 and June 2008, but only 123 of the tips were forwarded for further investigation; none led to enforcement action by the Securities and Exchange Commission. Despite Fuld‟s efforts to convince Congress and the Fed that naked short-sellers had “midwifed”

    Lehman Brothers‟ decline, public pressures in the political atmosphere kept the Fed from acting

    appropriately. The Fed weakly argued that the increased number of fails-to-deliver can be accounted for by misunderstandings between traders or a string of computer glitches; Congress merely would not listen, since it had already cast Fuld and Lehman Brothers as the “villain” in

    the situation (Matsumoto). Furthermore, Goldman Sachs‟ agreement to pay a $450,000 fine for

    the accusations (evidently, Goldman had a guilty conscience) resulted in the issue being figuratively “swept under the rug” (Reuters).

     The failure by the Fed, the Securities and Exchange Commission, and Congress to react appropriately to these blatantly reported abuses in the financial system can be circled back to political pressures. Evident in e-mails and notes that were dug up between Congressmen and Fed officials, including Ben Bernanke, it was clear that the fate of Lehman Brothers was at the heart of a political debate. Lucind Brinkler, from the Federal Reserve Bank in New York, is quoted: “There has also not been much appetite over the past few days for ideas that involve extending public support beyond the existing programs. These issues and speculation about how bankruptcy would likely unfold are the drivers of this thinking.” Also, an e-mail from Bernanke

    the night before Lehman declared bankruptcy suggested that research effort for alternative options for Lehman Brothers was minimal: “In case I am asked: How much capital injection

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