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Why Lehman is Still a Mess

April 8, 2014

More than five years after the collapse of Lehman Brothers, economists are still searching to understand why it failed as badly as it did. By this I don’t mean why it went bankrupt – everyone is well aware that its exposure to the mortgage market coupled with a high degree of leverage (31:1 by 2007) meant that only a small loss on its vulnerable positions would eliminate all of its equity.

The much more relevant question is why the insolvency proceedings have failed as miserably as they have for the firm. Writing for the New York Fed, Michael Fleming and Asani Sarkar reckon that Lehman’s senior unsecured creditors have only been paid out around 28% of their claims to date. (This implies a loss of around $200 billion.)

By way of comparison, between 1982 -1999 the average recovery rate for all financial institutions in a similar position was close to 60%. What makes Lehman so much difficult to wrap up (100% more difficult as the case may be) than other financial firms in dire straits?

The two Fed economists point to the inherent complexity of Lehman’s business model. This could be, though I doubt that Lehman is much more complex than other now defunct financials. It was undoubtedly larger, but its business model was not substantially different.

More tellingly, Fleming and Sarkar point to the lack of organized bankruptcy planning in the lead up to the 15 September 2008 Chapter 11 filing. There is no doubt that the filing caught pretty much everyone off guard, but this only begs the question of why.

Perhaps the surprise was a product of the U.S. government’s actions over the preceding months leading up to the failure of Lehman.

In March of 2008 the Federal Reserve issued a $29 billion nonrecourse loan to Bear Stearns in order to facilitate the failing company’s purchase by J. P. Morgan Chase. (“Nonrecourse” here refers to the fact that the Fed would be unable to go after J. P. Morgan Chase for repayment if Bear’s collateral proved insufficient to pay off its debt.) Bear Stearns held around $350 billion of assets at this point, and was the seventh largest securities firm in the world in terms of capital.

In the grand scheme of things, Bear Stearns was a bit player in the world of finance compared to Lehman. Lehman Brothers was nearly double the size in terms of assets, and its failure represents the single largest bankruptcy in US history.

Memories fade after five years, but in September of 2008 the world was shocked that no bailout was forthcoming for Lehman. Both the U.S. Treasury and Federal Reserve had previously committed to saving far smaller and less important firms – why would Lehman not be treated the same?

Turning back to the question of why Lehman has proven to be such a terrible mess even five years after its failure we should consider its preparedness (and that of its creditors) on the eve of its collapse. Research by the New York Fed points to the general unpreparedness of the company for its looming collapse. But why should it have prepared for something that seemed all but unfathomable? Everyone, and I don’t use that word lightly, thought the firm would be bailed out right up to the moment it filed for bankruptcy.

Today’s mess is a consequence of actions long past. There is a lot of talk of the government’s role in worsening moral hazard and sparking too big to fail firms to take undue risks, but there are other unintended consequences. By fostering an atmosphere of complacency that a large financial firm could fail, the Fed and Treasury primed the investment world to be unprepared. Today the disorderly nature of Lehman’s bankruptcy is apparent and a direct result of the shock it gave the world in September 2008.

There should not have been a bailout for Lehman, but neither should the Fed or Treasury have reinforced the belief that there would have been one by bailing out smaller and less important firms. Had the company filed for Chapter 11 in a more orderly manner, over $100 billion in losses could have been avoided.

(Originally posted at Mises Canada.)

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