RX For Revisionist Bunkum: A Lehman Bailout Wouldn’t Have Saved The Economy

Courtesy of David Stockman via Contra Corner

Here come the revisionists with new malarkey about the 2008 financial crisis. No less august a forum than the New York Times today carries a front page piece by journeyman financial reporter James Stewart suggesting that Lehman Brothers was solvent; could and should have been bailed out; and that the entire trauma of the financial crisis and Great Recession might have been avoided or substantially mitigated:

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.

That is not just meretricious nonsense; its a measure of how thoroughly corrupted public discourse about the fundamental financial and economic realities of the present era has become owing to the cult of central banking. For crying out loud, yes, there would have been a Great Recession – even had Lehman been pawned off to Barclays with a taxpayer guarantee or if it had been bailed-out in some other manner.

In fact, the Barclay’s logo did end up on Lehman’s 7th Avenue glass tower shortly after the September 15th screen shot below. Yet the decision to allow Lehman’s stock and bondholders to take a severe haircut first did not cause the thundering collapse of the housing and credit markets, nor the loss of the artificially bloated level of consumption spending, jobs and income that had accompanied the giant financial bubble that finally burst in September 2008.

The villain is the Greenspan Fed and the rampage of debt and speculation its cheap money and “wealth effects” coddling of Wall Street had engendered over the previous two decades. When Greenspan took office in 1987, total credit market debt outstanding was $10.5 trillion, but by the time of the Lehman event it was nearly $53 trillion. This means that the debt burden on the US economy had soared by 5X during a period when nominal GDP grew by only 2.9X. That’s called leveraging up big time—–and it fueled a party of consumption and speculation like the nation had not experienced since the 1920s, or even then.

Moreover, within the household sector the explosion of debt was even more stunning owing to the Greenspan policies of cheap mortgage rates and the overt encouragement of American families to raid their home ATM machines. As shown below, household debt ballooned from just $2.7 trillion when Greenspan took charge of the Eccles Building in August 1987 to nearly $14 trillion on the eve of the crisis.


And there can be little doubt as to what explains the above mountain of household debt. American households were raiding their home ATM machines – that is, cashing out the equity in their homes – in order to indulge in a massive orgy of consumption spending that they had not earned. In fact, at the peak in 2005-2007, households were extracting cash from their ATMs at nearly a $1 trillion annual rate, ballooning their disposable incomes by upwards of 8%. That is, they were buying flat screen TVs, granite top kitchen counters, restaurant dinners and trips to the mall with money they hadn’t earned, and based on rapidly rising leverage ratios that couldn’t be sustained.

What caused the Great Recession, therefore, was the day of reckoning when the household borrowing mania reached its limit. As shown below, the swing in household spending funded by withdrawals from home ATM machines was massive and violent. At its peak extent between 2006 and 2010 – it amounted to a reversal of nearly $1.4 trillion. Yes, when a gigantic, artificial spending bubble of this magnitude is pricked, the repercussions do cascade through the main street economy taking down sales, jobs and incomes as they go.

Accordingly, the chart below explains the Great Recession, not some revisionist gumming from the bowels of the New York Fed as to how the economy could have been “saved” if only Tiny Tim Geithner had gotten the word on Sunday evening September 14th that Lehman was “solvent” after all. In fact, the name on the glass tower above had nothing to do with the crash of household borrowing at upwards of 30 million home ATMs depicted in the graph below.

Moreover, what caused the recession to be so painful and deep is that the phony prosperity of the Greenspan era could no longer be fueled by pushing households deeper into debt. By the fall of 2008, “peak debt” had been reached in the household sector, and a modest deleveraging was begun owning to upwards of $1 trillion in mortgage defaults. But this wasn’t a recoverable loss of “aggregate demand”  per the Keynesian mantra at the Bernanke Fed. The US economy was drastically squeezed by the Great Recession because artificial mortgage fueled spending was being liquidated all across America, not because punters in Lehman stock and bonds lost their shirts, and deservedly so.

Household Leverage Ratio - Click to enlarge


In short, the Great Recession was about the abrupt end of the great financial party conducted by the Maestro. During his 19 year reign, the nation underwent a collective LBO, raising it leverage ratio from a historically sound and sustainable 1.5X national income to 3.5X on the eve of the Lehman collapse. Those two extra turns of debt amounted to $30 trillion at the time the US economy buckled in 2008; they were a measure of both the folly of the Greenspan/Bernanke spending party that had been financed by the Fed’s cheap money policies, and the enormity of the adjustment that was brought to bear on the US economy when the bubble finally collapsed.


Not surprisingly, upwards of $12 trillion in household wealth was destroyed by the financial crisis and the deep recession which followed. But given the enormous inflation of housing prices and risk asset values which had been driven by the debt bubble, it is ludicrous to suggest that save for not saving Lehman, the housing crash pictured below would not have happened. In fact, between late 1994 and early 2006 home prices in America rose each and every month for about 125 straight months, rising by nearly 140% over the period.


Needless to say, the above wasn’t sustainable and didn’t reflect either the free market at work or greed running rampant in the towns and cities of America. It was the cheap money and Wall Street coddling policies of the Fed which generated the housing binge, and the gambling hall known as Lehman Brothers that had gone along for the ride.

It is therefore especially misfortunate that mainstream journalists like Stewart take up the revisionist line that Lehman was “solvent”, and that a great mistake was made in not throwing it a life line. Well, it just doesn’t fricking matter whether it was “solvent”.  It was self-evidently illiquid because it – like the rest of Wall Street – had funded tens of billions of illiquid, opaque and drastically over-valued long-term assets in the short-term money markets. It was a classic, massive funding mismatch and there is no doubt whatsoever about what caused it, and why it happened.

What caused it, of course, is the fundamental tool of Fed policy – that is, pegging the money market rate (federal funds) and holding it rigidly in place until a well telegraphed decision to change it is announced from the Eccles Building.  Stated differently, Fed policy inherently offers a big fat yield curve arbitrage to Wall Street and a guarantee that it can be taken to the bank day after day.

By contrast, in the pre-Fed era money market rates could move by hundreds of basis points per day, and that most definitely did deter large banks from loading up on illiquid assets and funding their books with hot money. To be sure, there were plenty of punters prior to 1913, but the game was played in the call money market and their were no illusions among the participants.

Broker loans were instantly callable, and were called without hesitation by the street’s bankers when frothy markets took a dive. Needless to say, speculation was held in check by the discipline of the call money market and no one proposed to make a living by generating giant balance sheets with recklessly mismatched funding.

The latter is a disease of the Greenspan/Bernanke/Yellen era of Keynesian central banking and massive manipulation of financial market prices and rates. Its why the balance sheet of Goldman and Morgan had reached $2 trillion with hundreds of billions of hot money funding, and why Lehman’s $800 billion balance sheet was not even remotely liquid. Indeed, the idea that the Wall Street gambling houses were “solvent” but only needed a liquidity injection goes to the very heart of the matter, explains why financial crises have become endemic in the current era and why bailouts have become standard operating procedure.

Central bank apparatchiks like Tim Geithner and journalist fellow travelers like Stewart would have viewed the call market panics of the pre-Fed era as “bank runs” that needed to be stopped at all hazards. By contrast, they were, in fact, a healthy financial therapeutic that kept speculation reasonably in check.

But money market pegging by the central bank, to use Friedman’s phrase, always and everywhere causes bank runs and liquidity crises in the canyons of Wall Street. Tempt the titans of finance with the opportunity to scalp prodigious profits by ballooning their balance sheets with sticky assets that yield more than the pegged cost of hot money, and they will do it every time.

And when a black swan comes calling, the value of all those sticky assets will not be what’s on the books, but what can be salvaged in a plunging market when hot money lenders want their money back….and now.  So of course Lehman was insolvent and massively so. It had funded itself so that its assets were only worth their fire sale price.

The great error of September 2008, therefore, was not in failing to bailout Lehman. It was in providing a $100 billion liquidity hose to Morgan Stanley and an even larger one to Goldman.  They too were insolvent. That was the essence of their business model.

Not surprisingly, Greenspan co-architect in creating this madness was Alan Blinder. As he told Stewart in today’s article,  there was no doubt that the Fed could have saved Lehman and should have:

"Of course the Fed can stop a run,” said Mr. Blinder, the economist. “That’s what it’s all about.”

That’s right. Its policies inherently generate runs, and then it stands ready with limitless free money to rescue the gamblers.  You can call that pragmatism, if you like. But don’t call it capitalism.

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