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Even before Lehman Brothers failed a decade ago, the financial crisis was bad. But it was the failure of Lehman Brothers that rocked a bad situation into an absolute disaster and led the global financial system to the brink of collapse.
The Lehman Brothers company sign in polished metal is visible in the shop window of a London auction house on Friday, September 24, 2010. (AP Photo / Kirsty Wigglesworth)
Lehman Brothers did not have to fail, and the decision to allow him to fail was psychologically motivated. In recent years, I thought it was probably the case, having written about it in my book Behavioral Risk Management, and have taught the lesson to my risk management students at NYU.
Now, a new book by Laurence Ball, titled The Fed and Lehman Brothers, document the factors that motivated the decision to allow Lehman to fail. The book offers a compelling counterpoint to the official explanation of the reason for the failure of Lehman Brothers.
The official explanation is that because the value of the guarantees and Lehman's net worth was so low, the US government did not have the legal authority to save them. Key decision makers who chose not to save the company, former Treasury Secretary Hank Paulson, former Fed Chairman Ben Bernanke, and the former head of the Federal Reserve Bank New York Timothy Geithner, strongly defended this point of view.
Hank Paulson, president and founder of the Paulson Institute and former US Treasury Secretary, speaks as Ben S. Bernanke, former US Federal Reserve Chairman, was on the left and Tim Geithner, former Treasury Secretary American. a discussion of the Brookings Institution in Washington, DC, on Wednesday, September 12, 2018. The event is part of an initiative to document how and why the US government's responses to the 2007-2009 financial crisis have been designed as they were. . Photographer: Zach Gibson / Bloomberg
In my opinion, the individual psychological issues impacting Paulson and the group psychology issues that affected the dynamics that characterized the communication between the three directors were the real drivers of the decision. In my book Behavioral Risk ManagementI discuss Paulson's fear that a decision to rescue Lehman, following the decision to rescue Bear Stearns a few months earlier, would allow him to remember "Mr. Bailout, "leaving his conservative heritage in tatters.
In her book, Laurence Ball describes the dynamics of communication between Paulson, Bernanke and Geithner. Although the authority to save Lehman belonged to the Fed, not to the Treasury Department, by force of personality, Paulson persuaded Bernanke and Geithner that the default position should be to let Lehman fail. This seems to me a classic case of group thinking, where members of a group are reluctant to challenge the position advanced by a strong leader.
The psychological issues related to Lehman's economy, both the event itself and its launch, are incredibly interesting. The availability bias, which is a psychological bias on the overweight of easy-to-remember information, can be very strong. Paulson, Bernanke and Geithner worked very hard to convey the message that Lehman Brothers could not have been legally saved. Paulson complains that despite their efforts, they are still not believed. If he is right, their collective effort to exploit the availability bias has failed. However, until the publication of Ball's book, there was very little written in the press about what really drove the decision to let Lehman fail.
I argue that serious discussions about the financial crisis must take place in the context of Hyman Minsky's ideas on financial instability. Mr. Bailout's problem did not provoke the financial crisis. Rather, it was all of the issues that Minsky insisted on, such as excessive debt, reckless banking, Ponzi financing, asset pricing bubbles, and weak regulation. Mr. Bailout's problem has only worsened the situation.
It is natural to ask what lessons all this has for our current situation. In my opinion, to answer this question, we must start with the issues highlighted by Minsky.
The Federal Reserve Bank of New York provides many important data and outlooks on US debt levels. Earlier this year, the bank's president and CEO, William Dudley, told us that American households were far better prepared shock than a decade ago.
At the same time, Dudley made some reservations, specifically mentioning student loan debt. In this regard, the bank's website provides sobering statistics. Between 2006 and 2016, student debt increased by 170%. In addition, the default rate on this debt has increased significantly. Consider students who left college in 2010 and 2011. In this group, 28% defaulted on their student loans within five years. The corresponding default rate was 19% for those who left school in 2005 and 2006.
Abroad, there are many causes for concern. Turkey, Italy and China easily come to mind. With regard to China, our current trade with them encourages them to respond by reversing their policies to make their economies more stable. The former governor of the Central Bank of China, Zhou Xiaochuan, resigned last October. He warned that China might face a moment in Minsky, by which he heard falling asset prices, capital flight and a financial crisis that the Chinese government would be unable to prevent.
China is the second largest economy in the world. A Chinese financial crisis will trigger chain reactions so that their financial crisis becomes our financial crisis.
So who knows what Mr. Bailout's next event will be, that would take a bad situation and make it much worse.
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Even before Lehman Brothers failed a decade ago, the financial crisis was bad. But it was the failure of Lehman Brothers that rocked a bad situation into an absolute disaster and led the global financial system to the brink of collapse.
The Lehman Brothers company sign in polished metal is visible in the shop window of a London auction house on Friday, September 24, 2010. (AP Photo / Kirsty Wigglesworth)
Lehman Brothers did not have to fail, and the decision to allow him to fail was psychologically motivated. In recent years, I thought it was probably the case, having written about it in my book Behavioral Risk Management, and have taught the lesson to my risk management students at NYU.
Now, a new book by Laurence Ball, titled The Fed and Lehman Brothers, document the factors that motivated the decision to allow Lehman to fail. The book offers a compelling counterpoint to the official explanation of the reason for the failure of Lehman Brothers.
The official explanation is that because the value of the guarantees and Lehman's net worth was so low, the US government did not have the legal authority to save them. Key decision makers who chose not to save the company, former Treasury Secretary Hank Paulson, former Fed Chairman Ben Bernanke, and the former head of the Federal Reserve Bank New York Timothy Geithner, strongly defended this point of view.
Hank Paulson, president and founder of the Paulson Institute and former US Treasury Secretary, speaks as Ben S. Bernanke, former US Federal Reserve Chairman, was on the left and Tim Geithner, former Treasury Secretary American. a discussion of the Brookings Institution in Washington, DC, on Wednesday, September 12, 2018. The event is part of an initiative to document how and why the US government's responses to the 2007-2009 financial crisis have been designed as they were. . Photographer: Zach Gibson / Bloomberg
In my opinion, the individual psychological issues impacting Paulson and the group psychology issues that affected the dynamics that characterized the communication between the three directors were the real drivers of the decision. In my book Behavioral Risk ManagementI discuss Paulson's fear that a decision to rescue Lehman, following the decision to rescue Bear Stearns a few months earlier, would allow him to remember "Mr. Bailout, "leaving his conservative heritage in tatters.
In her book, Laurence Ball describes the dynamics of communication between Paulson, Bernanke and Geithner. Although the authority to save Lehman belonged to the Fed, not to the Treasury Department, by force of personality, Paulson persuaded Bernanke and Geithner that the default position should be to let Lehman fail. This seems to me a classic case of group thinking, where members of a group are reluctant to challenge the position advanced by a strong leader.
The psychological issues related to Lehman's economy, both the event itself and its launch, are incredibly interesting. The availability bias, which is a psychological bias on the overweight of easy-to-remember information, can be very strong. Paulson, Bernanke and Geithner worked very hard to convey the message that Lehman Brothers could not have been legally saved. Paulson complains that despite their efforts, they are still not believed. If he is right, their collective effort to exploit the availability bias has failed. However, until the publication of Ball's book, there was very little written in the press about what really drove the decision to let Lehman fail.
I argue that serious discussions about the financial crisis must take place in the context of Hyman Minsky's ideas on financial instability. Mr. Bailout's problem did not provoke the financial crisis. Rather, it was all of the issues that Minsky insisted on, such as excessive debt, reckless banking, Ponzi financing, asset pricing bubbles, and weak regulation. Mr. Bailout's problem has only worsened the situation.
It is natural to ask what lessons all this has for our current situation. In my opinion, to answer this question, we must start with the issues highlighted by Minsky.
The Federal Reserve Bank of New York provides many important data and outlooks on US debt levels. Earlier this year, the bank's president and CEO, William Dudley, told us that American households were far better prepared shock than a decade ago.
At the same time, Dudley made some reservations, specifically mentioning student loan debt. In this regard, the bank's website provides sobering statistics. Between 2006 and 2016, student debt increased by 170%. In addition, the default rate on this debt has increased significantly. Consider students who left college in 2010 and 2011. In this group, 28% defaulted on their student loans within five years. The corresponding default rate was 19% for those who left school in 2005 and 2006.
Abroad, there are many causes for concern. Turkey, Italy and China easily come to mind. With regard to China, our current trade with them encourages them to respond by reversing their policies to make their economies more stable. The former governor of the Central Bank of China, Zhou Xiaochuan, resigned last October. He warned that China might face a moment in Minsky, by which he heard falling asset prices, capital flight and a financial crisis that the Chinese government would be unable to prevent.
China is the second largest economy in the world. A Chinese financial crisis will trigger chain reactions so that their financial crisis becomes our financial crisis.
So who knows what Mr. Bailout's next event will be, that would take a bad situation and make it much worse.
