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Why Did the Fed Allow Lehman to Fail?

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Why did the Fed allow Lehman Brothers to fail? It's one of the most-asked questions confronting both Federal Reserve and Treasury officials. Today, in prepared remarks before the Financial Crisis Inquiry Commission, New York Fed General Counsel Thomas Baxter will say the premise of the question itself is flawed. And he's right, but for the wrong reason.

"It is an understandable question, but one that nevertheless contains a false premise," Baxter's testimony says. "The Federal Reserve did not "allow" Lehman Brothers to die, bankruptcy being the equivalent of death to a financial company. Instead, the Federal Reserve, the United States Treasury Department, the Securities and Exchange Commission (SEC), and others tried hard to save it—not for its own sake, of course, but for the sake of all the families and businesses who would be harmed by the devastating effects of a Lehman bankruptcy. We did not succeed, but the effort made was serious and determined. We came very close."

A flawed premise. Indeed. It's an interesting tactic for the Fed to take; and it's true, the premise is flawed, but not for the reason Baxter states. The real question, the one that won't be asked today in the circus-like atmosphere of the FCIC hearings, is not "Why did the Fed allow Lehman Brothers to fail?", but "Why did the Fed allow Lehman to remain in business for months and months after it became clear the firm was insolvent?"

The revisionist history that is repeated over and over again by Federal Reserve and Treasury officials is that the Fed had no supervisory role in monitoring Lehman Brothers until it was handed over to them by the SEC in March 2008. This is almost true, but also disingenuous  Some analysts, including Minyanville's Bennet Sedacca, were warning in 2007 that Lehman was overly levered and at serious risk of being unable to remain solvent if market conditions worsened, which at the time we were warning they would.

Instead, after assuming monitoring responsibilities for Lehman, the Fed did everything it could to allow Lehman to continue to operate for months, even essentially allowing Lehman to create its own fake stress test after the firm kept failing the New York Fed-created stress tests, a fact well-documented and reported. The question, then, is why?
POSITION:  No positions in stocks mentioned.