An old meme in new clothing has been circulating recently: The Federal Reserve could have and should have saved Lehman Brothers. It had the resources, the legal authority and the obligation to do so; its failure to act let a modest financial fire become a full-blown credit crisis.
It is an interesting post-crisis theory from academia. But some of the claims are irrelevant, and almost all of them are wrong.
Larry Ball, chairman of the economics department at Johns Hopkins University and a researcher at the National Bureau of Economic Research, makes this argument in a new paper titled "The Fed and Lehman Brothers." There are three issues here worth addressing, and one that time and space doesn't allow for:
1. Could the Fed have rescued Lehman?
2. Was Lehman solvent?
3. Was it capable of raising capital?
The issue I'm skipping for now (assuming the Fed could have rescued Lehman) is whether it should have done so. That's a separate question.
Let’s dispose of the first issue: That the Fed could have rescued Lehman Brothers, since a collapse would be an existential threat to the banking and financial systems, and withholding a bailout was likely to precipitate a much greater crisis. That’s not my belief, but it was the argument for a bailout in 2008, and ever since.
As subsequent events have shown, most especially with the Fed-led bailout of insurance giant American International Group, if there was a will, there most certainly was a way. Given all of the various bailouts of dubious legality, the Fed, Treasury and Congress most certainly could have devised a rescue plan for the 158-year old bank. But so what? The subprime meltdown was coming, and bailing out Lehman would have sent just as dire a signal about the health of the financial system as letting it collapse.
The second issue is two-fold: Was Lehman technically solvent and could this be determined in the weekend before the collapse with any degree of confidence? The answer to the former is probably not; the answer to the latter is definitely not.
As researchers William R. Cline and Joseph E. Gagnon at the Peterson Institute wrote, Lehman Brothers was “deeply insolvent.”