Some Ask Why Lehman Was Allowed To Fail

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There is a growing consensus that if the current crisis has a proximate cause it is Treasury's decision to let the Wall Street investment firm Lehman Brothers go under. The effects of letting the investment bank collapse are still rippling around the world.

MICHELE NORRIS, Host:

It's been four weeks since a frantic weekend of talks left Lehman Brothers without a buyer and without a government safety net. Treasury secretary Paulson said he had never seriously considered using taxpayer dollars to save the venerable Wall Street firm but many officials, analysts and investors are now saying the decision to let Lehman fail may have triggered the massive collapse in the credit and stock markets. NPR's John Ydstie reports.

JOHN YDSTIE: Criticism of the Treasury's decision not to save Lehman began almost immediately after the U.S. government turned its back on the company four weeks ago. But it came to a head over the weekend, as finance ministers and central bankers from around the world met in Washington for the fall meetings of the IMF, the World Bank and the G7. And some prominent officials voiced their opinions in public, including French finance minister Christine Lagarde.

NORRIS: That decision has precipitated a series of events and that have unfolded, that are unfolding and that have precipitated further additional and deeper financial crisis.

YDSTIE: Those comments made at a Washington think tank were more circumspect than the language Lagarde used last Wednesday when she called the US decision horrendous in a French radio interview. She said it led to widespread distrust and an unwillingness to lend. Indeed the Lehman collapse immediately began toppling other dominos, says Allan Blinder, a former vice chairman of the Federal Reserve, now a professor at Princeton.

P: There's no doubt about it. There's no doubt - look, this crisis I said has been going on for 13 months and it has waxed and waned during that 13 months. There have been periods when it looked like it was getting better and there were periods when it looked like it was getting worse. But on the day that Lehman went in to Chapter 11, everything just fell apart.

YDSTIE: Two days after Lehman declared bankruptcy, a huge money market fund, the Reserve Primary Fund, had its share value fall below a dollar, a fatal event for money market funds. It happened because the fund had invested in Lehman paper, Lehman Brothers debt. And that debt had become nearly worthless. There was a run on money market funds and the Dow plunged 450 points that day. The fear of Lehman paper spread to the commercial paper market, which provides operating funds for many large US businesses. The credit freeze led to a record sell-off in stocks as prospects for a long deep recession rose and panic set in. Still, when asked on Thursday whether he viewed his decision not to bail out Lehman as a mistake, Treasury secretary Paulson said no.

NORRIS: I think that looking back we've taken the right moves and there was no buyer for Lehman Brothers. And as I think we've said repeatedly, we did not have the wind-down authorities we needed for financial institutions that - non-banking financial institutions.

YDSTIE: Critics point out that Paulson didn't hesitate to take extraordinary action with questionable authority in other cases. But at the time Lehman was failing, Paulson was being criticized for rescuing Bear Stearns and Fannie Mae and Freddie Mac. Paulson was also getting pressure from across the political spectrum to quit bailing out Wall Street bankers and injecting the government into the economy. And Paulson was also feeling pressure to fight moral hazard, the belief by investors that they could take risks because the government would ride to the rescue. Ultimately, says Allan Blinder, the decision to let Lehman fail has probably increased moral hazard astronomically.

P: Ever since then, we have been doing things that cross out every moral hazard lesson that anybody ever taught. The governments are coming in and guaranteeing everything and buying everything, you know you just go down the line and now we're talking about infusing capital directly into banks. So I think the moral hazard arguments are at least temporarily completely out the window.

YDSTIE: So, when G7 finance officials emerged with a five-point plan of action this weekend, at the top of the list was: prevent the failure of systemically important financial institutions. Allan Blinder interpreted it this way.

P: When I read it, I translated it to no more Lehmans. But, that was my translation.

YDSTIE: John Ydstie, NPR News, Washington.

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