Ray Dalio: The Days Before Lehman’s Collapse
By Ray Dalio
“On Friday evening, reports surfaced that Fed officials had gathered the heads of Wall Street’s major banks—from Goldman Sachs to the Bank of New York Mellon—to urge them to bail out Lehman. Whether there would be any takers remained to be seen. Bank of America, Barclays, and HSBC had reportedly expressed interest, but none wanted to do the deal without government support. And Treasury officials publicly insisted no support would come. Paulson had hoped that by motivating a consortium of financial institutions to take on Lehman’s bad loans, a potential acquisition of Lehman could be facilitated (as a potential buyer could leave a substantial portion of Lehman’s bad assets behind when they acquired the firm). But while some progress was made with the consortium, no potential buyer emerged. Without a potential buyer, the Fed did not have any authorities which would have been effective in preventing the failure of a nonbank in the midst of a panic-driven run, according to Paulson, Bernanke, and Geithner.
Bernanke and Geithner had many conversations together and with Paulson about what they could do to help prevent Lehman’s failure, but, as in the case of Bear Stearns, they did not believe that a Fed loan would be effective. They believed that the legal requirement that a loan had to be “secured to their satisfaction” limited the amount they could lend, and that meant they could not lend Lehman enough to save it or guarantee its trading book. The weeks before that fateful weekend were consumed by the effort to figure out a way to prevent Lehman’s failure despite those constraints. They were willing to be very creative with their authority and to take a lot of risk, but only within the bounds of what the law allowed. They erred on the side of doing more, not less, but Section 13(3) (the section of the Federal Reserve Act that allowed for emergency lending to a wider set of borrowers) did not make them alchemists. Loans were not equity, and they had to be guided by what would work in practice.
Most everyone agrees that it would have been a lot better if these policy makers had the authority to liquidate Lehman in an orderly way; this was another classic example of how political constraints together with imperfectly thought-out legal constraints can get in the way of actions that are widely agreed to be beneficial. On Sunday afternoon the news broke that Lehman was headed for bankruptcy, and all hell broke loose. The shock was way bigger than any before because of Lehman’s size and interconnectedness to other vulnerable institutions, which made it clear that the contagion would spread. Even worse, the government’s failure to save it raised doubts about whether it could save the system. Lehman’s failure was particularly scary because of its large and poorly understood interconnectedness with the rest of the financial system.”
In the book I go on to explain what I and those I worked with thought and did and how events transpired from there. You can also hear the story in this mini-documentary video.