Months after the TARP infusion, Goldman reported a profit of $5.2 billion for the first half of 2009. In June the firm paid back the $10 billion of TARP money, and in July paid $1.1 billion to redeem the warrants that were issued to the government as part of the TARP infusion. For Goldman, even as a bank holding company, it was back to business as usual.
The real question about Goldman’s success, which could be asked about other firms as well, is this: How should regulators respond to continued risk taking—which generates enormous profits—when the government and taxpayers provide an implicit, if not explicit, guarantee of its business? Indeed, in Goldman’s second quarter of 2009, its VaR, or value at risk, on any given day had risen to an all-time high of $245 million. (A year earlier that figure had been $184 million.) Goldman’s trades have so far paid off, but what if it had bet the wrong way? For better or worse, Goldman, like so many of the nation’s largest financial institutions, remains too big to fail.
Could the financial crisis have been avoided? That is the $1.1 trillion question—the price tag of the bailout thus far.
The answer to that question is “perhaps.” But the preemptive strike would probably have had to come long before Henry Paulson was sworn in as secretary of the Treasury in the spring of 2006. The seeds of disaster had been planted years earlier with such measures as: the deregulation of the banks in the late 1990s; the push to increase home ownership, which encouraged lax mortgage standards; historically low interest rates, which created a liquidity bubble; and the system of Wall Street compensation that rewarded short-term risk taking. They all came together to create the perfect storm.
By the time the first signs of the credit crisis surfaced, it was probably already too late to prevent a crash, for by then a massive correction was inevitable. Still, it is reasonable to ask whether steps could have been taken even at that late stage to minimize the damage. Hank Paulson had, after all, been predicting a problem in the markets since the first summer he joined the Bush administration. Likewise, as chairman of the New York Fed, Tim Geithner had also warned for years that the interconnectedness of the global financial markets may well have made them more vulnerable to a panic, not less. Should these men have done more to prepare for an actual crisis?
To his credit, Paulson did speak openly for months about formalizing the government’s authority to “wind down” a failing investment bank. He never made that request directly to Congress, however, and even if he had, it’s doubtful he could have gotten it passed. The sad reality is that Washington typically tends not to notice much until an actual crisis is at hand.
That, of course, raises a more pointed question: Once the crisis was unavoidable, did the government’s response mitigate it or make it worse?
To be sure, if the government had stood aside and done nothing as a parade of financial giants filed for bankruptcy, the result would have been a market cataclysm far worse than the one that actually took place. On the other hand, it cannot be denied that federal officials—including Paulson, Bernanke, and Geithner—contributed to the market turmoil through a series of inconsistent decisions. They offered a safety net to Bear Stearns and backstopped Fannie Mae and Freddie Mac but allowed Lehman to fall into Chapter 11, only to rescue AIG soon after. What was the pattern? What were the rules? There didn’t appear to be any, and when investors grew confused—wondering whether a given firm might be saved, allowed to fail, or even nationalized—they not surprisingly began to panic.
Tim Geithner admitted as much in February 2009, acknowledging that “emergency actions meant to provide confidence and reassurance too often added to public anxiety and to investor uncertainty.”
Of course, there are many people on Wall Street and elsewhere who argue to this day that it was the government’s decision to let Lehman fail that was its fundamental error. “On the day that Lehman went into Chapter 11,” Alan Blinder, an economist and former vice chairman of the Federal Reserve, said, “everything just fell apart.”
It is, by any account, a tragedy that Lehman was not saved—not because the firm deserved saving but because of the damage its failure ultimately wreaked on the market and the world economy. Perhaps the economy would have crumbled anyway, but Lehman’s failure clearly hastened its collapse.
CEO Richard Fuld did make errors, to be sure—some out of loyalty, some out of hubris, and even some, possibly, out of naïveté. But unlike many of the characters in this drama, whose primary motive was clearly to save themselves, Fuld seems to have been driven less by greed than by an overpowering desire to preserve the firm he loved. As a former trader whose career was filled with any number of near-death experiences and comebacks, he remained confident until the end that he could face down this crisis, too.
Despite claims to the contrary by Paulson, it seems undeniable that the fear of a public outcry over another Wall Street rescue was at least a factor in how he approached Lehman’s dilemma. One person involved in the government’s deliberations that weekend, in a remarkably candid moment, told me that the fact that the UK government indicated that it would face a major struggle to approve a deal with Barclays was “actually a strange coincidence,” because “we would have been impeached if we bailed out Lehman.”
While hindsight suggests that the federal government should have taken some action to prop up Lehman—given the assistance it was prepared to offer the rest of the industry once it began to face calamity—it is also true that the federal government did lack an established system for winding down an investment bank that was threatened with failure. Paulson, Geithner, and Bernanke were forced to resort to what MIT professor Simon Johnson has called “policy by deal.”
But deals, unlike rules, have to be improvised—and the hastier ones tend by their very nature to be imperfect. The deals hatched in sleepless sessions at the Federal Reserve Bank of New York or at Treasury were no different. They were products of their moment.
In truth, while unnoticed, it wasn’t the fate of the U.S. operations of Lehman Brothers that caused the white-knuckled panic that quickly spread throughout the world. To its credit, the Fed wisely decided to permit Lehman’s broker-dealer to remain open after the parent company filed for bankruptcy, which allowed for a fairly orderly unwinding of trades in the United States. Outside the country, however, there was pandemonium. Rules in the United Kingdom and Japan forced Lehman’s brokerage units there to shut down completely, freezing billions of dollars of assets held by investors not just abroad, but perhaps more important, here in the United States. Many hedge funds were suddenly left short of cash, forcing them to sell assets to meet margin calls. That pushed down asset prices, which only sparked more selling as the cycle fed on itself.
Washington was totally unprepared for these secondary effects, as policy makers had seemingly neglected to consider the international impact of their actions—an oversight that offers a strong argument for more effective global coordination of financial regulations.
Subsequently, Paulson, in trying to defend his decisions, managed to muddy the waters by periodically revising his reasons for not having saved Lehman. In a January 4, 2009, op-ed piece in the New York Times, Michael Lewis and David Einhorn wrote: “At first, the Treasury and the Federal Reserve claimed they had allowed Lehman to fail in order to signal that recklessly managed Wall Street firms did not all come with government guarantees; but then, when chaos ensued, and people started saying that letting Lehman fail was a dumb thing to have done, they changed their story and claimed they lacked the legal authority to rescue the firm.”
Once the Barclays deal failed, it appears that the United States government truly did lack the regulatory tools to save Lehman. Unlike the Bear Stearns situation, in which JP Morgan was used as a vehicle to funnel emergency loans to Bear, there was no financial institution available to act as conduit for government loans to Lehman. Because the Fed had already determined that Lehman didn’t have sufficient collateral to borrow against as a stand-alone firm, there were effectively no options left.