A forgotten financial failure

The regulatory responses to the global financial crisis have for the most part been conditioned on a false narrative about the causes and consequences of the crisis. In the US, this has seen a complete re-regulation of financial institutions and retail consumer finance. In Australia, the regulatory responses have been more limited, but still reflect a mistaken view of the underlying causes of the crisis.

Perhaps the most pernicious myth about the crisis is that it was the failure of the US government to rescue Lehman Brothers that precipitated these events. Indeed, it has become common practice to date the crisis from 15 September 2008 when Lehman Brothers was allowed to fail. Yet trouble had been brewing in credit markets for more than 12 months before.

The failure of Lehman Brothers was a trivial event compared to a much bigger but largely ignored financial failure that took place one week before when the two US mortgage giants Freddie Mac and Fannie Mae were put into conservatorship by the US government. These Congressionally-mandated, government-sponsored enterprises (GSEs) either owned or guaranteed two-thirds of the bad mortgages in the US financial system. They were far more highly leveraged than the private US or European investment banks. They will also ultimately cost US taxpayers more than all the other bail-outs of private financial institutions combined.

The two GSEs were the financial arms of US government housing policy, which from 1992 explicitly sought to extend mortgage finance to low income borrowers and those with impaired credit histories previously denied housing finance. The dominant predatory lender in the US was none other than the US government itself. This explains how the two GSEs came to dominate US housing finance. The Congressional Budget Office estimates that the failure of these institutions will cost US taxpayers $389 billion, the equivalent of 300 Nic Leesons (the rogue trader who brought down Barings Bank in the 1990s).

In the aftermath of the financial crisis, the failure of these two institutions has been largely ignored, not least by the US Financial Crisis Inquiry Commission that was charged with investigating the crisis. Those who want to understand the real causes of the financial crisis should read the excellent dissenting report by Peter Wallison, a member of the Commission and one of the few people to have warned about the risks posed by the GSEs as far back as 1999.

It is likely there will never be a public inquiry or investigation into the failure of the two GSEs, not least because the US Congress is not about to incriminate itself in relation to one of the worst financial crises in human history. The failure to acknowledge the real cause of the financial crisis and the false narrative built around the failure of the Lehman Brothers is designed to disguise the culpability of US politicians and regulators for the crisis and to scapegoat financial markets.

This false narrative now dominates discussion of the regulatory responses to the crisis. At the Reserve Bank of Australia's 50th anniversary symposium last year, United Kingdom economist Charles Goodhart gave this analysis of the implications of the failure of Lehman Brothers:

"the outcome was regarded as so awful that in virtually every major economy the authorities have effectively taken a vow that they will not allow any similar really large, interconnected systemic institution to be closed."

This view implies an absurd and barely considered counter-factual, that if Lehman Brothers had been rescued, then the crisis might have been prevented or would not have been as severe. The failure of Lehman Brothers was merely a symptom rather than a cause of the crisis and the unwillingness of the US authorities to rescue Lehman was perhaps the one good US policy decision made through this episode. Federal Reserve Chairman Ben Bernanke conceded as much recently, when he tried to defend the decision as a necessary one, but then undercut his own argument by maintaining that the decision also had disastrous consequences. What Bernanke should have argued was that the winding up of Lehman Brothers was fairly orderly as far as these things go and not a source of major systemic problems in the financial system.

The systemic problems that emerged in the wake of the failure to rescue Lehman were partly due to the decision being inconsistent with earlier actions, but also due to Bernanke and then US President George Bush going public in the following week to argue that unless Congress passed the Troubled Asset Relief Program (TARP), which gave the Bush Administration a blank cheque to fund further bail-outs, the world would come to an end. As Booth School of Business economist John Cochrane has noted, 'on what planet do stock markets not crash after that?'

Peter Wallison has refuted the dominant post-crisis narrative by noting that 'there is no example in all of US history in which the failure of an unregulated financial entity – securities firm, hedge fund, insurance company, finance company or private equity fund – caused a systemic breakdown.' That history includes Lehman Brothers. Ordinary bankruptcy laws provide an orderly process for the winding-up of failed financial institutions, a process that provides considerable certainty compared to the massive uncertainty that accompanies discretionary government bail-outs. It ensures that the burden of failure falls on the owners and managers of these institutions and not taxpayers.

The assets of failed financial institutions were not worthless and typically enjoyed positive cash flows that would have found ready buyers at the right price. Unfortunately, those prices were not consistent with the continued solvency of these institutions, which should have been allowed to fail, making way for new entrants. Unfortunately, US policymakers and their counterparts around the world acted mainly for the benefit of incumbents. Taxpayers are justifiably outraged at government support for financial institutions, but this outrage needs to be directed at politicians and not bankers.