Sophia Farrara and Chelsey KohlerECN 272: Financial Crisis Professor CottrellDecember 3, 2010

An Analysis of the Significance, Cause, and Motives behind Lehman’s Bankruptcy

During the Financial Crisis of 2008 many factors contributed to the sustained state of

economic chaos which ensued in the following months. While many financial institutions were

saved by the government and other rescue operations, the collapse of Lehman Brothers remains

an outlier in these instances; rather than follow the seemingly apparent protocol of “rescue” the

government did quite the opposite in letting Lehman fail. This paper seeks to explain the reason

for this decision and investigate the ramifications it had on the economic and political system.

Much controversy surrounded the decision to let Lehman collapse and several explanations have

developed to justify the actions of the government. Lehman Brothers and its collapse was at the

center of a political debate during the Financial Crisis which was based on theories of

conspiracy, lessons being taught, and public pressure that was tied to political motives on the

part of the Fed.

There is no doubt that the downfall of investment bank Lehman Brothers was a major

contributing factor to the Financial Crisis. There is however doubt regarding exactly why this

financial institution was allowed to collapse and what specifically the ramifications were for the

financial system as a whole. In the middle of March, 2008, the Federal government working with

J. P. Morgan Chase bailed out Bear Sterns, however only several months later in September of

the same year, Lehman Brothers was left to file for bankruptcy after the Federal government

declined to rescue them. This inconsistency on the part of the government and the Federal

Reserve contributed to the uncertainty which the Financial Crisis fostered.

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Much debate has arisen over the inconsistency in the policies which were applied to Bear

Sterns and Lehman in the onset of the financial crisis in 2008. Speculation surrounding these

decisions includes conspiracy theories, hopes of sending a message, as well as theories based on

public pressure, politics and other external influences from Wall Street. One of the most cited

reasons why Lehman Brothers was allowed to file for bankruptcy rather than be saved was the

need to enforce the existence of consequences in the banking system. Cassidy pointedly theorizes

that “Many people suspect Paulson and Bernanke let Lehman go bankrupt to reestablish the

principle that irresponsible behavior would be punished” (Cassidy 325). In the months which

preceded the crisis the financial sector was in a “free-fall-climb” of unchecked wealth,

unmonitored risk-taking, and un-acknowledged bubbles. Housing prices skyrocketed, new

financial services were offered which were meant to bundle risks, and the overall accountability

of firm’s risk taking shrank. By letting Lehman Brothers collapse rather than intervene, the Fed

sent a message which meant to cause firms to take responsibility for their actions and the risks

which they had amassed. Kenneth Rogoff of Harvard University agrees that the decision to not

bail out Lehman set a good baseline by establishing that “…we’re just not going to bail out

everyone in America” (“Uncertainty Hits Wall Street”). This argument however is flawed if one

considers the fact that the Fed had previously agreed to, and succeeded in, bailing out several

large firms who had done exactly what Lehman had in that they mismanaged their risk. Why

then would the Fed decide to allow the collapse of Lehman Brothers after they had already bailed

out Bear Sterns, Fannie Mae, Freddie Mac, and AIG among others?

The answer to this question comes from an argument based on the inter-connectedness of

an institution in determining whether the Fed would step in or not. The argument is based upon

the fact that many people said Lehman Brothers wasn’t big enough to save implying that its

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failure would not lead to such disastrous consequences as the failure of larger, more inter-

connected firms; “…the people behind the Federal Reserve had most probably conducted

assessments already which show that the collapse of Lehman [wouldn’t] bring much chaos to the

markets opposed to the collapse of AIG, Bear Stearns, or Fannie Mae or Freddie Mac” (“Why

AIG was bailed out”). With regards to the inconsistency in the policy decisions in dealing with

Bear Sterns and Lehman Brothers the Fed argues that the rescue of Bear was an “extraordinary

event” and if the Fed then turned around and rescued Lehman as well “it would have repudiated

the claim that the Bear rescue was extraordinary…” (“Why AIG was bailed out”). The initial

argument that Lehman was not inter-connected enough to save has many dissenters and the

evidence for their disagreement is vast; the consequences of Lehman’s fall did have massive

ripple effects in the economy which contributed to the prolonged economic crisis.

Robert C. Pozen, an economics lecturer at Harvard, recognizes the confusion surrounding

the decision why Lehman was not saved and why such controversy has resulted. In discussing

the lessons to be learned from Lehman’s fall, Pozen points out that since many people thought

Bear Stearns was “too big to fail, then many investors assumed that the Fed would bail out

Lehman since it was twice as large as Bear” (Pozen). Pozen describes investors surprise at the

decision to not intervene with Lehman as a result of the lack of communication between the Fed

and the general public of investors. He specifically says that “The turmoil that followed

Lehman’s failure was a direct result of the government’s failure to clearly explain why the Fed

had bailed out Bear Stearns in March of 2008” (Pozen). To rectify this lack of communication,

Pozen offers the suggestion that the Secretary of the Treasury should “state his reasons for

bailing out any financial institution” and then further requiring a report outlining the costs and

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benefits of any bailout decision (Pozen). This inconsistency in the policy of the Fed led to

uncertainty felt by investors and the financial institutions themselves.

The effects from the collapse of Lehman Brothers were far reaching and affected all

aspects of the economy. The global financial community was shocked by the fact that the Federal

Treasury allowed Lehman to go bankrupt and as a result “…no one knew who might be next.

Bankers stopped lending to each other and credit markets froze” (Baldwin 9). The major result of

the Lehman collapse, besides the direct negative impact on Lehman Brothers and their investors

and assets was a sense of fear which gripped the global financial sector. The “unsteady and ill-

explained behavior of the US government [led to the formation of] a massive feeling of

uncertainty” which worsened the Financial Crisis (Baldwin 10). This fear factor affected

willingness to borrow, lend, and spend; firms and investors played a game of “wait and see”

which led to a “sudden financial arrest” (Baldwin 10). The “sudden financial arrest” led to a

global credit freeze and many other financial instruments felt negative effects of the same sort

(Bladwin 11). These negative effects were only a few of the many that were to come.

Another result of the Lehman collapse dealt a blow to the safety of other major financial

investment firms in the coming months. Help for major financial firms like Lehman had

previously been sought from “major sovereign funds in Asia and the Middle East” was

increasingly hard to come by… any chance of these large state-sponsored funds coming in…to

invest in beaten-down financial institutions is for the most part finished” (Thomas Jr.).

Additionally the strength of the dollar gave way and investors sold assets choosing instead to

seek refuge “…in the safest securities they could find, government bonds” (Thomas Jr.). The

effects just mentioned prove that Lehman was in fact significantly interconnected in the financial

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markets as their collapse led to uncertainty on a global scale and worsened the credit freeze while

also negatively impacting other major financial institutions ability to obtain funding.

In considering the downfall of Lehman Brothers and the policies that were instituted by

the Fed many arguments have arisen which tend towards the support of conspiracy theories in

which the decisions of the Fed were not objective as they should have been. Investigating the

validity of these claims is important in determining the real reason why Lehman Brothers was

left to collapse, setting off the negative ripples which affected the rest of the financial

community. In the case of Lehman, J.P. Morgan and Goldman Sachs are two of the major

financial institutions which have been blamed as culprits of conspiracies (or conspiratorial

actions) against Lehman Brothers thus facilitating their downfall.

Politics and personal relationships between top officials have been cited as the source of

the elements which contributed to the so called non-objective treatment of Lehman Brothers. J.P.

Morgan is “…alleged to have frozen $17 billion of cash and securities belonging to Lehman on

the Friday before it’s failure” (Dey and Forston). This action has been cited as the cause of “the

liquidity crisis that embroiled the firm” (Dey and Forston). In an article for Rolling Stone Matt

Taibbi makes the assumption that a conspiracy between Treasury Secretary Hank Paulson, the

former CEO of Goldman Sachs, was an obvious contributor to the decision regarding Lehman

Brothers. In addition to the former loyalties of Paulson which Taibbi cites, he also discusses the

negative effect which “naked-short-selling” had on both Bear Stearns and Lehman Brothers and

how “[these] methods used to destroy these companies pointed to widespread and extravagant

market manipulation…” (Taibbi). The possibility that the decision of the Fed in handling the

failing Lehman Brothers was not made by objective parties and policies had great implications in

the preceding months and the unwinding of the financial sector. Uncertainty remained a major

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factor in the Financial Crisis and the support for conspiracy theories and other public pressures

only contributed to the uncertainty.

The core issue in the fall of Lehman Brothers, which has been proclaimed as a “failure

[that will] go down in history as a gigantic misstep,” is whether the Federal Reserve was able to

maintain objectivity in its decision (Sorkin). Historically, the Fed has been well-regarded

internationally as a non-politicized agent independent from Congressional and Executive

pressures. However, one consequence of the Financial Crisis has been the downfall of this

reputation. Regarding the issue of Lehman Brothers, it is debatable whether the Fed made the

decision to let Lehman fail “in a vacuum.” Although the ex-CEO of Lehman Brothers, Richard

Fuld, has attempted to place blame on a number of different players in the crisis for the downfall

of his firm, the potential conspiracy that this paper will explore involves Goldman Sachs,

Congress, and the Fed (Taylor). The claim is as follows: By intentionally spreading rumors and

participating in naked short-selling of Lehman Brothers stock, Goldman Sachs largely

contributed to the weakening and eventual downfall of Lehman Brothers. Due to the nature of

the political atmosphere at the time, the Securities Exchange Commission and the Federal

Reserve did not perform the proper due diligence in order to protect Lehman Brothers;

furthermore, there is evidence of an underlying motive to let Lehman fail in order to prove to

Congress that a dramatic financial crisis was imminent, and proper powers needed to be allotted

to the Fed and other authorities in order to manage it. Thus, spurred by Goldman Sachs and

exacerbated by the Fed, the fall of Lehman Brothers was not entirely unintended and was, in a

way, used as a “means to an end” to pass TARP funds through Congress.

Dramatic public pressure on the Fed was evident through political debates and opinions

voiced through media outlets. Public anger towards Wall Street resonated with Congress and

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President George W. Bush and resulted in heavy scrutiny surrounding bailout debates in regard

to using public funds. Therefore, at the time Lehman was struggling, Congress did not have the

momentum to support the use of public funds for a bailout of the financial system. Henry

Paulson, Secretary of the Treasury during the Financial Crisis, was quoted saying, “I am being

called Mr. Bailout. I can’t do it again” (Nocera). Between March (acquisition of Bear Stearns)

and September of 2008 (fall of Lehman Brothers), Henry Paulson and Ben Bernanke attempted

to persuade Congressional leaders of the impending financial crisis in an attempt to secure the

necessary powers to deal with the issues in the aftermath. However, they were met with strong

opposition; there was no political will to get anything done. Ironically, once Lehman announced

bankruptcy in September of 2008, $700 billion in TARP funds were allotted to the Treasury

(Nocera). It is speculated that Paulson and Bernanke realized that something needed to happen in

order for Congress to understand the gravity of the situation and pass the necessary bailout. The

victim of their strategy, debatably, was Lehman Brothers (Carpenter).

Richard Fuld, in Lehman Brothers’ Financial Crisis Inquiry Commission (FCIC) on

September 1, 2010, furthered this speculation by arguing that Lehman Brothers was the unfair

victim of the Federal Reserve’s accommodation of public opinion. His argument contained three

major points. Primarily, he argues that Lehman Brothers was essentially in the wrong place at the

wrong time. If the Fed had opened its financing window to investment banks before Bear Stearns

failed in March, Bear Stearns could have remained operational, which would have lessened the

need for government intervention and kept overall confidence in the market higher than it was

otherwise. However, the failure of Bear Stearns and the rescue mission conducted by the Fed set

a precedent of intervention, which impacted expectations of financial institutions and public

opinion in opposite ways. Almost immediately, the federal government was criticized for using

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public funding to bail out a financial firm, which initiated a wave of debates about “how not to

handle a bank failure.” Therefore, when Lehman Brothers was the next major institution to be

faced with serious issues, it became the victim to Fed appeasement of public opinion (Fuld).

Secondly, this unanticipated spotlight on Lehman Brothers caused it to be subjected to a

disproportionate number of negative, often inaccurate, rumors about the stability and health of

the company. This loss of confidence, argued by Fuld to be irrational and unjustified, became a

self-fulfilling prophecy; if the public and investors believed Lehman Brothers was going to fail,

its likelihood of failure skyrocketed. Lastly, in attempts to save Lehman Brothers, company

executives actually suggested many solutions that could be implemented to bolster liquidity for

the company. Although these suggestions were not taken at the time, many were ironically used

on other investment banks after Lehman declared bankruptcy. This seemingly easy dismissal of

and weak attempts to save Lehman Brothers suggests that there may have been other factors

involved in the decision to let it fail (Fuld). In conclusion, federal hesitation and resistance to bail

out Lehman Brothers was certainly apparent. However, this alone did not cause the institution to

fail; questionable activities in the financial sphere, potentially originating with Goldman Sachs,

may have played a significant part.

Speculative accusations of insider trading began against Goldman Sachs when, in the

midst of a financial meltdown post-Lehman failure, the company seemed to actually benefit from

its bankruptcy. While many investment banks and financial institutions had to sell themselves or

look to the government for support, Goldman Sachs got out of the subprime business just before

Lehman Brothers went under and managed to attain record profits in the 2nd Quarter of 2009

(Wilson). The major accusation against Goldman Sachs was its involvement in intentional short-

selling of Lehman Brothers stocks. By illegally filling the market with misinformation and

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intentionally spreading negative rumors about the stability of Lehman Brothers, this practice of

naked short-selling1 turned out to be extremely profitable for Goldman and very detrimental to

Lehman (Colby, Portilla, Lange). The most damaging rumors to the future of Lehman Brothers

speculated that the company was going to be acquired at a discount, and that it was losing two

significant trading partners. Evidently, that alone would have strong negative effects on the stock

value of the company (Matsumoto).

To further complicate issues for Lehman Brothers, “abusive short-selling amount[ed] to

gasoline on the fire for distressed stocks and distressed markets” (Matsumoto). The extent of

short-selling that was apparent in the market in 2008 before the fall of Lehman and Bear largely

contributed to the failure of both institutions. The amount of short sales can be illustrated

quantitatively through the number of fails-to-deliver, which is what occurs in a naked short-sell

because the security that is traded is not delivered to the buyer. Naked short-selling is detrimental

to the company whose stock is traded because it artificially “increases the number of shares, thus

devaluing the stock” (Matsumoto). Between 1995 and 2007, the number of fails-to-deliver

multiplied nine-fold; the average daily value of fails-to-deliver went from $838.5 million in 1995

to $7.4 billion in 2007. Although this does not prove that short-sales caused the fall of Lehman,

it is estimated that the rapid increase in the number of failed trades of Lehman and Bear Stearns

stocks accounted for 30-70% of the decline in the value of the companies’ stocks. Coupled with

negative rumors about the health of the institution, such a drastic, immediate decline in the stock

value of Lehman Brothers became a self-fulfilling prophecy (Matsumoto).

Faced with these statistics, an important question to ask is: Why wasn’t anything done to

stop these short-selling practices before they spiraled out of control? In fact, the Enforcement 1 Definition via web: “Short sellers arrange to borrow shares, then dispose of them in anticipation that they will fall. They later buy shares to replace those they borrowed, profiting if the price has dropped. Naked short sellers don’t borrow before trading -- a practice that becomes evident once the stock isn’t delivered. Such trades can generate unlimited sell orders, overwhelming buyers and driving down price” (Matsumoto).

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Complaint Center, responsible for financial fraud, received approximately 5,000 complaints

between January 2007 and June 2008, but only 123 of the tips were forwarded for further

investigation; none led to enforcement action by the Securities and Exchange Commission.

Despite Fuld’s efforts to convince Congress and the Fed that naked short-sellers had “midwifed”

Lehman Brothers’ decline, public pressures in the political atmosphere kept the Fed from acting

appropriately. The Fed weakly argued that the increased number of fails-to-deliver can be

accounted for by misunderstandings between traders or a string of computer glitches; Congress

merely would not listen, since it had already cast Fuld and Lehman Brothers as the “villain” in

the situation (Matsumoto). Furthermore, Goldman Sachs’ agreement to pay a $450,000 fine for

the accusations (evidently, Goldman had a guilty conscience) resulted in the issue being

figuratively “swept under the rug” (Reuters).

The failure by the Fed, the Securities and Exchange Commission, and Congress to react

appropriately to these blatantly reported abuses in the financial system can be circled back to

political pressures. Evident in e-mails and notes that were dug up between Congressmen and Fed

officials, including Ben Bernanke, it was clear that the fate of Lehman Brothers was at the heart

of a political debate. Lucind Brinkler, from the Federal Reserve Bank in New York, is quoted:

“There has also not been much appetite over the past few days for ideas that involve extending

public support beyond the existing programs. These issues and speculation about how

bankruptcy would likely unfold are the drivers of this thinking.” Also, an e-mail from Bernanke

the night before Lehman declared bankruptcy suggested that research effort for alternative

options for Lehman Brothers was minimal: “In case I am asked: How much capital injection

would have been needed to keep LEH [Lehman] alive as a going concern? I gather $12B or so

from the private guys together with Fed liquidity support was not enough” (Sorkin).

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In this situation, the Fed did not react objectively; it had an ulterior motive to use the

failure of Lehman Brothers as leverage to convince politicians and the public that a large, federal

bailout was necessary to reign in on an impending financial crisis. Whether this ulterior motive

was valid is debatable. On the one hand, by letting Lehman fail and convincing Congress of the

need for TARP funds, the Fed may have staved off an even worse recession. However, by taking

such a political, strategic approach, the Fed may have lost its credibility as an objective

institution, further harming domestic and international confidence in the U.S. economy; the

extent of this damage is not measureable.

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Works Cited

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Carpenter, Dave. "CNBC Anchor Bartiromo Says Government 'needed' to Let Lehman Brothers Fail | The Post and Courier, Charleston SC - News, Sports, Entertainment." The Post and Courier. Associated Press, 19 Sept. 2010. Web. Nov.-Dec. 2010. <http://www.postandcourier.com/news/2010/sep/19/qa/>.

Cassidy, John. How Markets Fail : The Logic of Economic Calamities. 1st ed. Farrar, Straus and Giroux, 2009. Print.

Colby, Robert L. D., David L. Portilla, and Christian L. Lang. "The Bear "Naked" Truth: Short Sales and Rumors." Practical Compliance and Risk Management for the Securities Industry. Wolters Kluwer Financial Services, Inc., Sept.-Oct. 2009. Web. Nov.-Dec. 2010. <http://www.davispolk.com/files/Publication/7b58464d-67b7-4e4d-a0b7-29eff68f716f/Presentation/PublicationAttachment/5930344b-17ac-431b-8386-3af1dc6d280b/Colby.Portilla.PCRM.shortsales.article.sep-oct09.pdf>.

Dey, Iaian and Danny Forsten. “JP Morgan ‘brought down’ Lehman Brothers.” The Sunday Times. Web. 5 Oct. 2008. <http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article4882281.ece>

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Sorkin, Andrew R. "Sorkin: 2 Zombies to Tolerate for a While - NYTimes.com." Mergers, Acquisitions, Venture Capital, Hedge Funds - DealBook - NYTimes.com. New York Times, 17 Aug. 2010. Web. Nov.-Dec. 2010. <http://dealbook.nytimes.com/2010/08/17/sorkin-2-zombies-to-tolerate-for-a-while/>.

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Stempel, Jonathan. "UPDATE 2-US Fines Goldman Unit over Short-sale Violations | Reuters." Business & Financial News, Breaking US & International New. Reuters, 04 May 2010. Web. Dec. 2010. <http://www.reuters.com/article/idUSN0410776520100504>.

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<http://www.rollingstone.com/politics/news/12697/64824?RS_show_page=0>

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