All Commentary
Thursday, February 24, 2011

Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves

Books about the 2008 financial crisis keep coming, and New York Times reporter Andrew Ross Sorkin offers one of the better accounts of the meltdown. Using a large number of interviews, he reconstructs the words and acts of key people during the six months from the near-collapse of Bear Stearns in March to the bankruptcy of Lehman Brothers in September.

The book is somewhat bloated, but the tale is compelling. It starts as Bear Stearns, the smallest of the five Wall Street investment houses, wobbles on the edge of bankruptcy. Treasury Secretary Henry Paulson and the Federal Reserve facilitate JP Morgan’s takeover of Bear, leaving Lehman the smallest of the remaining investment banks. Its stock drops precipitously.

From a huge cast of characters, one man emerges as a tragic figure—Lehman chief executive Richard Fuld. He became obsessed with short sellers (traders who borrow and sell shares to profit from a future price decline), blaming them for spreading malicious rumors about Lehman instead of confronting the bank’s real weakness. That was one in a series of dreadful mistakes. With Fuld’s backing, Lehman president Joseph Gregory had pushed the bank into mortgages, commercial real estate, and leveraged loans. He put inexperienced managers in charge of those activities and got rid of specialists who warned of danger. Catastrophic losses from the real-estate slump were killing Lehman by 2008. Short selling the stock was a symptom rather than a cause of the disease.

Sorkin recounts Lehman’s destruction, which occurred despite Fuld’s increasingly frantic efforts to raise capital or sell the company. Bank of America bought Merrill Lynch instead of Lehman, with the blessing of the Treasury and the Fed. A deal was worked out with Barclays Capital but scuttled at the last minute by British regulators, a debacle their American counterparts could almost certainly have prevented.

Timothy Geithner, then head of the New York Federal Reserve, was fixated on merging other banks. During a tense phone call, he effectively ordered Morgan Stanley chief John Mack to sell his company to JP Morgan for almost nothing. “I just won’t do it,” Mack said and hung up. There was no good business reason for the merger, and JP Morgan chief Jamie Dimon did not want it either.

Mack managed to save Morgan Stanley by getting capital from the Japanese bank Mitsubishi. Had Geithner succeeded in bulldozing Mack into selling, tens of thousands of employees would have lost their jobs and the too-big-to-fail problem would have been exacerbated. The incident does not inspire confidence in Geithner, currently Treasury secretary.

Another bad shotgun marriage was arranged by Sheila Bair, head of the Federal Deposit Insurance Corporation, who decided to sell Wachovia to Citigroup with a government guarantee for toxic assets. Fortunately, Wells Fargo chief Richard Kovacevich, who was interested in Wachovia all along, took action just in time. Wells Fargo was willing to pay a higher price without a taxpayer guarantee.

These events raise the question of why government agents can dispose of other people’s property. They certainly don’t seem to worry about preserving the value of businesses or reducing taxpayer liability.

What’s the lesson in this? Unfortunately, Sorkin doesn’t make the big picture clear. The boom-and-bust happened because the Fed opened the floodgates to easy money. That’s what got everybody, from the second-mortgaged homeowner to Lehman Brothers, to leverage up. Our supposedly expert government players apparently never realized this: Their conceit that they know how to manage the economy is the root of our trouble.

They might avoid fueling bubbles, but let’s leave that aside, since Sorkin doesn’t dig that deep. He describes interventions notable, among other things, for their sheer arbitrariness. The Fed and Treasury backstopped Bear Stearns debt in the acquisition by JP Morgan, but would not do the same for Lehman. The first action created expectations that the same support would be available for other banks and led to a false sense of security. There is no obvious reason why two sets of bond holders should be treated differently. It would be vastly better if government officials were deprived of the authority to bail out anyone.

Our financial system has suffered tremendously as a result of capricious interventions by government officials who themselves never bear any costs from the adverse effects of their decisions. If anything, they benefit. Though the entire boom-bust cycle provides evidence that government agencies, from the Fed on down, should have far less discretion, the massive financial regulation law passed this year rewards them with greater powers and wider room to do whatever they want. We should be afraid of the economic and social damage their arbitrary actions will wreak in the future.