Learning from Lehman

Lehman’s bankruptcy and Merrill Lynch’s takeover have important lessons for policymakers, writes Dean Glenn Hubbard.

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It’s Monday again, and in what has become a too-familiar weekend drill, major financial institutions — Lehman Brothers and Merrill Lynch — failed to emerge in their last-Friday form. And Lehman’s bankruptcy and Merrill’s takeover have important lessons for policymakers.

Lehman’s demise as one of Wall Street’s oldest and most well known independent firms comes on the heels of the forced sale of Bear Stearns to JPMorgan Chase, the government’s “conservatorship” of Fannie Mae and Freddie Mac, and now Bank of America’s acquisition of Merrill Lynch. Just two Wall Street titans remain.

The Treasury and the Fed have been aggressive. The “blank check” power given to the Treasury by Congress has provided taxpayer support of unknown size to mortgage giants Fannie Mae and Freddie Mac. The Fed’s rush of liquidity injections reflect Walter Bagehot’s classic Lombard Street advice “to lend freely.” And lend freely it has, with extraordinary liquidity provisions — through a more attractive regular primary credit program, the Term Auction Facility, the Term Securities Lending Facility, and the Primary Dealer Credit Facility. Borrowers include banks, investment houses, Fannie and Freddie and, now, AIG. The credit risk on the Fed’s balance sheet will be borne by — you guessed it — the taxpayer.

Now the Treasury and Fed should not ignore systemic risk just to limit moral hazard. But all of this firefighting has left us with problems remaining. Additional write-downs are coming. We cannot and should not try to protect every institution.

But, stepping back, there are steps we should take. To limit the further spread of real estate woes to the broader economy, expanded FHA authority for mortgage refinancing can make sense. In addition, putting in place a clean-up agency like the 1930s’ Homeowner’s Loan Corporation or the 1980s’ Resolution Trust Corporation would help. Taxpayer funds used to support such vehicles offer more stimulus and stabilization than temporary tax cuts or public spending.

The financial meltdown that engulfed Lehman and the uncomfortable responses of policymakers the past several months also highlight the need for regulatory reform. The problem is actually not too little regulation — both lightly and heavily regulated institutions are in trouble. And some regulations encouraged the growth of high-risk mortgage lending.

We do need smarter regulation: a key step is to broaden capital and liquidity requirements and increase them during financial booms to lean against excessive risk-taking.

The events of the past three years highlight that risk misperceptions in a boom can lead to a scramble for liquidity if collateral values decline. Ascertaining this problem in real time will always be tough for regulators (even for the increased number of regulators the Treasury recently proposed).

Bagehot picked up on this, too. His admonition goes on to say: “The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times.” That is, regulation of capital adequacy could require more capital to support incremental risk-taking in a boom and lower such capital in a bust. With such requirements, financial institutions would find risk-taking marginally more costly in a credit boom, in which credit risk and liquidity risk are very low. In a downturn, a scramble for liquidity to meet capital requirements would be attenuated.

While strong supervision obviously remains important, this other advice from Bagehot would be an important addition to the policy tool kit. This could be implemented by raising banks’ capital requirements proportionately as risk-weighted bank assets grow. By varying capital cushions over credit cycles, consequences of risk distortions for actual lending and borrowing decisions will be reduced, along with the likelihood of asset fire sales and extraordinary central bank liquidity provisions.

I hope Secretary Paulson will be able to take Chairman Bernanke on one of his famous bird-watching expeditions next weekend.

This column also appeared on Forbes.com.