Mini-Case 2 Letting Go of Lehman Brothers

Question 1: Do you believe that the U.S. government treated some financial institutions differently during the crisis? Was that appropriate?

To assure the financial stability and viability of the U.S. financial system, the U.S. Federal Reserve, the Comptroller of the Currency and the Federal Deposit Insurance Company (FDIC) have the responsibility to support, protect and buffer financial institutions whose failures, they believe, might have a significant effect on the market as a whole. Before making a decision about whether an institution should be poured capital into, the Federal Reserve will consider the institution`s collateral and the ability to repay loans.

The Federal Reserve said that the companies that did receive bailouts, such as AIG, Fannie Mae and, Freddie Mac, clearly had the collateral and showed great promise of paying them back in the future, while Lehman Brothers did not. When Federal Reserve Chairman Ben Bernanke was asked how the Lehman case differed from that of American International Group Inc., which received $182 billion in taxpayer aid, Bernanke said there was a fundamental difference. They believed AIG, as the biggest insurance company in the U.S., had valuable assets which could back up the Fed's emergency loan. So the Federal Reserve will absolutely be paid back by AIG.

However, Richard S. Fuld Jr., the former chairman and chief executive officer of Lehman Brother, said that they did have the collateral and the capital, and should have been bailed out. He also stated that Lehman was forced into bankruptcy not because it neglected to act responsibly or seek solutions to the crisis, but because of a decision, based on flawed information, not to provide Lehman with the support given to each of its competitors. (Lewis, 2010)

Zakaria (2010) believes that the collapse of Lehman Brothers shocked the political system into coming to the rescue, into recognizing that this was a huge, deep financial crisis that required extraordinary measures on the part of the U.S. government. Without the collapse of Lehman Brothers, it would have been very difficult to have effected the rescue operation that took place over the next month. However, if Lehman Brothers had been aided, perhaps the financial world would not have come to a screeching halt, stopping lending and borrowing altogether for a brief period of time.

Whether the different treatment given to financial institutions was "appropriate" is difficult to determine. It does not seem "fair" for Lehman Brothers to not have received any government aid, but then again they were known for taking large risks and with the chance to succeed also comes the risk to fail.

Question 2: Many experts argue that when the government bails out a private financial institution it creates a problem called "moral hazard," meaning that if the institution knows it will be saved, it actually has an incentive to take on more risk, not less. What do you think?

It is human nature to push limits, and the moral hazard argument fits very well with the Lehman Brothers case. If rewards are associated with higher risk, one might think that an organization would push until punished. If people are insulated from the negative effects of their gambles they are more likely to act rashly. Surowiecki(2009) said when Bear Stearns was bailed out, last spring, the move was attacked for exacerbating the threat of moral hazard. When Lehman Brothers was allowed to go bankrupt, in mid-September, the decision was praised by some for reducing the risk of moral hazard. If banks think that the government will bail them out in a pinch, they're more likely to make risky bets. That's why moral-hazard fundamentalists advocated letting Lehman Brothers fail, and making it clear that bad decisions have consequences.

There certainly are situations where moral hazard does seem to have an effect on people's choices. Deposit insurance can make depositors less vigilant about the quality of banks, increasing the likelihood that bankers will make bad gambles with depositors' money, as they did during the savings-and-loan crisis of the eighties.

Moral hazard already existed in the system on at least three levels. First, bank employees and managers had asymmetric compensation