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September 15, 2008

Learning from Lehman

Glenn Hubbard
Dean and Russell L. Carson Professor of Finance and Economics
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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.

Photo credit: T. Shein


by David Prince | September 15, 2008 at 3:14 PM

Heard a good quote today about this crisis for both Merrill and Lehman, attributed to Columbia's own Ben Graham. Perhaps other grads might like it too, and can place emphasis on either side- "the stock owner should not be too concerned with erratic fluctuations in stock prices, since in the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine."

by Kenneth Mitchell | September 16, 2008 at 1:11 PM

The fundamental question remains: how did we get . . . arrive . . . here? The removal of governmental oversight by referring to such actions as "red tape"; the business mantra that every business major can recite in their sleep -- "maximize shareholder value"; and the knowledge of knowing that timing is everything. I believe we played the same game when we were children; it is called "musical chairs". Lehman Brothers was caught standing when the music stop. However, just like the game of "musical chairs", the music of "Wall Street" will start again and at some point, it will stop. At the root of the matter is the systemic problem of a monopolistic culture which concentrates massive amounts of wealth in the hands of a few individuals and companies. I'm not advocating redistribution of wealth but I am stating as a point of fact that "you should never put all of your eggs into one basket". The key to long term stable and economic growth in this country is the creation of small agile enterprises - - more baskets, which are more nimble and can shift more quickly in changing tides. Unfortunately, we continue down the path of bigger is better. Microsoft forced us to open "Windows" and now us "Google" all over us. It never ceases to amaze me how we dismantled "ATT"decades ago only to see it re-evolve into what it once was. People need to sit down and have a conversation with themselves and then with others whereby the address the glaring flame of reality which clear shows either we change our basic premise from "maximizing profit" to balancing "the greater good" with "economic preservation" or we will continue to build and create a financial system that is will make us destine to destroy our own way of life.

by Yogik Pitti | September 18, 2008 at 3:28 AM

The problem of this seed was put up by the fed years ago during the time of Alan Greenspan.It took 2-3 years to build this problem.So definitely it will take 2-3 yrs or more to eradicate this problem.This is problem which is related to comman man .The money circulating is from the pockets of bankers.These pockets were filled by a comman man like you and me.This is not phase has only one solution which would be remain calm and remain confident. This is a chain reaction which has started and this chain reaction will end where it started.I would rather like to tell that;you know only bit about US financial services sector .Still whole of Europe is remainin and in the mean while China has already started cuttin its interest rates.What ever you are seeing in the market these days is because of the cracks in the banking system .This happens because of excessive borrowings .When you have one dollar in your pocket and you go across the globe borrowing one thousand dollar.Then this day will come again this is what we should learn from this experience . We should put our resources and focus to minise the the impact of the problem rather than findong the solution.In my views this problem is caused mainly because of cash crunch in the market .So as the central bank duty is to infuse liquidity in the time of need .So thats why whatever central banks are doing I think that they perfectly doin right.If they dont react like this then the market will be in panic so will be the people. There is no end to this chain reaction in the short term .Instead of falling straight down it is better to do safe landing .That is what the central bank thinks and which is not wrong at all

by Pamela Prudence | September 18, 2008 at 4:14 PM

Opinions count: the global impact of Lehman spilled over 3 continents - US, Europe and Asia. That, affirms the US' global economic influence; yet, as AIG widely divestified presence turns around, fair balance was attained. On the domestic front, the Fed's efforts to exert fiscal policy and pumping in more funds into the economy may be pre-emptive of capacity building for something greater to come. An average man on the street may think about how many eggs and how many baskets, the real consideration is how much disposible income and for how long can one afford to draw on savings, certainly not an issue of wealth redistribution. Few phenomenons are rarely reversible, commonly cyclical - what goes around may come back and when it eventually does, some things have evolved. Back to the second "how did we get . . . arrive . . . here?" ~ perspective of an optimist

by Sanjeev Sharma | September 23, 2008 at 1:35 PM

Somewhere the sacrosanct theme of maximization of profits needs to be questioned. A balance between the goal of an organization and profit-maximization needs to be defined for example fannie mae's giving easy mortgages made housing expensive and thus less affordable for people rather than more. Maximization of short term growth at the expense of higher long term risks and losing focus from the goal of the organization needs to be studied independently.

by Ronald Facchinetti | September 26, 2008 at 5:18 AM

I believe Columbia Business School itself should learn from these fiascoes. Many of my fellow alums have blindly followed the euphoria while recently finding themselves cleaning their desks. Columbia Business school faculty should think long and hard why it has not produced a generation of whistleblowers that could have had the lucidity to see the flaws in the system and lobby with courage to prevent their consequences. It is a sad moment for Wall Street, but also for Columbia Business School.

by R. Glenn Hubbard | September 26, 2008 at 5:27 PM

These unprecedented times in the capital markets do offer some teaching moments. We made changes in the School’s curriculum several years ago to prepare better leaders with big-picture business skills who are capable of making complex decisions, taking into account personal integrity, corporate governance, and corporate social responsibility. We can’t undo some of the poor decisions made on Wall Street, but we have an opportunity to be part of the solution by promoting public policy and advancing education, ideas and people who will shape regulation, reform, and behavior.

by Ronald Facchinetti | October 03, 2008 at 3:08 AM

I certainly respect the efforts that you and the great faculty at Columbia have made in the past years. Infact I have benefitted directly from these efforts with a lucid and comprehensive outlook on the business world. However, what I suggest a more public, more bold step in this regard. Columbia prides itself for being the primary hunting ground for wall street. The relationship is cozy to the benefit of all. It is so cozy however that when Wall Street fails, so do we. By internalizing the crisis on wall street, instead of criticizing it from the outside the school could find the energy for a more focused evolution of its curricula. An easy start could be creating a seminar or a series of debates for students and multidisciplinary faculty through which alumni that were involved in this mess would come to campus and explain the mistakes they made and why. From this seminars, perhaps it will emerge that CBS alumni were totally exempt from the ills that beget us, and in fact were working in the shadows to prevent it. I doubt it, but it would be interesting to find out. This would be a vindication of the changes in the curricula you mention. If such is not the case a series of faculty meetings could be organized to see how to tweak the curricula, in particular for those interested in Finance. This Mea Culpa process would result in a stronger business school, and in the long term, in a stronger Wall Street.

by George Henke | October 10, 2008 at 1:57 PM

The simple concepts of "due dilligence" and "fiduciary responsibility" seem to be absent or ignored in all of the discussions I have seen and heard. Are these concepts still taught or understood in American business, or anywhere else? The lack of analytical intelligence and personal accountability in our financial system is staggering. How can anyone feel comfortable providing hard-earned equity and savings into the hands of mindless shovelers of raw sewage? This system has gone "viral". The level of infection is widespread but fundamentally unknown. Huge populations have it and the symptoms pop up as the level of stress increases. We may need the help of contagion experts to fully come to grips with our disease. Quarantine may be needed for the fatally involved and their management.

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