Why a Lehman deal would not have saved us

If only. Lawrence McDonald begins his insider's account of the fall of Lehman Brothers with seven "what if" scenarios, speculating on how different decisions might have saved his former employer. If only Dick Fuld, Lehman's chief executive, had listened to those who warned of impending losses on the bank's property portfolio. If only Mr Fuld had not antagonised Hank Paulson, the then Treasury secretary. And so on.* Mr McDonald is far from the only person who believes that the Lehman bankruptcy could have been avoided. Alan Blinder, the former Federal Reserve vice-chairman, has called the decision to let the bank fail "a colossal error". Christine Lagarde, the French finance minister, denounced it as a "horrendous" mistake. When an event is followed by such upheaval - the biggest financial panic since 1931, the worst recession since the war - it is only human to imagine how the milk might not have been spilt. When, at January's World Economic Forum in Davos, I argued that this was wishful non-thinking, I found few supporters. If only. If only Lehman had been saved, there would have been no credit crunch. No near-Depression. The S&P 500 would not have sunk to 682 (its nadir last March). We would probably be back to 1,500 by now.

If only Lehman had been saved, Republicans might muse, there would have been no Democratic landslide in November's US elections. Instead of President Barack Obama, we would have John McCain in the White House. After all, the presidential race was still pretty close in the summer of last year. It was the severity of the economic crisis after September 15 that really doomed Mr McCain - not least because he himself had earlier confessed his ignorance of economics.

A McCain presidency, of course, would have had very different priorities: no Keynesian stimulus bill, no "public option" in any healthcare reform. If only Lehman had been saved, there would be no threat of Obamacare and no town hall hysteria about socialist "death panels". Why stop there? If only Lehman had been saved and Mr McCain had won, the Green Revolution in Iran would have had American support and Mahmoud Ahmadi-Nejad would no longer be president.
If only Lehman had been saved and the stock market had not tanked, Michael Jackson would not have needed to commit to those 50 comeback gigs in London. He would not have felt so stressed and would not have taken all those sedatives. If only Lehman had been saved, Jacko would still be alive.
If only.

Actually, no. All would not have been for the best in the best of all possible worlds if only Lehman Brothers had been saved. On the contrary, a decision to bail out Mr Fuld would almost certainly have had worse consequences than letting him and his company go under.

In a parallel universe, no doubt, another Mr Fuld might have made a serious effort to sell Lehman. Having seen the fate that befell Bear Stearns, he had six months to find a buyer. There were at least three potential suitors: the Korean Development Bank, Bank of America and Barclays.

But in this universe, Lehman's chief executive persistently over-played his hand, overvaluing the property assets on the bank's balance sheet by as much as $25bn-30bn. Mr Fuld was adamant: "As long as I am alive this firm will never be sold. And if it is sold after I die, I will reach back from the grave and prevent it."
In another parallel universe, another Treasury secretary and Fed chairman might have come up with the money to incentivise a buyer of Lehman (as they had when JPMorgan Chase bought Bear Stearns with the help of a $30bn loan).

But there was a reason why no buyer could be found in this universe. Lehman was a firm in its death throes. It had lost $6.7bn in the space of six months. It had debts in excess of $600bn. Its assets were collapsing in value. Even when a deal with Barclays seemed within reach, the British Financial Services Authority vetoed it. Alistair Darling, the chancellor of the exchequer, made it clear: "We are not going to import your cancer."

So, in a third and final parallel universe, an alternate Mr Paulson and an alternate Ben Bernanke could have nationalised Lehman outright - as they had already nationalised Fannie Mae and Freddie Mac on September 7, and would nationalise AIG the day after Lehman filed for bankruptcy. These surely were the kind of "unusual and exigent" circumstances that permit the Fed to take emergency action.

In this universe, however, Mr Paulson had resolved to stop being "Mr Bail-out". More than once, he stated bluntly that there would be "no taxpayer money on the line" for Lehman. When Mr Fuld's lieutenants warned that their bank's failure would unleash a financial tsunami, Mr Paulson accused them of "talking their own book". It is clear that he underestimated the consequences of letting Lehman fail. Maybe, as a former Goldman Sachs chief executive, he did let his prejudice against Mr Fuld get the better of him. In one respect, however, Mr Paulson did the right thing - albeit unwittingly. By showing Americans - and particularly their legislators in Congress - just what could happen if even the fourth-largest investment bank failed, he created what had hitherto been lacking: the political will for a wholesale bail-out of the US financial system.

The critical point is that, like Bear Stearns, Lehman was just an extreme case of a general phenomenon. A relatively small number of very large financial institutions had become dangerously leveraged and were on a fast track to insolvency as their property investments imploded. Reliant on misleading risk-management models, and counting on the vastly over-extended insurer AIG to pay out if their counterparties defaulted, they were like lemmings in a line, going over the cliff one by one - or rather being pushed off by short-sellers.

What was needed was not a succession of ad hoc government-backed takeovers. As Ken Lewis, Bank of America's chief executive, came to realise when he looked more closely at Merrill Lynch, today's buyer risked being for sale tomorrow, since no one's balance sheet was safe. Bob Diamond must thank his maker every day that the FSA did not approve a deal that might have destroyed Barclays; instead, he got what he wanted - Lehman's core investment banking business - dirt cheap from the bankruptcy court.

What was needed was a huge bail-out across the board. And that was what the $700bn troubled asset relief programme (Tarp) ended up being. Recall that even after Lehman's failure it still took two attempts to get Tarp passed. If Mr Paulson and Mr Bernanke had taken over Lehman on their own initiative, there would have been an outcry in Congress against yet another handout to a manifestly mismanaged institution. There might very well have been no Tarp. That surely would have been a death sentence for Citigroup, an institution three times larger than Lehman.

Like the executed British admiral in Voltaire's famous phrase, Lehman had to die pour encourager les autres - to convince the other banks that they needed injections of public capital, and to convince the legislature to approve them.

Not everything in history is inevitable; contingencies abound. Sometimes it is therefore right to say "if only". But an imagined rescue of Lehman Brothers is the wrong counterfactual. The right one goes like this. If only Lehman's failure and the passage of Tarp had been followed - not immediately, but after six months - by a clear statement to the surviving banks that none of them was henceforth too big to fail, then we might actually have learnt something from this crisis.
The real tragedy is that the failure of Lehman has left Wall Street's survivors both bigger in relative terms and more secure politically. As long as the big banks feel confident that they can count on the government to bail them out - for who would now risk "another Lehman"? - they can more or less ignore calls for lower leverage and saner compensation.

If only we had learnt from Lehman that no bank should be "too big to fail", we might still have a real capitalist system, instead of the state-guaranteed monstrosity that is the real legacy of last year's crisis. If only.