Lehman got burned holding the hot potato the government baked

Ten years ago this month, Lehman Brothers, the fourth-largest investment bank in America filed for bankruptcy. It was the largest bankruptcy in U.S. history: Lehman had over $639 billion in listed assets when it filed, sparking a global financial panic that has still not been fully absorbed.

The bankruptcy itself is widely considered a turning point that began the Great Recession. That myth, much like the myth that a stock market crash caused the Great Depression of 1929, is incorrect. Officials date the recession’s start in late 2007, a full year before Lehman died.

{mosads}Basically, Lehman got caught holding the hot potato of subprime mortgage debt that other banks were selling off. Why didn’t Lehman sell its mortgage-backed securities, too? That’s the wrong question, and a waste of time.

The real question is how the mess of mortgage-backed securities got created in the first place. A fundamental reality of life, whether in sports or finance or war, is that somebody loses. Ten years ago, it was Lehman, but even if they had been bailed out, somebody was going to eat the bad mortgage debt. Who baked it?

The federal government, not private markets, created the subprime mortgage crisis, and it did so purposefully for many years despite repeated warnings. In the simplest terms, government policy erred in three ways: low rates, lax rules and bailouts.

I remember seeing Federal Reserve Chairman Alan Greenspan testifying time and again before the Senate during the early 2000s, imploring reforms to Fannie Mae and Freddie Mac. I remember tut-tutting from Rep. Barney Frank (D-Mass.) who said those institutions were fine and would never need a bailout.

Fannie and Freddie are government-sponsored enterprises (GSEs) created during the 1930s to support mortgages in a collapsing market. There was a market failure at the time, but it healed, and yet the GSEs lived on.

Their lending standards, which set the standard for the industry, were loosened dramatically in 1992 and 1999 to facilitate home-buying by low-income families. Like most admirable goals, this one become corrupted in execution so that hundreds of billions of dollars in mortgages were given to people that should not have gotten the loans.

Wall Street banks didn’t own 76 percent of the subprime and other risky mortgages; government agencies did. Let’s not forget that a week before the Lehman collapse, the U.S. Treasury declared the insolvency of Fannie and Freddie. Lehman is a footnote to the fraud and scandal of bad federal housing policy.

But if the congressional and White House policies started the game of hot potato, it was monetary policies that turned up the heat. Interest rates are set by the Fed, and lower interest rates enhance demand for homes.

In retrospect, the Fed’s decision to cut rates in 2003 was an epic and era-defining mistake. All indicators except one were positive, but the Fed wanted to nudge payroll numbers, which turned out to be flawed, higher.

If the Fed had tightened monetary policy as it should have in 2003, the economy would not have overheated. The bubble in mortgages would still have bubbled up, only smaller and less perilous.

After Lehman, the Bush administration erred more than once. It was inconsistent on the bailout front, helping Bear Stearns in March, abandoning Lehman in September, begging Congress for Troubled Asset Relief Program (TARP) funds later that same month, bailing out General Motors and Chrysler, then forcing healthy banks to take its loans.

The Obama administration swept into office in January 2009 and went even further with the bailout and regulatory frenzy. To this day, it baffles me why Congress passed Dodd-Frank’s regulatory reform that rewrote the rules for Wall Street but left Fannie and Freddie intact. Ten years on, those agencies are still owned and run by the Treasury. They should be wound down.

Meanwhile, Obama set the course for permanent trillion-dollar annual budget deficits. The deficits were cemented in place in 2011, 2012, 2013, 2014, 2015 and even his last year in office — all years when the economy was in recovery.

To be sure, the Trump administration has a hand in widening deficits, but the Congressional Budget Office was forecasting a steady state of trillion-dollar annual deficits long before the election of Donald Trump.

The question is not whether the next recession will be bigger than the Great Recession, it is simply where the bubble is now. Credit cards? Student loans? Treasury bonds? Mortgages redux? Interest rates were slashed to zero after 2008 and held there for far too long, overstimulating the economy.

Simultaneously, for the past 10 years, Congress has spent the trillions that it borrowed, burdening us with debt today while over-stimulating the economy. You tell me: What have we learned? 

Tim Kane is an economist who is currently a research fellow at the Hoover Institution at Stanford University.