Learning from Lehman Bros.

Policymakers have better tools now to avert a crash. Do they have the political will to intervene?

TALK ABOUT an unhappy anniversary. Ten years ago Saturday, one of the country’s most influential Wall Street firms — the investment banking giant Lehman Bros. — declared bankruptcy, triggering a collapse in credit markets that tanked not just the U.S. economy, but those throughout the industrialized world. The result here was the deepest recession in eight decades, one whose effects are still felt by many Americans today.

Some people argue that federal regulators could have found a way to keep Lehman alive. But even if they had, the problems caused by toxic housing-finance investments — subprime loans that were packaged and repackaged into securities of increasingly dubious and obscure value, along with derivative securities and vital shortterm financing arrangements pegged to those packages — were large and metastasizing. The credit markets were bound to crumble eventually.

Plus, it’s worth remembering that public sentiment at the time was running strongly against the federal government bailing out Lehman the way it had rescued Bear Stearns, Fannie Mae and Freddie Mac earlier that year. The Times editorial board was among the voices praising the decision to let Lehman go under, writing the day after the filing: “The hands-off response sent the market a badly needed signal that mortgage brokers and lenders wouldn't be the only big losers in the downturn…. [T]he bailouts of Bear Stearns, Fannie and Freddie only reinforced the notion that big financial firms would be spared the consequences of the ensuing meltdown because they were just too big to fail.”

But Wall Street needed more than a signal. First, it needed an influx of capital to contain the damage and prevent the country from sinking into depression. That help came largely from the Federal Reserve.

Next, it needed new financial incentives that would deter companies in the future from becoming too big to fail and from gambling with government-insured deposits. It needed more transparency to help measure investment risk. It needed regulators with a new focus on the financial system in its entirety, along with new tools to help stop problems from spreading among deeply interconnected companies.

The Dodd-Frank financial reform law in 2010 provided all that and more — too much more, in some respects. And there remains a risk that, in seeking to roll back some of the overreaction, lawmakers will leave the industry underregulated again.

So far, however, the most important pieces of Dodd-Frank remain in place. Mortgage lenders now have a strong incentive not to make loans that a borrower probably can’t repay. The Consumer Financial Protection Bureau provides at least some protection against predatory lenders. Regulators have new powers to liquidate big firms in an orderly way, sans bailouts. It’s up to the administration to use these powers appropriately, and the Trump administration’s actions so far haven’t instilled much confidence on that front (see, for example, how it has handicapped the CFPB).

Still, just as every big financial crash has taught different lessons, so too have they typically been set off by different forces. That’s why it’s a mistake to keep looking in the rearview mirror for clues to the next big downturn — and why it’s so hard for regulators to identify potentially ruinous practices until after the damage has been done.

Nevertheless, the last recession may well play a role in the next one.

The U.S. economy has grown steadily since the downturn, with low unemployment finally starting to boost wages. But the gains made during the recovery, like much of the growth in the 21st century, have flowed disproportionately to the wealthiest Americans. Making matters worse from the public’s point of view, no top executives at Wall Street firms were prosecuted for their role in weaponizing mortgages against unsophisticated consumers. That’s why the steps that the Fed and the Treasury took to revive the credit markets before and after the Lehman bankruptcy continue to rankle much of the country.

As unpopular as those interventions may be, we would be in much worse shape without them. But in the face of an even bigger backlash today, would the Trump administration and Congress have the fortitude to take necessary but politically poisonous steps to avert a depression? The importance of political will is one of the biggest lessons from the decision to let Lehman fail, but it’s the hardest one to learn.