Sophia Farrara and Chelsey Kohler

ECN 272: Financial Crisis

Professor Cottrell
December 3, 2010
An Analysis of the Significance, Cause, and Motives behind Lehmans Bankruptcy
During the Financial Crisis of 2008 many factors contributed to the sustained state of
economic chaos which ensued in the following months. While many financial institutions were
saved by the government and other rescue operations, the collapse of Lehman Brothers remains
an outlier in these instances; rather than follow the seemingly apparent protocol of rescue the
government did quite the opposite in letting Lehman fail. This paper seeks to explain the reason
for this decision and investigate the ramifications it had on the economic and political system.
Much controversy surrounded the decision to let Lehman collapse and several explanations have
developed to justify the actions of the government. Lehman Brothers and its collapse was at the
center of a political debate during the Financial Crisis which was based on theories of
conspiracy, lessons being taught, and public pressure that was tied to political motives on the part
of the Fed.
There is no doubt that the downfall of investment bank Lehman Brothers was a major
contributing factor to the Financial Crisis. There is however doubt regarding exactly why this
financial institution was allowed to collapse and what specifically the ramifications were for the
financial system as a whole. In the middle of March, 2008, the Federal government working with
J. P. Morgan Chase bailed out Bear Sterns, however only several months later in September of
the same year, Lehman Brothers was left to file for bankruptcy after the Federal government
declined to rescue them. This inconsistency on the part of the government and the Federal
Reserve contributed to the uncertainty which the Financial Crisis fostered.

2
Much debate has arisen over the inconsistency in the policies which were applied to Bear
Sterns and Lehman in the onset of the financial crisis in 2008. Speculation surrounding these
decisions includes conspiracy theories, hopes of sending a message, as well as theories based on
public pressure, politics and other external influences from Wall Street. One of the most cited
reasons why Lehman Brothers was allowed to file for bankruptcy rather than be saved was the
need to enforce the existence of consequences in the banking system. Cassidy pointedly theorizes
that Many people suspect Paulson and Bernanke let Lehman go bankrupt to reestablish the
principle that irresponsible behavior would be punished (Cassidy 325). In the months which
preceded the crisis the financial sector was in a free-fall-climb of unchecked wealth,
unmonitored risk-taking, and un-acknowledged bubbles. Housing prices skyrocketed, new
financial services were offered which were meant to bundle risks, and the overall accountability
of firms risk taking shrank. By letting Lehman Brothers collapse rather than intervene, the Fed
sent a message which meant to cause firms to take responsibility for their actions and the risks
which they had amassed. Kenneth Rogoff of Harvard University agrees that the decision to not
bail out Lehman set a good baseline by establishing that were just not going to bail out
everyone in America (Uncertainty Hits Wall Street). This argument however is flawed if one
considers the fact that the Fed had previously agreed to, and succeeded in, bailing out several
large firms who had done exactly what Lehman had in that they mismanaged their risk. Why
then would the Fed decide to allow the collapse of Lehman Brothers after they had already bailed
out Bear Sterns, Fannie Mae, Freddie Mac, and AIG among others?
The answer to this question comes from an argument based on the inter-connectedness of
an institution in determining whether the Fed would step in or not. The argument is based upon
the fact that many people said Lehman Brothers wasnt big enough to save implying that its

3
failure would not lead to such disastrous consequences as the failure of larger, more interconnected firms; the people behind the Federal Reserve had most probably conducted
assessments already which show that the collapse of Lehman [wouldnt] bring much chaos to the
markets opposed to the collapse of AIG, Bear Stearns, or Fannie Mae or Freddie Mac (Why
AIG was bailed out). With regards to the inconsistency in the policy decisions in dealing with
Bear Sterns and Lehman Brothers the Fed argues that the rescue of Bear was an extraordinary
event and if the Fed then turned around and rescued Lehman as well it would have repudiated
the claim that the Bear rescue was extraordinary (Why AIG was bailed out). The initial
argument that Lehman was not inter-connected enough to save has many dissenters and the
evidence for their disagreement is vast; the consequences of Lehmans fall did have massive
ripple effects in the economy which contributed to the prolonged economic crisis.
Robert C. Pozen, an economics lecturer at Harvard, recognizes the confusion surrounding
the decision why Lehman was not saved and why such controversy has resulted. In discussing
the lessons to be learned from Lehmans fall, Pozen points out that since many people thought
Bear Stearns was too big to fail, then many investors assumed that the Fed would bail out
Lehman since it was twice as large as Bear (Pozen). Pozen describes investors surprise at the
decision to not intervene with Lehman as a result of the lack of communication between the Fed
and the general public of investors. He specifically says that The turmoil that followed
Lehmans failure was a direct result of the governments failure to clearly explain why the Fed
had bailed out Bear Stearns in March of 2008 (Pozen). To rectify this lack of communication,
Pozen offers the suggestion that the Secretary of the Treasury should state his reasons for
bailing out any financial institution and then further requiring a report outlining the costs and

4
benefits of any bailout decision (Pozen). This inconsistency in the policy of the Fed led to
uncertainty felt by investors and the financial institutions themselves.
The effects from the collapse of Lehman Brothers were far reaching and affected all
aspects of the economy. The global financial community was shocked by the fact that the Federal
Treasury allowed Lehman to go bankrupt and as a result no one knew who might be next.
Bankers stopped lending to each other and credit markets froze (Baldwin 9). The major result of
the Lehman collapse, besides the direct negative impact on Lehman Brothers and their investors
and assets was a sense of fear which gripped the global financial sector. The unsteady and illexplained behavior of the US government [led to the formation of] a massive feeling of
uncertainty which worsened the Financial Crisis (Baldwin 10). This fear factor affected
willingness to borrow, lend, and spend; firms and investors played a game of wait and see
which led to a sudden financial arrest (Baldwin 10). The sudden financial arrest led to a
global credit freeze and many other financial instruments felt negative effects of the same sort
(Bladwin 11). These negative effects were only a few of the many that were to come.
Another result of the Lehman collapse dealt a blow to the safety of other major financial
investment firms in the coming months. Help for major financial firms like Lehman had
previously been sought from major sovereign funds in Asia and the Middle East was
increasingly hard to come by any chance of these large state-sponsored funds coming into
invest in beaten-down financial institutions is for the most part finished (Thomas Jr.).
Additionally the strength of the dollar gave way and investors sold assets choosing instead to
seek refuge in the safest securities they could find, government bonds (Thomas Jr.). The
effects just mentioned prove that Lehman was in fact significantly interconnected in the financial

5
markets as their collapse led to uncertainty on a global scale and worsened the credit freeze while
also negatively impacting other major financial institutions ability to obtain funding.
In considering the downfall of Lehman Brothers and the policies that were instituted by
the Fed many arguments have arisen which tend towards the support of conspiracy theories in
which the decisions of the Fed were not objective as they should have been. Investigating the
validity of these claims is important in determining the real reason why Lehman Brothers was
left to collapse, setting off the negative ripples which affected the rest of the financial
community. In the case of Lehman, J.P. Morgan and Goldman Sachs are two of the major
financial institutions which have been blamed as culprits of conspiracies (or conspiratorial
actions) against Lehman Brothers thus facilitating their downfall.
Politics and personal relationships between top officials have been cited as the source of
the elements which contributed to the so called non-objective treatment of Lehman Brothers. J.P.
Morgan is alleged to have frozen $17 billion of cash and securities belonging to Lehman on
the Friday before its failure (Dey and Forston). This action has been cited as the cause of the
liquidity crisis that embroiled the firm (Dey and Forston). In an article for Rolling Stone Matt
Taibbi makes the assumption that a conspiracy between Treasury Secretary Hank Paulson, the
former CEO of Goldman Sachs, was an obvious contributor to the decision regarding Lehman
Brothers. In addition to the former loyalties of Paulson which Taibbi cites, he also discusses the
negative effect which naked-short-selling had on both Bear Stearns and Lehman Brothers and
how [these] methods used to destroy these companies pointed to widespread and extravagant
market manipulation (Taibbi). The possibility that the decision of the Fed in handling the
failing Lehman Brothers was not made by objective parties and policies had great implications in
the preceding months and the unwinding of the financial sector. Uncertainty remained a major

6
factor in the Financial Crisis and the support for conspiracy theories and other public pressures
only contributed to the uncertainty.
The core issue in the fall of Lehman Brothers, which has been proclaimed as a failure
[that will] go down in history as a gigantic misstep, is whether the Federal Reserve was able to
maintain objectivity in its decision (Sorkin). Historically, the Fed has been well-regarded
internationally as a non-politicized agent independent from Congressional and Executive
pressures. However, one consequence of the Financial Crisis has been the downfall of this
reputation. Regarding the issue of Lehman Brothers, it is debatable whether the Fed made the
decision to let Lehman fail in a vacuum. Although the ex-CEO of Lehman Brothers, Richard
Fuld, has attempted to place blame on a number of different players in the crisis for the downfall
of his firm, the potential conspiracy that this paper will explore involves Goldman Sachs,
Congress, and the Fed (Taylor). The claim is as follows: By intentionally spreading rumors and
participating in naked short-selling of Lehman Brothers stock, Goldman Sachs largely
contributed to the weakening and eventual downfall of Lehman Brothers. Due to the nature of
the political atmosphere at the time, the Securities Exchange Commission and the Federal
Reserve did not perform the proper due diligence in order to protect Lehman Brothers;
furthermore, there is evidence of an underlying motive to let Lehman fail in order to prove to
Congress that a dramatic financial crisis was imminent, and proper powers needed to be allotted
to the Fed and other authorities in order to manage it. Thus, spurred by Goldman Sachs and
exacerbated by the Fed, the fall of Lehman Brothers was not entirely unintended and was, in a
way, used as a means to an end to pass TARP funds through Congress.
Dramatic public pressure on the Fed was evident through political debates and opinions
voiced through media outlets. Public anger towards Wall Street resonated with Congress and

7
President George W. Bush and resulted in heavy scrutiny surrounding bailout debates in regard to
using public funds. Therefore, at the time Lehman was struggling, Congress did not have the
momentum to support the use of public funds for a bailout of the financial system. Henry
Paulson, Secretary of the Treasury during the Financial Crisis, was quoted saying, I am being
called Mr. Bailout. I cant do it again (Nocera). Between March (acquisition of Bear Stearns)
and September of 2008 (fall of Lehman Brothers), Henry Paulson and Ben Bernanke attempted
to persuade Congressional leaders of the impending financial crisis in an attempt to secure the
necessary powers to deal with the issues in the aftermath. However, they were met with strong
opposition; there was no political will to get anything done. Ironically, once Lehman announced
bankruptcy in September of 2008, $700 billion in TARP funds were allotted to the Treasury
(Nocera). It is speculated that Paulson and Bernanke realized that something needed to happen in
order for Congress to understand the gravity of the situation and pass the necessary bailout. The
victim of their strategy, debatably, was Lehman Brothers (Carpenter).
Richard Fuld, in Lehman Brothers Financial Crisis Inquiry Commission (FCIC) on
September 1, 2010, furthered this speculation by arguing that Lehman Brothers was the unfair
victim of the Federal Reserves accommodation of public opinion. His argument contained three
major points. Primarily, he argues that Lehman Brothers was essentially in the wrong place at the
wrong time. If the Fed had opened its financing window to investment banks before Bear Stearns
failed in March, Bear Stearns could have remained operational, which would have lessened the
need for government intervention and kept overall confidence in the market higher than it was
otherwise. However, the failure of Bear Stearns and the rescue mission conducted by the Fed set
a precedent of intervention, which impacted expectations of financial institutions and public
opinion in opposite ways. Almost immediately, the federal government was criticized for using

8
public funding to bail out a financial firm, which initiated a wave of debates about how not to
handle a bank failure. Therefore, when Lehman Brothers was the next major institution to be
faced with serious issues, it became the victim to Fed appeasement of public opinion (Fuld).
Secondly, this unanticipated spotlight on Lehman Brothers caused it to be subjected to a
disproportionate number of negative, often inaccurate, rumors about the stability and health of
the company. This loss of confidence, argued by Fuld to be irrational and unjustified, became a
self-fulfilling prophecy; if the public and investors believed Lehman Brothers was going to fail,
its likelihood of failure skyrocketed. Lastly, in attempts to save Lehman Brothers, company
executives actually suggested many solutions that could be implemented to bolster liquidity for
the company. Although these suggestions were not taken at the time, many were ironically used
on other investment banks after Lehman declared bankruptcy. This seemingly easy dismissal of
and weak attempts to save Lehman Brothers suggests that there may have been other factors
involved in the decision to let it fail (Fuld). In conclusion, federal hesitation and resistance to bail
out Lehman Brothers was certainly apparent. However, this alone did not cause the institution to
fail; questionable activities in the financial sphere, potentially originating with Goldman Sachs,
may have played a significant part.
Speculative accusations of insider trading began against Goldman Sachs when, in the
midst of a financial meltdown post-Lehman failure, the company seemed to actually benefit from
its bankruptcy. While many investment banks and financial institutions had to sell themselves or
look to the government for support, Goldman Sachs got out of the subprime business just before
Lehman Brothers went under and managed to attain record profits in the 2nd Quarter of 2009
(Wilson). The major accusation against Goldman Sachs was its involvement in intentional shortselling of Lehman Brothers stocks. By illegally filling the market with misinformation and

9
intentionally spreading negative rumors about the stability of Lehman Brothers, this practice of
naked short-selling1 turned out to be extremely profitable for Goldman and very detrimental to
Lehman (Colby, Portilla, Lange). The most damaging rumors to the future of Lehman Brothers
speculated that the company was going to be acquired at a discount, and that it was losing two
significant trading partners. Evidently, that alone would have strong negative effects on the stock
value of the company (Matsumoto).
To further complicate issues for Lehman Brothers, abusive short-selling amount[ed] to
gasoline on the fire for distressed stocks and distressed markets (Matsumoto). The extent of
short-selling that was apparent in the market in 2008 before the fall of Lehman and Bear largely
contributed to the failure of both institutions. The amount of short sales can be illustrated
quantitatively through the number of fails-to-deliver, which is what occurs in a naked short-sell
because the security that is traded is not delivered to the buyer. Naked short-selling is detrimental
to the company whose stock is traded because it artificially increases the number of shares, thus
devaluing the stock (Matsumoto). Between 1995 and 2007, the number of fails-to-deliver
multiplied nine-fold; the average daily value of fails-to-deliver went from $838.5 million in 1995
to $7.4 billion in 2007. Although this does not prove that short-sales caused the fall of Lehman,
it is estimated that the rapid increase in the number of failed trades of Lehman and Bear Stearns
stocks accounted for 30-70% of the decline in the value of the companies stocks. Coupled with
negative rumors about the health of the institution, such a drastic, immediate decline in the stock
value of Lehman Brothers became a self-fulfilling prophecy (Matsumoto).
1 Definition via web: Short sellers arrange to borrow shares, then dispose of
them in anticipation that they will fall. They later buy shares to replace those
they borrowed, profiting if the price has dropped. Naked short sellers dont
borrow before trading -- a practice that becomes evident once the stock isnt
delivered. Such trades can generate unlimited sell orders, overwhelming
buyers and driving down price (Matsumoto).

10
Faced with these statistics, an important question to ask is: Why wasnt anything done to stop
these short-selling practices before they spiraled out of control? In fact, the Enforcement
Complaint Center, responsible for financial fraud, received approximately 5,000 complaints
between January 2007 and June 2008, but only 123 of the tips were forwarded for further
investigation; none led to enforcement action by the Securities and Exchange Commission.
Despite Fulds efforts to convince Congress and the Fed that naked short-sellers had midwifed
Lehman Brothers decline, public pressures in the political atmosphere kept the Fed from acting
appropriately. The Fed weakly argued that the increased number of fails-to-deliver can be
accounted for by misunderstandings between traders or a string of computer glitches; Congress
merely would not listen, since it had already cast Fuld and Lehman Brothers as the villain in
the situation (Matsumoto). Furthermore, Goldman Sachs agreement to pay a $450,000 fine for
the accusations (evidently, Goldman had a guilty conscience) resulted in the issue being
figuratively swept under the rug (Reuters).
The failure by the Fed, the Securities and Exchange Commission, and Congress to react
appropriately to these blatantly reported abuses in the financial system can be circled back to
political pressures. Evident in e-mails and notes that were dug up between Congressmen and Fed
officials, including Ben Bernanke, it was clear that the fate of Lehman Brothers was at the heart
of a political debate. Lucind Brinkler, from the Federal Reserve Bank in New York, is quoted:
There has also not been much appetite over the past few days for ideas that
involve extending public support beyond the existing programs. These issues
and speculation about how bankruptcy would likely unfold are the drivers of
this thinking. Also, an e-mail from Bernanke the night before Lehman
declared bankruptcy suggested that research effort for alternative options for

11
Lehman Brothers was minimal: In case I am asked: How much capital
injection would have been needed to keep LEH [Lehman] alive as a going
concern? I gather $12B or so from the private guys together with Fed
liquidity support was not enough (Sorkin).
In this situation, the Fed did not react objectively; it had an ulterior motive to use the
failure of Lehman Brothers as leverage to convince politicians and the public that a large, federal
bailout was necessary to reign in on an impending financial crisis. Whether this ulterior motive
was valid is debatable. On the one hand, by letting Lehman fail and convincing Congress of the
need for TARP funds, the Fed may have staved off an even worse recession. However, by taking
such a political, strategic approach, the Fed may have lost its credibility as an objective
institution, further harming domestic and international confidence in the U.S. economy; the
extent of this damage is not measureable.

12
Works Cited
Baldwin, Richard. The Great Trade Collapse: Causes, Consequences and Prospects. CEPR.
Print.
Carpenter, Dave. "CNBC Anchor Bartiromo Says Government 'needed' to Let Lehman Brothers
Fail | The Post and Courier, Charleston SC - News, Sports, Entertainment." The Post and
Courier. Associated Press, 19 Sept. 2010. Web. Nov.-Dec. 2010.
<http://www.postandcourier.com/news/2010/sep/19/qa/>.
Cassidy, John. How Markets Fail : The Logic of Economic Calamities. 1st ed. Farrar, Straus and
Giroux, 2009. Print.
Colby, Robert L. D., David L. Portilla, and Christian L. Lang. "The Bear "Naked" Truth: Short
Sales and Rumors." Practical Compliance and Risk Management for the Securities
Industry. Wolters Kluwer Financial Services, Inc., Sept.-Oct. 2009. Web. Nov.-Dec. 2010.
<http://www.davispolk.com/files/Publication/7b58464d-67b7-4e4d-a0b729eff68f716f/Presentation/PublicationAttachment/5930344b-17ac-431b-83863af1dc6d280b/Colby.Portilla.PCRM.shortsales.article.sep-oct09.pdf>.
Dey, Iaian and Danny Forsten. JP Morgan brought down Lehman Brothers. The Sunday
Times. Web. 5 Oct. 2008.
<http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/art
icle4882281.ece>
Fuld, Richard S. "Written Statement of Richard S. Fuld, Jr. Before the Financial Crisis Inquiry
Commission." 1 Sept. 2010. Web. Nov.-Dec. 2010.
<http://www.fcic.gov/hearings/pdfs/2010-0901-Fuld.pdf>.
Matsumoto, Gary. "Naked Short Sales Hint Fraud in Bringing Down Lehman." Bloomberg. 19
Mar. 2009. Web. Nov.-Dec. 2010. <http://www.bloomberg.com/apps/news?
pid=newsarchive&sid=aB1jlqmFOTCA>.
Nocera, Joe. "Lehman Had to Die so Global Finance Could Live." Business. New York Times, 11
Sept. 2009. Web. Nov.-Dec. 2010.
<http://www.nytimes.com/2009/09/12/business/12nocera.html?_r=1&dbk>.
Pozen, Robert C. Two Lessons From Lehman. Harvard Business Review. 14 Sept. 2009. Web.
Nov.-Dec. 2010. <http://blogs.hbr.org/cs/2009/09/learning_from_lehman.html>
Sorkin, Andrew R. "Sorkin: 2 Zombies to Tolerate for a While - NYTimes.com." Mergers,
Acquisitions, Venture Capital, Hedge Funds - DealBook - NYTimes.com. New York
Times, 17 Aug. 2010. Web. Nov.-Dec. 2010.
<http://dealbook.nytimes.com/2010/08/17/sorkin-2-zombies-to-tolerate-for-a-while/>.

13
Stempel, Jonathan. "UPDATE 2-US Fines Goldman Unit over Short-sale Violations | Reuters."
Business & Financial News, Breaking US & International New. Reuters, 04 May 2010.
Web. Dec. 2010. <http://www.reuters.com/article/idUSN0410776520100504>.
Taibbi, Matt. Wall Streets Naked Swindle. Rolling Stone. 5 April 2010. Web. Nov.-Dec. 2010.
<http://www.rollingstone.com/politics/news/12697/64824?RS_show_page=0>
Taylor, Mike. "Fuld: Rampant Rumors, Fed Failure Led to Lehman Collapse." New York
Observer: Wall Street. 1 Sept. 2010. Web. Nov.-Dec. 2010.
<http://www.observer.com/2010/politics/fuld-unfounded-rumors-fed-failure-led-lehmancollapse>.
Thomas Jr., Landon. Examining the ripple effect of the Lehman bankruptcy. The New York
Times. Web. Nov.- Dec. 2010.
<http://www.nytimes.com/2008/09/15/business/worldbusiness/15ihtlehman.4.16176487.html?_r=2>
Why AIG was bailed out but not Lehman Brothers. Pinoyymoneytalk.com. 23 Sept. 2008. Web.
Nov.-Dec. 2010. <http://www.pinoymoneytalk.com/lehman-brothers-aig-bailout/>
Wilson, Amy. "Lehman Collapse: Winners from the Financial Crisis." The Telegraph. 15 Sept.
2009. Web. Nov.-Dec. 2010.
<http://www.telegraph.co.uk/finance/financetopics/financialcrisis/6160861/Lehmancollapse-winners-from-the-financial-crisis.html>.