Wonder why Lehman failed?        Photographer: Prashanth Vishwanathan/Bloomberg
Wonder why Lehman failed?        Photographer: Prashanth Vishwanathan/Bloomberg

One of the most puzzling aspects of the financial crisis was the zig-zag-zig by the U.S. authorities, who saved Bear Stearns from bankruptcy, then let Lehman Brothers fall off the cliff only to rescue AIG a day later. After plowing through the first half of Tim Geithner's book "Stress Test," I'm none the wiser.

Geithner, who was at the helm of the New York Federal Reserve during the meltdown and then became President Barack Obama's Treasury secretary in its aftermath, has no time for "moral hazard fundamentalists" who object to bailouts for banks. "The truly moral thing to do during a raging financial inferno is to put it out," he argues. So why didn't he throw buckets of dollars on Lehman when it was blazing away?

After saying his book isn't meant to cast him as the Cassandra of the financial crisis, Geithner tries to convince us that he was ahead of the curve from the moment he arrived at the Fed. "Even though the financial sector seemed healthy, I talked about the systemic risks in almost every speech I delivered as New York Fed President." That talk failed to translate into action.

In 2005, Geithner advisers Lee Sachs and Stanley Druckenmiller started bringing him graphs showing the U.S. credit boom, which the trio dubbed "Mount Fuji" charts. The alarms that should have sounded didn't go off. In August 2006, he played truant from a conference to go fly fishing and his guide, a mortgage broker, told him "horror stories of sketchy loans to homeowners with sketchy credit." Still the bells stayed silent.

A year later Countrywide, the largest mortgage lender in the U.S. with $500 billion of housing loans in 2006, got into trouble. In mid-August 2007, Bank of New York Mellon threatened to pull Countrywide's funding unless the Fed indemnified it against potential losses. Geithner refused; instead, he strong-armed the bank into holding fire in exchange for Countrywide upgrading its collateral. Then the funding that kept Bear Stearns afloat disappeared almost overnight:

"This felt much darker than the Countrywide scare, because Bear seemed more systemic, and the broader financial world was in a much more fragile place," Geithner writes.

Bear was poised for collapse after its liquidity shrank to $2 billion from $18 billion in a handful of days. The Fed spent a night and the early hours of a morning examining its books. "The closer Fed officials looked at Bear's connections with the broader financial system, the more they feared the sudden failure would unleash utter chaos," Geithner recalls. "It was completely enmeshed in the fabric of the system."

When JPMorgan balked at buying the securities firm, citing the riskiness of Bear's mortgage securities, the Fed agreed to a $30 billion backstop secured on investment-grade assets from Bear:

The entire Bear episode was a turning point for the Fed. We had used our power to help prevent the disorderly collapse of a private firm, protecting creditors and counterparties from losses. We didn't want to do any of those things; we saw them as the least-bad options. The moral hazard fundamentalists were missing the point. It was hard to imagine that other firms would take much comfort from Bear's plight or have any desire to follow Bear's path.

Here's where I disagree fundamentally with Geithner. Bear Stearns should have been allowed to go bust, economic Darwinism would have cleansed the system, and the world of finance would have taken a beating but emerged stronger for it. Instead, other bankers and other firms -- notably Dick Fuld at Lehman Brothers -- took the rescue as evidence that the Fed safety net would also be extended in their hour of need. Geithner acknowledges this, but reaches a different conclusion.

Some would later argue that the moral hazard of the Bear Stearns rescue made this kind of complacency inevitable, that investment banks and other major institutions now had reason to believe they would be bailed out of their mistakes. Our successful intervention to prevent Bear's collapse might have influenced Fuld's refusal to believe we would ever let Lehman collapse. But his reluctance to act probably had less to do with moral hazard than self-delusion.

When Lehman ran out of money later in 2008, and a plan for Barclays to buy the firm was vetoed by British regulators, Geithner decided that the Fed would be violating its mandate by funding a rescue. Without another firm willing to step in, Lehman was allowed to go bust:

The world naturally assumed we had consciously decided to teach Wall Street a lesson. We hadn't chosen to draw a line. We had been powerless, not fearless. We had tried but failed to prevent a catastrophic default.

So because the collapse of Bear Stearns was a surprise and there was a willing buyer, Geithner was willing to pledge taxpayer money to get a deal done. But because Lehman was unloved and unwanted by its peers, Geithner felt he couldn't act.

That would make some kind of sense, I guess, if it wasn't for what happened a day after Lehman failed when the holes in AIG's balance sheet came to light. Geithner instantly found $85 billion to patch it up.

AIG's decline "had been much swifter, which would be even scarier to markets," Geithner writes. "Letting AIG fail seemed like a formula for a second Great Depression. By law, the Fed can only lend against reasonably solid collateral, but I thought AIG could clear that hurdle, even though Lehman had not."

There's a logical disconnect here. None of the collateral at that time could be described as solid. Mark-to-market had become mark-to-myth -- the banks and financial companies were making up their asset values. AIG's assets were at least as toxic as those of Lehman -- and arguably more so in the aftermath of the world's biggest bankruptcy. Either Bear Stearns should have been allowed to go bust, or Lehman should have been propped up. To me, Geithner's inconsistency still seems crazy after all these years.

To contact the author of this article: Mark Gilbert at magilbert@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.