By Frank Medina 

Former Chairman of the Federal Reserve Board Ben Bernanke’s memoire of the financial crisis—The Courage to Act— has hit the bookstores.​

Most of the early commentary has centered around two remarks that Bernanke has made on his book’s release. The first is that as Chairman of the Federal Reserve, Bernanke found the September 2008 failure of Lehman Brothers to be a “terrible surreal moment,” in which events unfolded in a blur. The second is some Wall Street executives should have gone to prison for the role they played in helping to bring about the financial crisis.

At first glance, these two remarks seem to have nothing to do with each other, but a closer look shows otherwise. The conventional narrative is that the financial crisis suddenly erupted in the fall of 2008, catching everyone—regulators and market participants alike—completely unaware. But in fact Lehman’s failure—the spark that ignited the financial crash and precipitated the economic crisis—was something that the Federal Reserve should have anticipated, certainly no later than the failure of Bear Stearns in the spring of 2008. (We won’t detail here the many reasons the Fed should have seen the catastrophe coming long before then.)

As Ohio State University finance professor René Stulz has explained, the Fed should have and could have done something to either prevent or plan for Lehman’s failure in light of the failure of Bear Stearns. As he puts it:

[What] these officials should not receive the benefit of the doubt is for what happened before the fall of Lehman. One could argue that the difficulties at mortgage banks in early 2007, as well as the share decline of various ABX indices at that time, should have been a wake-up call for regulators and the Treasury that there were problems in the housing market. . . .

The road to Lehman’s bankruptcy was marked with still more wake-up calls. The fall of Bear Stearns in the spring of 2008 made it transparently clear that runs on investment banks could take place. . . . After Bear Stearns’s failure, one had to know that investment banks were fragile and that what to do if a run took place was a key question that had to be addressed . . .

The task for [the official] sector was to focus on events that could endanger the financial system. At this they failed.

In other words, in light of the collapse of Bear Stearns, what the world needed in 2008 was a little less courage and a little less action, and a little more foresight and a lot more planning.

And Ben Bernanke in particular should have known that Lehman was going to fail; for the Chairman of the Federal Reserve Board, Lehman’s failure should not have been a “terrible surreal moment.” Instead, it should have been something that the Fed should have been planning for, certainly no later than during the five months between the failure of Bear Stearns and “Lehman weekend.”

In fact, the vice-Chairman of the Federal Reserve Don Kohn e-mailed Ben Bernanke in June 2008, to let him know that Lehman was circling the drain:

One of the hedge fund types on Cape Cod told me that his colleagues think Lehman can’t survive—the question is when and how they go out of business not whether. He claimed this was a widely shared view on the Street.

This was not a one-off email about a comment from one “hedge fund type.” This was indisputably the “widely shared view on the Street” and elsewhere.

As fascinating as the e-mail from Kohn to Bernanke is, how that e-mail came to light is as interesting. That e-mail came from the examiner’s report on Lehman’s bankruptcy. In addition to shedding light on what the Fed knew (or should have known) about Lehman’s impending and inevitable failure, the examiner’s report also showed that Lehman was using an accounting gimmick to hide the extent to which it was leveraged in its quarterly report.

More specifically, Lehman Brothers used foreign accounting rules to engineer a short-term sale of securities coupled with a promise to buy those securities back in the next quarter. This circular transaction was effectively a very short term loan, but the accounting treatment allowed Lehman to book the transaction as a sale, which meant that Lehman was able to make it seem better capitalized than it was on its public quarterly statements. Or as law professor James Kwak more succinctly put it:

Lehman was cooking the books. If this sounds like Nigerian barges (Enron) to you, you’re not the only one.

But when Ben Bernanke said upon the release of his book that bank executives should have been prosecuted for their role in helping to bring about the financial crisis, he conspicuously failed to name a single executive. You would have thought that the executives at Lehman—as demonstrated and documented by the bankruptcy examiner’s report—would have been obvious candidates.

But there is a problem. A problem that the examiner’s report also makes clear.

Not only did the Fed fail to plan for Lehman’s failure, the Fed also apparently knew that Lehman was apparently fraudulently cooking the books for the purpose of deceiving the public and the markets, and didn’t do anything about it.

As reported in 2010 by Andrew Ross Sorkin, in March 2008—just after Bear Stearns failed:

[A] team of officials from the Securities and Exchange Commission and the Federal Reserve Bank of New York quietly moved into the headquarters of Lehman Brothers. They were provided desks, phones, computers — and access to all of Lehman’s books and records. At any given moment, there were as many as a dozen government officials buzzing around Lehman’s offices. These officials . . . were assigned . . . to monitor Lehman in light of the near collapse of Bear Stearns.

These Fed (and SEC) officials either missed the accounting fraud or, even worse, they turned a blind eye to it. Either way, the Fed’s negligence or complicity made it difficult if not impossible to prosecute the Lehman fraud. As Sorkin put it, “If Lehman Brothers executives are sued civilly or prosecuted criminally, they may actually have a powerful defense: a raft of government officials from the S.E.C. and Fed vetted virtually everything they did.”

And Lehman’s apparent fraud would not be the last time that the Fed was aware of wrongdoing and did nothing about it. At the height of the financial crisis, the President of the New York Fed, Tim Geithner, was specifically informed that the biggest global banks that the New York Fed was supposed to be supervising were manipulating LIBOR, a key interest rate that determines the price consumers and businesses pay on $350 trillion of financial products, ranging from credit cards to mortgages.

Despite Ben Bernanke’s after-the-fact assertion that bank executives should have been held accountable for their wrongdoing, the NY Fed failed to do anything at all with the LIBOR fraud information, including never even informing the Justice Department for investigation or prosecution. Eventually, discovering and investigating the massive global LIBOR fraud fell to the tiny and perpetually underfunded Commodity Futures Trading Commission (CFTC), which dragged other seemingly reluctant regulators and prosecutors into a series of comprehensive enforcement actions against the megabanks that had manipulated this interest rate.

Thus, as with Lehman, it appears that the Fed would have been happy for the LIBOR rate-fixing fraud scandal to go unprosecuted, indeed, unmentioned and unknown.

So while it is refreshing to hear the former Chairman of the Federal Reserve call for the criminal prosecution of those bank executives that helped cause the financial crisis (better late than never), one wonders whether the time for “the courage to act” on this issue was back when the former Chairman had the power and authority to do something to make these prosecutions happen.