Lessons to Be Learned One Year After Lehman Brothers Collapse Roiled the World

Worst recession since the Great Depression followed Lehman's collapse.

ByABC News
September 13, 2009, 7:33 PM

Sept. 14, 2009 — -- On the morning of Saturday, Sept. 13, 2008, Treasury Department official Tony Fratto was talking to a friend at a major New York City investment firm. The offices at every big bank in the city, Fratto's friend told him, were packed with staffers trying to figure out their firms' counterparty risk to Lehman Brothers.

"To me, that was just jaw-dropping," Fratto said.

The legendary investment bank had been teetering on the brink of collapse for months. To think that banks were only now scrambling to assess their vulnerabilities to Lehman was, Fratto felt, "staggering."

Two days later, on Sept. 15, Lehman went bankrupt. Just like that, the world had changed.

Lehman's failure rocked the financial system to its core, sending shockwaves around the world and sparking a global crisis that can still be felt today.

In his address to Congress last week, President Obama said confidently, "We have pulled this economy back from the brink."

On the eve of the one-year anniversary of Lehman's bankruptcy, a look at the past year provides insight into the current economic environment and hints at what lies ahead.

After Lehman Brothers collapsed, the financial system fell into a state of fear and panic.

"Over the course of 20 years, the financial system had become bigger and much more risk-loving in a way," said Simon Johnson, a professor at MIT and senior fellow at the Peterson Institute. "Sept. 15 is when we woke up to the dangers."

With the system in shambles, the economy started its descent into the deepest recession since the Great Depression.

"It was an intense environment," Fratto recalled. "We were dealing with a whole series of crises ... investment banks collapsing, the takeover of [mortgage giants] Fannie Mae and Freddie Mac, money markets freezing up, auto companies collapsing, the AIG problem.

"The world had in fact changed," he said. "There were things happening that no one could anticipate and no one knew what the next unintended consequence was going to be."

The Bush administration was faced with a choice between letting major firms like Lehman collapse or rescuing the financial system.

If the situation in mid-September had continued to deteriorate, "You would have seen a collapse of the global financial system," Fratto recalled. "That would have been absolutely catastrophic."

The government chose to bail out the financial system, a move made more difficult in the midst of last year's presidential elections -- "the perfect storm," Fratto called it.

Weeks after Lehman failed, Congress passed the $700 billion Troubled Asset Relief Program to rescue the financial system.

"I think it's one of the great achievements of all time that we were able to get Congress to understand the problem and to agree to pass that legislation because in my opinion, there has never been a more reviled piece of legislation to make it through the Congress than the financial rescue legislation. Nothing has ever been less popular and more urgently needed, and in retrospect, it worked."

But some analysts, such as Jim Paulsen, chief investment strategist for Wells Capital Management, contend that the government's sounding the alarm bells only made matters worse.

"This crisis was made far worse than it needed to be because our leadership fostered the environment of fear rather than trying to extinguish it," Paulsen said.

"Everyone understands that if you yell fire in a crowded theater, even if there is no fire just saying that will create fundamental damage," Paulsen said. "But for some reason if we yell fire in the midst of an economic panic, we seem to think that it won't have any detrimental impact."

Since last fall, the $700 billion TARP has now morphed into a much larger bailout. The government has now spent trillions of dollars to bail out a slew of other companies on the brink of collapse, from automakers such as General Motors and Chrysler to insurance behemoth AIG.