Lehman

by Russ Roberts on December 13, 2011

in Financial Markets, Frenetic Fiddling, The Crisis

I hope I find the time to comment more fully on this recent column in the WaPo by Robert Samuelson defending the Fed. But for now, let me pull out one paragraph:

After Lehman Brothers’ failure in September 2008, American credit markets began shutting down. Banks wouldn’t lend to banks. Investors balked at buying commercial paper — a type of short-term loan — and many “securitized” bonds. Fearing they’d lose credit, businesses dramatically cut spending. Layoffs exploded: 6.3 million jobs vanished between that September and June 2009. Firms canceled investment projects in plants and equipment. In the first quarter of 2009, business investment spending fell at a 31 percent annual rate.

This is a common view–that Lehman’s collapse and the failure of the policymakers to rescue Lehman precipitated the crisis. It could be true but the evidence is quite cloudy. The claim also ignores the possibility that it once the Fed had rescued the creditors of Bear Stearns in March of 2008, lenders to Lehman (such as Reserve Primary–a money market fund!) figured they were safe. It was the unexpectedness of the government actually letting creditors lose money that caused the dislocations, not the failure of Lehman, per se.

There’s a problem with Samuelson’s version of the standard narrative. He writes:

Investors balked at buying commercial paper — a type of short-term loan — and many “securitized” bonds. Fearing they’d lose credit, businesses dramatically cut spending. Layoffs exploded: 6.3 million jobs vanished between that September and June 2009.

Well, yes. There was a lot of uncertainty about the solvency of banks and the value of their assets. There was a lot of fear of securitized loans. I would argue that both of those were generally a good thing. Banks and investors had been out of control. It was a good idea to pull back from some of the riskier activities. And yes, there were problems with commercial paper and money market funds. But is that why layoffs exploded? The implicit claim is that when the credit market “froze up” companies got scared they’d have trouble getting access to short-term credit and so they began laying off workers in droves.

The problem with this story is that it undermines the claim in the rest of the article and elsewhere that the Fed saved the day. In the weeks following the Lehman bankruptcy, the government was hyperactive. In the next three weeks, AIG was rescued. TARP was passed. Money market funds were guaranteed. And on October 7th, just three weeks after Lehman’s collapse, the Fed said it would buy commercial paper in whatever volume it took to keep that market going. The Washington Post reported:

Using its emergency authority for the third time this year, the Fed will create a special entity that will purchase “commercial paper,” the debt that companies use to fund their inventories, payrolls and other short-term cash needs. The Treasury Department will help fund the program.

Problems in the commercial paper market have been one of the most direct ways in which the financial crisis has threatened to affect the nuts and bolts economy. Banks and financial firms have become hesitant to lend, and companies have worried about raising the money needed to pay their bills.

Today’s radical move by the Fed puts the central bank in the position of funding individual financial institutions and ordinary companies, even with “unsecured” debt, or that which is backed only by the company borrowing money, rather than with specific collateral.

There is no cap on the size of the program, senior Fed staffers said, other than the size of the total universe of eligible commercial paper: $1.3 trillion. Fed officials do not anticipate taking on anywhere near that much debt, but rather are hoping that private buyers of debt will feel newly confident knowing that the central bank is available as a backstop.

So why did 6.3 million jobs disappear between September of 2008 and June of 2009? It can’t be because of Lehman and credit markets freezing up. Firms weren’t laying off workers because of inadequate action in response to the Lehman collapse. The Fed (and the Treasury) were pouring liquidity into the system with a fire hose. The layoffs occurred despite the Fed’s efforts. Maybe most of those 6.3 million lost jobs occurred because of something else, a fear that the world was coming to end, that government was out of control, that we had learned way too much about how lousy were the balance sheets of banks or who knows what. But it wasn’t Lehman.

I’ve been thinking about this after coming across this rather calm article from late in the afternoon of September 15, the day Lehman declared bankruptcy. It’s an attempt to explain why the government didn’t rescue Lehman (and its creditors) and why the government had rescued the creditors of Bear Stearns. I mention how calm the article is because you’d think from the accounts of today, the world went haywire when Lehman went down. The Dow Jones Industrial Average did fall 500 points. But that wasn’t viewed with much alarm by the contemporaneous observers that day:

Barry Ritholtz, CEO of Fusion IQ, said that Bear Stearns’ holdings also posed a greater risk to the nation’s financial institution than did Lehman’s. He said Bear Stearns had $9 trillion worth of financial instruments known as derivatives, much of it shared with other financial institutions such as its eventual buyer, JPMorgan Chase. He said Lehman had about a tenth that much exposure.

“Lehman was only incompetent enough to blow up and destroy themselves, where as Bear’s degree of incompetence was enough to threaten the entire financial system,” Ritholtz said.

There is also a sense that investors, financial regulators and Wall Street firms have a better handle on the problems in the financial markets than they did six months ago. The fact that Bear Stearns took place when there was so much more uncertainty is also a reason the Fed kept it out of bankruptcy then, but didn’t step in to help Lehman now.

“We didn’t know what we didn’t know in March,” said Art Hogan, chief market analyst at Jefferies & Co. “We know much more now.”

No panic. No wild worries. Yes, over the next two weeks, things did go a little crazy. But a lot of things happened in those two weeks other than that it was after the Lehman bankruptcy. Check out this nice Washington Post timeline. Scroll down to September 15 and work your way up. Watch markets see-saw up down up down as new information arrives. Very hard to attribute the downs of that see-saw to Lehman or the failure of government intervention when you read what else was going on.

Of course the ups and downs of the stock market are not the only measure of the health or mood of the economy. Check out John Taylor’s analysis of how interest rates (a measure of the alleged freezing up of credit markets) reacted to the Lehman bankruptcy and the various interventions of the time.

Correlation is not causation. A lot of bad things happened after Lehman failed. But there is little evidence that letting Lehman fail caused those bad things.

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{ 51 comments }

Jon Murphy December 13, 2011 at 7:43 pm

Fascinating analysis, Russ. If this is just a smidgen of what you are planning on writing, I look forward to reading the remainder.

Methinks1776 December 13, 2011 at 7:54 pm

Hey, the moment Lehman went bust and inter-bank lending hit the skids, I panicked started handing out pink slips. Didn’t everyone?

What I remember most about that period was everyone wondering who is going to be next – how many bankrupt companies would need to be flushed out before we were done with the rot. We were worried that our Prime Broker would cut our leverage and we were worried that our Prime Broker would be next to go bankrupt because it had huge positions in what we jokingly called “z-tranche” CDOs, MBS, etc. We were a lot worried about the last part (but our accounts was segregated, so we didn’t worry too much). Our leverage was cut, but we managed fine. I remember we were scared and exhausted. I don’t remember feeling any panic. Everyone we talked to who also depended on interbank lending was concerned about having their leverage cut, but that concern didn’t begin to approach panic level. That’s my anecdote.

nailheadtom December 14, 2011 at 9:22 am

As the WaPo article says: “…companies have worried about raising the money needed to pay their bills.” We can’t have people worrying.

Greg Webb December 13, 2011 at 7:57 pm

Russ, it is nice that there are still a few truth seekers out there. You may have a bias, but that does not appear to get in the way of objectively analyzing the data and drawing reasonable conclusions about the causes.

Josh S December 14, 2011 at 4:25 pm

An EconTalk with Samuelson might be interesting…IMO he’s a genuine “truth seeker,” though I often find plenty to disagree with in what he writes. But unlike, say, Krugman, he appears to hold his opinions genuinely and respect people who disagree with him.

Henri Hein December 13, 2011 at 8:33 pm

For an overview, that WAPO link is a good timeline, but I don’t like the juxtaposition of congressional activities and the DOW. It implies stock markets should drive policy. That is a dangerous principle.

Henri Hein December 13, 2011 at 8:54 pm

I also cannot quite make sense out of the quoted DJI deltas. I think it is the movement over the course of that day. In that case, Sept 7 should be 0. It was a Sunday and the markets were closed.

Methinks1776 December 13, 2011 at 9:13 pm

I think the DOW is there to illustrate what was going on in the market rather than to imply that fluctuations in the stock market should drive policy. I also don’t understand this antiquated media clinging to the DOW, which is a price-weighted index of only 30 stocks, instead of the S&P 500, which is what everyone really pays attention to, but I digress.

Just FYI: While the stock market is closed on Sundays, the index futures markets opens at 5pm on Sundays. So, the Dow and S&P futures would have traded Sunday afternoon into the open on Monday morning.

Jon Murphy December 13, 2011 at 9:32 pm

I don’t understand the obsession with the stock market. It is, historically, an unreliable indicator of economic health, at best.

Greg Webb December 13, 2011 at 9:40 pm

Yep.

Methinks1776 December 13, 2011 at 9:53 pm

You mean besides the obvious reason that this is where assets priced and expectations are reflected?

Jon Murphy December 13, 2011 at 9:58 pm

Right, but as a leading indicator, it is very unreliable and more often than not reflective of short-term expectations than actual fundamentals. For example, just look at this past summer: the stock market was in free fall, yet the economy was growing and adding jobs at a rate not seen since the early 90′s!

The stock market has its use, to be sure, but one should be very cautious when interpreting it as an economic indicator.

Methinks1776 December 13, 2011 at 10:24 pm

Jon, not everything that is important is a leading economic indicator.

For example, just look at this past summer: the stock market was in free fall, yet the economy was growing and adding jobs at a rate not seen since the early 90′s.

The economy could be adding jobs at the same time the market realizes stocks are overpriced. The two things are not mutually exclusive. Stock prices change to reflect changing expectations as new information becomes available. This summer, the market was pricing in a lot of fast changing information from Europe as well as the debt ceiling issue, the S&P downgrade and changing expectations of more Fed interventions.

more often than not reflective of short-term expectations than actual fundamentals.

What is an “actual fundamental” vs. a “short-term expectation”? Fundamentally, expectations change when with new information. If the information changes quickly, then expectations will change to reflect the new information.

Methinks1776 December 13, 2011 at 10:42 pm

One more thing about the employment numbers, Jon. Markets are forward looking, the employment data is an account of happened in the past. While it is one peace of information upon which the market will base expectations of the future, it is still just one piece of data and its positive (or negative) effect on expectations can be easily overwhelmed by other information.

Seth December 14, 2011 at 12:17 am

“For example, just look at this past summer: the stock market was in free fall, yet the economy was growing and adding jobs at a rate not seen since the early 90′s!” -Jon Murphy

Do you mean leading indicator or concurrent indicator?

I think in normal times, a leading indicator would precede economic conditions by 3-6 months. However, when things are changing rapidly, like when the government is playing chicken with absorbing another large chunk of the economy by raising a debt ceiling, it prices that uncertainty in rather quickly.

I don’t find your example compelling. The S&P 500 was generally increasing 3 – 6 months ahead of the summer, which would support your observation of the health of the economy in the summer.

The summer S&P 500 would be projecting the economy 3-6 months in advance, while pricing in any big changes, like mentioned above.

Jon Murphy December 14, 2011 at 7:23 am

Sorry, Seth, I meant as a concurrent indicator.

Again, I’m not saying that the stock market doesn’t have value, but as an indicator it is unreliable. There are much better indicators out there that no one focuses on.

Methinks1776 December 14, 2011 at 8:18 am

You only think it’s unreliable because prices are dynamic and reflective of millions of people’s changing expectations rooted in constantly changing information. The economic data you favour as an indicator measures a single thing at a single point in time. The thing you seem to miss is that the reason the market is important is that it factors in all those backward looking indicators you think are so important.

Jon Murphy December 14, 2011 at 8:40 am

All I am saying is that to focus on one indicator is foolish. One cannot get the big picture just by looking at one indicator. It’s like reading the first page of War and Peace and claiming to know the whole story.

The stock market is just one indicator that is prone to wild swings in prices that may or may not be reflective of overall economic conditions and trends. In my professional opinion, there are much better indicators that represent the economic health of the economy (US Leading Indicator, US Industrial Production, Purchasing Managers Index, and Nondefense Capital Goods New Orders, to name a few).

Seth December 14, 2011 at 12:52 pm

Jon – You may want to consider that the market may not always confirm your biases, but it could be that your biases are not correct or that you are missing some key things entirely.

I have found it to be worthwhile to being open to what the market (that is the pricing of securities by millions of participants) is saying. I ask, “what am I missing?” rather than assuming that millions of other individuals are missing something.

Methinks1776 December 14, 2011 at 10:20 am

The equity market is not a leading indicator.

It’s where all those leading indicators you mentioned are digested and their implications are reflected in asset prices. And that is why the equity market is important and that is the reason for the “obsession” with the equity markets.

Newt Represents The GOP Best December 13, 2011 at 8:57 pm

Russ Roberts, at best, distorts what Robert Samuelson wrote, when he writes, “This is a common view–that Lehman’s collapse and the failure of the policymakers to rescue Lehman precipitated the crisis.”

Robert Samuelson never said that Lehman’s collapse “precipitated the crisis.” Samuelson wrote only that the crisis came “After Lehman Brothers’.”

The forces that precipitate the crisis caused Lehman’s collapse and then continued, causing firms to fail and lossess of millions of jobs.

We are then treated to this misleading paragraph:

“So why did 6.3 million jobs disappear between September of 2008 and June of 2009? It can’t be because of Lehman and credit markets freezing up. Firms weren’t laying off workers because of inadequate action in response to the Lehman collapse. The Fed (and the Treasury) were pouring liquidity into the system with a fire hose. The layoffs occurred despite the Fed’s efforts. Maybe most of those 6.3 million lost jobs occurred because of something else, a fear that the world was coming to end, that government was out of control, that we had learned way too much about how lousy were the balance sheets of banks or who knows what. But it wasn’t Lehman.”

1. Contrary to the first sentence, Lehman failing was a symptom of the credit markets freezing.

2. As to the assertion that, “Firms weren’t laying off workers because of inadequate action in response to the Lehman collapse,” such is a total distortion of reality. Even if the Fed’s response was “adequate,” it is self evident that the economy is not as responsive as even a Chevy Volt. Firms could judge that the calvary will not arrive in time and still lay off workers. In fact, since the reasoned judgment at the time was that the fiscal stimulus would late in arriving and was not large enough, any firm well grounded in Keynesian economics would still lay off. Firms had inquiry notice from the first moment that Krugman signaled the need for a larger stimulus than was being considered.

3. The last sentence contradicts your earlier assertion that Samulson maintains that Lehman’s collapse precipitated events.

In sum, Why oh Why can’t we have better blogging?

Methinks1776 December 13, 2011 at 9:14 pm

Luzha is back.

Dances with Wolves December 13, 2011 at 9:27 pm

Yuck! I think that you are right.

Majuscule December 13, 2011 at 10:49 pm

Dude, pick a name and stick to it.

LuLu-Luza, Far Reaches of Left Field December 14, 2011 at 12:21 am

Oh, you wuvvv me,,,

House of Cards December 14, 2011 at 9:23 am

Not so much, idiot…

Darren December 14, 2011 at 1:27 pm

Robert Samuelson never said that Lehman’s collapse “precipitated the crisis.” Samuelson wrote only that the crisis came “After Lehman Brothers’.”

The implication is that it contributed to it; that it was the final straw. Otherwise, why bring it up Lehman Brothers at all?

jpm December 13, 2011 at 9:04 pm

This article:
http://www.zerohedge.com/news/why-uk-trail-mf-global-collapse-may-have-apocalyptic-consequences-eurozone-canadian-banks-jeffe

at Zero Hedge on the MF Global blow up really is a red flag that we have more of this sort of stuff to come. In fact, we may have seen nothing yet.

Methinks1776 December 13, 2011 at 9:18 pm

I’m pretty convinced that that banking system is held together with scotch tape and old nail polish, but the apocalypse has been right around the corner at Zerohedge for a long time.

GAAPrulesIFRSdrools December 14, 2011 at 12:23 am

Sounds like Taleb is in the house.

mcwop December 14, 2011 at 11:39 am

But, but, but, Dodd-Frank should stop all this, and,Democrats are pious democratic people – Corzine will find the money and fix everything any day now. Of course, if Obama unleashes a $1.2 billion ad campaign during the election, well, then we will know where that money went. What we need now is Dodd-Frank 2 to really fix the problem this time.

Roger McKinney December 13, 2011 at 9:47 pm

Post hoc fallacies and spurious correlations have invaded and taken over the discussion for the past four years.

Newt Represents The GOP Best December 13, 2011 at 10:03 pm

The alert reader will note a reference above to an essay by John Taylor.

The really alert reader will note that at the bottom of page 4 of his essay that Taylor admits away his case, when he observes the lot rate of savings 2003 (+/-)

The admission is that Taylor does not ask, why were savings so low?

By rights, given the low taxes and inflation, savings (investment) ought to have been high.

Taylor also fails to apply Friedman’s insight. Taylor claims that interest rates were too low, but as Friedman explained, low interest rates show a lack of money (thus, also, savings and investment)

In sum, what you are seeing is a world destroyed by low taxes. While there is no Ricardian equivalence, investors understand the imperative of effective, fisically sound government. If they do not see such in the future, as per Keynes, they will not invest. The ECB just did a study on the importance of effective gov’t.

steve December 13, 2011 at 11:13 pm

“No panic. No wild worries. Yes, over the next two weeks, things did go a little crazy. But a lot of things happened in those two weeks other than that it was after the Lehman bankruptcy.”

The last quarter of 2008 was one of the worst that we have recorded. We saw record TED spreads. El-Arian, who was there and watched the number claims that credit markets froze. What do you think caused all of this? I don’t think Lehman alone was responsible, but there was a whole chain of events, like the run on commercial paper that can be plausibly linked to Lehman going down. Those there at the time have also said that they feared other large banks might also be insolvent. I think the key is in your statement that follows.

” Maybe most of those 6.3 million lost jobs occurred because of something else, a fear that the world was coming to end, that government was out of control, that we had learned way too much about how lousy were the balance sheets of banks or who knows what. But it wasn’t Lehman.”

Lehman was found to be insolvent. None of the other big banks was willing or able to step in and take it over. That certainly seemed to send a signal about the strength of the entire financial sector. The AIG crisis then occurred over the next two days. With Lehman being the (then) largest bankruptcy in US history, followed so quickly by AIG, which was intertwined with nearly all of the other large financials, I remember everyone thinking that all of the financials were at risk of insolvency. But, perhaps my memory fails.

Steve

GlibFighter December 13, 2011 at 11:13 pm

When did the Reserve Primary Fund break the buck? That’s right, one day after Lehman collapsed. The two days after Lehman’s death witnessed a net outflow of roughly $150 billion for US money market funds (the average two-day outflow then was around $5 billion). Childish scolding that ‘correlation is not causation’ and callow post hoc ergo propter hoc warnings do not present a serious intellectual challenge to the claim that, immediately post-Lehman, there was a run on the US money market. Perhaps, circa 9/16/08, an epidemic of fear that the US ‘government was out of control’ broke out across the land?

Prof. Roberts, who doubts there was a freezing of credit markets post-Lehman, refers to John Taylor’s work. Has he read this piece?

http://online.wsj.com/article/SB123414310280561945.html

There Prof. Taylor notes that, post-Lehman, the US economy experienced ‘a serious credit crunch.’ Roberts would do well to pay better attention to Taylor.

Russ Roberts December 13, 2011 at 11:45 pm

A more interesting question is why a money market fund, Reserve Primary, was lending to Lehman. Do you think that had something to do with the rescue of Bear Stearns creditors in March who received 100 cents on the dollar despite lending to a zombie?

You quote Taylor out of context. Here is what he said:

“After a year of such mistaken prescriptions, the crisis suddenly worsened in September and October 2008. We experienced a serious credit crunch, seriously weakening an economy already suffering from the lingering impact of the oil price hike and housing bust.

“Many have argued that the reason for this bad turn was the government’s decision not to prevent the bankruptcy of Lehman Brothers over the weekend of Sept. 13 and 14. A study of this event suggests that the answer is more complicated and lay elsewhere.”

steve December 14, 2011 at 12:18 am

Lehman the 15th, AIG the 16th and 17th, then WAMU on the 25th, which IIRC, is still the largest bankruptcy in the history of the US. Throw in the commercial paper run and was it a surprise that banks would not lend to each other? Do those record, and persistent TED spreads mean nothing?

Steve

Russ Roberts December 14, 2011 at 7:59 am

I’m not sure what you’re saying Steve. I think the economy and financial markets were very unhealthy in 2008 and 2009. The question is what caused the problem. I am trying to make two points in this post. The first is that many people have concluded that the problems of 2008 and 2009 were caused by the decision to let Lehman collapse and go into bankruptcy. That, according to the semi-received wisdom, was the policy mistake of those times.

This strikes me as akin to saying that the thermometer registering 10 degrees Fahrenheit is why it’s cold outside. The system struggled because financial institutions had made lousy decisions for a long time. My claim is that the rescue of the creditors of Bear Stearns (and previous rescues) made decision makers less prudent. The best example is Reserve Primary being one of Lehman’s creditors. Money market funds should not be financing firms leverage 30-1 invested in stuff that was revealed six months before to be really ugly. You do that either because you’re crazy or crazy like a fox–you assume you’ll be rescued as has usually happened in the past.

My second point is that the Fed is portrayed in Samuelson’s article (and elsewhere) as the savior that kept things from getting worse. It’s possible. But Samuelson is arguing that credit markets were so horrible that layoffs exploded at the same time he is arguing that the Fed saved the credit markets. It’s hard to have it both ways.

Finally, I didn’t mean to imply that there weren’t serious credit crunches or problems. That’s what happens when there is fear. My point is that some fear is good–it gets you to stop doing some stupid things. To suggest that that fear was caused by letting Lehman go bankrupt and that that led to layoffs because credit markets weren’t working is a weird claim when the Fed was backstopping everything including the market for commercial paper.

Methinks1776 December 14, 2011 at 8:56 am

You do that either because you’re crazy or crazy like a fox–you assume you’ll be rescued as has usually happened in the past.

There’s another reason you would do that, Russ. The loans were overnight. Such a short time horizon reduces the risk of lending to even very ugly institutions. All the Reserve Primary had to bet was that Lehman wouldn’t go bankrupt in the next 24 hours.

I don’t know how much that factored into their reasoning. I don’t know the size of the loans they were making either. One way to mitigate risk is to reduce the size of the loan. It’s entirely possible that they lulled themselves into thinking that they were okay because others were still lending to Lehman and the time horizon was short enough. It’s possible that a bailout was not on their minds at all. I’m generally supportive of your thesis, anecdotally I know that we were less worried about business interruptions because we thought that our TBTF Prime Broker would be bailed out. That seemed to be the general consensus on The Street – although we all did take precautions by moving more firm capital to brokers who were not in trouble. That said, it’s possible that Money Market funds continued to lend for the reasons I mentioned above. Lending overnight to financial institutions is what Money Market funds do. It’s the way they earn a return, after all.

It’s possible inter-bank lending seized up after the Lehman Bankruptcy because the market got more information (the bankruptcy) realized those overnight loans were riskier than previously thought.

How much of it was a bet on a bailout and how much was a bet that the bank wouldn’t disintegrate the next day I couldn’t even guess, but I think it’s a lot more difficult than you imply to determine ex ante that a decision to lend to Lehman overnight is “crazy”.

Newt Represents The GOP Best December 14, 2011 at 9:08 am

Mr. Roberts writes, “many people have concluded that the problems of 2008 and 2009 were caused by the decision to let Lehman collapse and go into bankruptcy.”

Who are these “many people,” other than Newt and all the other Republican candidates for president who maintain that Lehman was solvent and failed only because the Fed imposed mark to market accounting rules. Read Newt’s book at pages 188-89.

In fact Russ, why don’t you become a one man truth train about Newt. You are above on record that both the Bear and Lehman were zombies.

You can not make this up. Newt wrote these companies could not have been insolvent. It was a conspiracy by the Fed to put them out of business using mark to market accounting.

Instead of mindless quotes from the past, why not daily blasts on Newt?

To the contrary, of course, is your statement that, “My second point is that the Fed is portrayed in Samuelson’s article (and elsewhere) as the savior that kept things from getting worse. It’s possible. But Samuelson is arguing that credit markets were so horrible that layoffs exploded at the same time he is arguing that the Fed saved the credit markets. It’s hard to have it both ways.”

Now Russ, we can all agree that this is a Newtian fib by you. A skilled surgeon can save your life after a horrible traffic accident. You will still be intensive care when you awake and you may have scars and disabilities for the rest of your life.

Newt Represents The GOP Best December 14, 2011 at 9:11 am

Russ,

Give it up. Even Methinks1776 says you are making it up.

Or, is Methinks1776 an impostor, this morning?

steve December 14, 2011 at 9:24 am

The economy was unhealthy earlier than 2008, but most people did not know or want to know. I think the way I look at it, and many other people also, is that Lehman’s collapse signaled the weakness of our financials. Lehman alone collapsing would not have been enough to cause panic. Lehman coming so soon after Bear Stearns was concerning. The fact that other banks were unwilling, or maybe unable (which I think was the big fear) to step in was big.

Then, everything else fell apart right after. AIG was a central part of the finance structure. WAMU was the 6th biggest bank in the country. That is not enough to create panic? To stop people from hiring? To cause layoffs? How often have we had banks the size of Lehman/WAMU fail within a week of each other?

“My second point is that the Fed is portrayed in Samuelson’s article (and elsewhere) as the savior that kept things from getting worse. It’s possible. But Samuelson is arguing that credit markets were so horrible that layoffs exploded at the same time he is arguing that the Fed saved the credit markets. It’s hard to have it both ways.”

Fair point, but let me ask you this. What caused banks to start lending to each other again? Ted spreads went from about 5%, IIRC, back to normal. I think that you can make the case that the Fed played a part in stopping the contagion and keeping most of our top 20 banks from going under. You may think that was needed, but I dont think that any politician, other than Paul, would let this happen. Once credit markets were functioning again, you still had many smaller banks failing. You still had a large supply side, at least, shock. Banks may have been willing to lend to each other again, but who was willing to borrow and were banks willing and able to lend to them?

Steve

Greg Webb December 14, 2011 at 9:34 am

Hear, hear. Russ, you are right in your assessment that it was crazy or crazy like a fox for Reserve Primary to be lending to Lehman. I agree with Methinks1776 about overnight lending, but your comment is valid. Either Reserve Primary did not properly evaluate the risk in lending to Lehman on an overnight basis or, more probably, Reserve Primary wasn’t concerned about the risk as they should have been because of their comfort that the federal government would rescue Lehman.

Economiser December 14, 2011 at 10:10 am

I don’t think Russ and methinks are disagreeing. It’s true that money market funds lend overnight, but they don’t make a one-time loan and walk away. They roll over their overnight funding indefinitely, until there’s a reason to stop. I’m sure Reserve Primary thought that the short-term nature of the loans meant they could get out before trouble hit, but it’s not that easy. When financial firms fail, they fail very rapidly. In all of the big failures of recent years (Lehman, Bear, AIG, MF Global, etc, etc), the companies were assuring everyone of their solvency until they went under. The risk of failure for any one overnight loan is miniscule; the risk if you keep rolling it over gets bigger.

In a Russ-ian world of no bailouts, I’d think that any money market fund would think twice and thrice about lending to a 30:1 leveraged institution with black box financials, even for an overnight term.

Methinks1776 December 14, 2011 at 10:40 am

Economiser is right, I don’t fundamentally disagree with Russ.

I caution that ex poste analysis is infinitely more simple than ex ante and to say you know why someone made the decision they did when you have so little information about how that decision was made (which is further than I think Russ is going. I think.) is…dare I say it?….the pretense of knowledge.

If you are the guy who is deciding ex ante to commit tens or hundreds of millions of your firm’s capital and you’re evaluating all the information and your opportunity cost, it’s not so easy. It is, in fact, painfully difficult. It is absolutely wrong, in my opinion, to simply assume that you know he either just said “oh, fuck it. Give ‘em the dough. Heads we win, tails taxpayers lose.” or that he was crazy.

Economiser is right that they keep rolling over the loans. But, they get to decide whether to roll them over or not. That decision is made daily. It’s not clear at all that they didn’t think twice or thrice and still got it wrong.

In a Russ-ian world of no bailouts, we would still have bad outcomes.

Economiser December 14, 2011 at 1:15 pm

> In a Russ-ian world of no bailouts, we would still have bad outcomes.

Oh, certainly. The benefit of the Russ-ian world (I like saying that) of no bailouts is not that it would eliminate bad outcomes. It’s that it would create better incentives and lead to less malinvestment over time.

Methinks1776 December 14, 2011 at 2:49 pm

In my opinion, the benefit of a Russ-ian world of no bailouts (yes, I like that term very much) is that government will no longer shake down innocent by-standers to insure its cronies against the consequences of their actions. More prudence on the part of investors and creditors is just icing for me. Why should I, a third party, spend my energy caring? It’s their money.
The reminder that bad outcomes are with us to stay is my way of saying that it is not a given that good decisions will result in good outcomes and not a given (as I’m afraid Russ’s reply to Steve strongly implied in this sentence: “You do that either because you’re crazy or crazy like a fox–you assume you’ll be rescued as has usually happened in the past.”) that Money Market funds would not have continued to loan to Lehman in the absence of a bailout precedent.
Lending to financial institutions is what these funds do. It’s part of their business model, as I understand it. It’s very likely that they would have increased the interest rate at which they are willing to lend and reduced exposure to distressed borrowers, but not lend at all? Certainly some wouldn’t have, but none, for any price? I don’t see it.

Newt Represents The GOP Best December 14, 2011 at 8:35 am

GlibFighter did not quote Taylor out of context. You have been caught making it up as you go along.

First, you wrote that the “common view” was that Lehman “Lehman precipitated the crisis.” I pointed out this statement was not what Samuelson wrote. He used the word “after.”

You then quote Taylor showing that wasn’t the common view, at all. In fact, no one holds that view.

GlibFighter’s point was that “immediately post-Lehman, there was a run on the US money market.” Your statement that he took Taylor out of context” is inaccurate. This is exactly what Taylor said. You just quoted the passage.

Then, in an act of utter dis-ingenuousness you attempt to change the subject, writing, “A more interesting question is why a money market fund, Reserve Primary, was lending to Lehman. Do you think that had something to do with the rescue of Bear Stearns creditors in March who received 100 cents on the dollar despite lending to a zombie?”

The purpose of a rescue is to restore market confidence and, thus, lead to lending. Thus, your observation is nothing more than a complaint that the Bear Stearns action worked. Are we to understand that you support the Bear Sterns action, the proof being in the pudding in that it worked?

Newt Represents The GOP Best December 14, 2011 at 8:48 am

Having linked to this Taylor piece, such gives us an opportunity to get two birds with one stone.

In the piece Taylor writes, “Diagnosing the reason for this sudden increase was essential for determining what type of policy response was appropriate. If liquidity was the problem, then providing more liquidity by making borrowing easier at the Federal Reserve discount window, or opening new windows or facilities, would be appropriate. But if counterparty risk was behind the sudden rise in money-market interest rates, then a direct focus on the quality and transparency of the bank’s balance sheets would be appropriate.

Early on, policy makers misdiagnosed the crisis as one of liquidity, and prescribed the wrong treatment.”

Taylor falsely implies a number of things.

First, he implies that liquidity is not a solution for balance sheet problems when, in fact, there is no greater a time for concerns about liquidity than when there are balance sheet problems.

Second, he implies that by providing liquidity the Fed was disregarding “quality and transparency of the bank’s balance sheets.” Apparently, Taylor projects that the Fed cannot walk and chew gum at the same time.

Third, and here Taylor borders on dis-ingenuousness, Taylor implies that there were immediate and short term steps the Fed could have taken regarding quality and transparency of the bank’s balance sheets which we not taken. Taylor (who is surprised), doesn’t say what those steps were. He just says, The Fed worked on the wrong problem. I have never read a more political hatchet job.

It is no surprise the piece appears in the WSJ, confirming that Taylor is no economist, he is a politician in sheep’s clothing.

Don December 14, 2011 at 9:40 am

Good article, Russ. Samuelson clearly overstates the link between a liquidity crisis and a recessionary cost cutting. The whole “don’t criticize the FED” theme is dumb. Accountability for mistakes is always a good thing. It seems to me that the FDIC has been a more important stabilizing force than the FED and Samuelson gives the FED too much credit.

Todd Miller December 14, 2011 at 6:43 pm

I still find it unbelievable that no one has gone to prison over the financial disaster that lead to this recession. The fed caused the problem and they’re making things worse every day.

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