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The revisionist view of Lehman
This kind of observation is becoming popular:
Almost everyone I’ve ever spoken to in Hank Paulson’s old Treasury Department agrees that without the immediate panic caused by the Lehman default, the government would never have agreed to make the loans needed to save A.I.G., a company it knew very little about. In effect, the Lehman bankruptcy caused the government to panic, which in turn caused it to save the firm it really had to save to prevent catastrophe. In retrospect, if you had to choose one firm to throw under the bus to save everyone else, you would choose Lehman.
Here is much more, by Joe Nocera.
Posted by Tyler Cowen on September 12, 2009 at 08:57 PM in Economics | Permalink
Comments
But what to make then of Stanford's John Taylor thesis that the turmoil followed paulson's own paniced remarks.
Posted by: Jon at Sep 12, 2009 9:39:36 PM
So basically the government had to balance between letting a large firm die and letting a firm die quickly enough.
alpha(die soon) + (1-alpha)(die big)
or something like that?
So they should have just let Freddie and Fannie die?
Posted by: Akshay at Sep 12, 2009 9:54:50 PM
What freaked people out was that the government did not bail them out as everyone expected them too.
Posted by: Seward at Sep 12, 2009 10:58:01 PM
That's the essence of the market: fear, greed, and hope. Looks liek the government followed Lehman's cue.
I am one for the natural order of things. It might have caused temporary shockwaves but like any "financial disaster" the country would have weathered it.
RB
Posted by: Ryan Biddulph at Sep 12, 2009 11:21:40 PM
Let them fail.
Posted by: Drewfus at Sep 13, 2009 5:38:27 AM
O those poor poor Lehman executives who only made the same mistakes "everyone else was making." How dare the government not save everybody! So unfair.
Joe Nocera needs to step back from the Wall Street crack pipe for a while.
Posted by: David at Sep 13, 2009 7:09:54 AM
The whole discussion raises an interesting threshold problem: given that the entire financial sector was in a massively overleveraged condition that rested on assets whose value was liable to sudden (and probably, ultimately unavoidable) writedown, when is the right moment for the deleveraging and write-down to happen? (That such overleveraging on the basis of dubious assets might have been prevented in advance by better regulation is a separate issue worthy of serious debate, but not here).
One might argue, 'the sooner the better', and say that Bear Stearns should have been allowed to dangle and fall, rather than having Wall Street and the government cooperate in 'saving' it. Or, as a poster above suggests, one of the GSEs could have been liquidated -- although here, the entanglement with government guarantees and the sheer exposure means that a bankruptcy would probably have resulted in the government taking back all the bonds, so the deleveraging effect would have been muted.
The next opportunity that circumstance offered was Lehman, at least in the US (England got into bailouts earlier with RBS, as I recall). Was this the 'optimal' moment -- politically as well as fiscally, by causing enough political shift as well as allowing the entire payments system to be saved? (Those who argue that not only Lehman, but the entire international payments system, should have been allowed to crash and burn may be true to their principles, but the ultimately political framework of the economy made such an outcome both undesirable and unlikely).
Or, Lehman could have been bailed out, and then Merrill?
The longer the wait, the more expensive the bailout and more traumatic the side-effects, but also the more effective the triggering of deleveraging. The shorter the wait, the less expensive and traumatic, but also less effective in initiating a deleveraging.
Since deleveraging was ultimately inevitable, the question of when the trigger was 'optimal' seems, to me, to be an ultimately political question of competing goods and harms that rests on assessments of 'what is valuable', and therefore external to any purely economic analysis.
Posted by: PQuincy at Sep 13, 2009 10:06:45 AM
In my role as armchair quarterback (and with a boatload of hindsight), I agree with the other commenter that Bear was probably the one that should have been allowed to fail completely. Smaller than Lehman, earlier on in the process, etc.
Posted by: Greg at Sep 13, 2009 2:13:53 PM
I think Quincy's point was correct: if you had to deleverage, Lehman was the point to start to signal your intentions. Although there was collateral damage, there was less than would have been under any alternative scenario of either wait, save the next, and then the next. Sort of like the centipede problem in game theory.
Nor could the government be credible without having someone die...how do you get others to reform their ways, or take your money so they have adequate capital, without an actual failure. Do you think that Wells Fargo would submit to soft cajolling to raise capital, or would it be more likely to respond the the prospect of the grim reaper at the doorstep? Fear is power to the person who can offer relief to get you out of your problem. So, Treasury got more power and voice in the deleveraging of the financial market.
Posted by: Bill at Sep 13, 2009 2:44:34 PM
What will all these massive bailed-out institutions now do without an enourmous housing bubble and over-valued stock market to keep them propped up?
Posted by: Drewfus at Sep 14, 2009 12:05:57 AM
I caught part of a BBC story reviewing the Lehman story in UK that sounded like the UK assets required an injection of 100 million (pounds/dollars from the Royal Bank?) the week of the Monday filing just to cover the expenses of that week.
Can anyone provide some data on how expensive the Lehman bankruptcy is just to go bankrupt and liquidate - the costs after the losses are set by the filing? If it costs hundreds of millions in cash injections to liquidate a firm with negative balance sheet, its it too big to fail, and thus too big to be allowed to exist?
Posted by: mulp at Sep 14, 2009 2:56:18 AM
Freddie and Fannie were like Wamu, Indymac, Citi, and BofA et al, in a relationship with the Fed, tho Freddie and Fannie weren't insured by FDIC, they could be placed in involuntary receivership, as banks regularly are, for violating regulatory measures like asset ratios. At the time Freddie and Fannie were taken over, they were not technically insolvent, but merely under capitalized. From the last report, it does not appear that one has actually deplete the capital that it had when seized, and the condition of the other is confused by its role in being the primary underwriter of all securitized loans written in the past year. In any case, as the holder of or insurer or at least $7 trillion in mortgages, it doesn't appear that so far they have lost more than a few hundred billion, and a good portion of that was from its venture into subprimes under pressure from the admiistration in 2005 that was fairly quickly ended by its regulator (the one that supposedly Barney Frank would allow to be created or replaced depending on the story).
While you can argue that Freddie and Fannie were allowed to be under capitalized, their capital requirement was set based on a half century plus of history writing 20% down mortgages, with 10% down mortgages that had PMI covering the losses to 20%. So, while asset prices seem to have fallen 25%, their mortgates are underwater in many cases, but the property owners have both the incomes and the sunk capital investment incentive to hold on through the trough in real estate prices.
I can't imagine what real estate prices would be today if we didn't have the GSEs backing or buying mortgages. Yes, some local banks and credit unions are anxious to write loans, the ones with the cash to write the loans are in the communities where financial stress is least, hense their vaults full of cash to lend, and thus the lower local demand for mortgages. A New England credit union isn't going to write mortgages in Detroit for a lot of reasons, and I doubt many Detroit area credit unions have the cash to write mortgages. That's why that FDR created the institution that served nicely for four decades, until is was "improved" by making it two competing profit seeking institutions who needed to be more innovative and take higher risks to produce higher returns for the stockholders, and justifying the hundreds of millions in executive bonuses in the past decade. The problem with the GSE regulator wasn't that it wasn't supervising them, but that it was risk adverse and preventing them from taking greater risk to produce higher returns to stockholders.
The benchmark for the GSE returns to shareholders was, among others, Lehman. Lehman was more highly leveraged than the GSEs, Lehman was writing more subprimes with higher interest rates and fees than the GSEs, so Lehman was more profitable than the GSEs. And the stockholders wanted the GSEs to be more like Lehman.
Was it a failure on the part of the GSE management that they didn't match Lehman in return to stockholders, or was it a success that the GSEs failed to obtain the high returns of Lehman in 2006?
Of course, the trillions riding on the GSEs wasn't actual stocks and bonds, but bucket shop bets, bucket shop being the illegal betting on stocks and bonds outlawed after they were credited with the 1907 crash, and then explicitly made legal in the 14,000 omnibus budget bill of December 2000. It seems that those were mostly hedges taking advantage of the friction between the stock prices, the shorts, the options, puts, and the bets called credit defaut swaps aka insurance, but without the underlying asset. Insurance regulation normally require that you own the asset being insured, but credit default swaps were simply bets, akin to naked shorts, etc. It seems the settling of all the bets cost rather little.
And Freddie and Fannie are likely to cost relatively little compared with the lossed from Lehman because Freddie and Fannie were constrained by a too lack regulator into being far less successful than Lehman in 2006 in producing high rates of returns from taking on high risk, high return debt.
Posted by: mulp at Sep 14, 2009 3:54:11 AM
I'm not sure it really happened that way.
The turning-point significance of Lehman wasn't recognized for a few days. It wasn't until a large money market fund broke the buck (as a direct consequence of Lehman) that panic started to cascade. The panic trigger was not the bankruptcy itself, but a hitherto overlooked unintended consequence rearing its ugly head. Like hurricane Katrina, a few people probably even breathed a brief sigh of relief in the immediate aftermath before becoming aware that the levees had in fact been breached.
Conversely, in the days immediately before Lehman definitively blew up many commentators and bloggers were already saying that AIG was going to be a much bigger deal than Lehman, with far more wide-ranging repercussions, and that unlike Lehman some kind of government intervention was therefore unavoidable.
My memory, of course, may be faulty. But my impression has always been that bailing out AIG was decided in principle before Lehman was even fully dead.
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