Not About Lehman?

November 25, 2008 11:44 a.m.

From TPM Reader BW, disagreeing with a point I made yesterday …

“There seems to be a pretty clear consensus at this point that letting Lehmann fail in the way it did, for instance, was a category error.”

One might also question the conventional wisdom that says that letting Lehman go into bankruptcy was such a key factor.

It is true that market seems to have received a signal at the time of Lehman’s bankruptcy. But, given the actual and proximate consequences of Lehman’s bankruptcy, which were very mild, one probably ought to consider the possibility that AIG’s insolvency might have had something to do with what happened.

The problem that has frozen market trust is the uncertainty surrounding credit default swaps, and the huge cash and collateral demands that they can entail — demands on vivid display in the case of AIG, which was ruined, seemingly overnight.

AIG was rescued, but it doesn’t matter. What frightened the horses was just how much cash AIG has needed.

Lehman’s bankruptcy caused barely a ripple. The functioning parts of the Lehman investment bank were almost instantly absorbed at Barclays, with no operational disruption of the broker-dealer function, which is where one might fear an investment bank failure would impact the market. Geithner and Paulson may have been right. Lehman’s failure was so long anticipated that the market was well-prepared. No one was prepared for AIG.

I have little idea how the writers of narrative journalism, like the NY Times’ Andrew Ross Sorkin decide between Lehman and AIG, when both events occurred simultaneously, but I suspect they ask industry insiders. And, industry insiders have a strong interest in blaming the failure-to-bailout, since such blame is useful politically, in motivating future bailouts. But, as a matter of objective economics, it doesn’t make all that much sense. And, as a basis for criticizing Geithner’s competence? Please.

And quite a few disagreements with BW

From TPM Reder JS

I wouldn’t put BW on your short list for the financial reporter/blogger position. someone who writes “Lehman’s bankruptcy caused barely a ripple” has no idea what is going on in the financial system.

Allowing Lehman to file for bankruptcy had two immediate consequences. It caused a big default in the commercial paper market and required the writers of credit default swap protection for Lehman debt to post collateral. The violent response in short-term funding markets suggests that market participants were -not- anticipating a Lehman bankruptcy. At my firm we certainly were not. What resulted was a “run” on the commercial paper market and a desperate grab for U.S. Treasurys among the hedge funds and banks who wrote Lehman credit default swaps. And, after a few days of metastasization, there you have your short-term funding crisis. AIG had almost nothing to do with it.

It is quite possible that something else would have triggered such a crisis, since the preconditions were there. But the Lehman failure was in fact the trigger. Those who made the decision to let Lehman fail must bear some responsibility for what followed.

And TPM Reader GG

Lehman’s failure affected the system in three ways which your reader underplays. First, the Reserve Fund’s writedown of its Lehman bonds forced them to break the buck and suspend redemptions, which led to a fairly scary run on money market funds generally. These funds are the bread and butter buyers of commercial paper (short term bonds), so when they started hoarding cash to meet redemptions, the banking system stress was almost immediately transmitted to the real economy. Second, several billion dollars of hedge fund assets were locked up in the UK division of Lehman. Depression era laws prevented that in the U.S. Third, global trade is (still) largely conducted via letter of credit. With the possibility of well-known names disappearing, that system has broken down catastrophically. (Pull up the Dry Goods Shipping Index for confirmation.)

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