More on Lehman's Failure

John Cochrane and Luigi Zingales have an interesting article on the impact of the closure of Lehman. They argue that it is a mistake to single out Lehman. Many other phenomena were occurring in that period:

Two weeks prior, on Sept. 7, the government took over Fannie Mae and Freddie Mac, wiping out much of their shareholder equity. On Sept. 16, the government bailed out AIG, lending it $85 billion. On Sept. 25, Washington Mutual, the nation's sixth-largest bank, was seized by the FDIC. On Sept. 29, Wachovia, the nation's seventh-largest bank, was sold to avoid a similar fate. All this would have happened without Lehman. Meanwhile, the Federal Reserve and the Treasury Department went to Congress to ask for $700 billion for the Troubled Asset Relief Program (TARP).

Which, they ask was pivotal?

The nearby chart shows that the main risk indicators only took off after Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke's TARP speeches to Congress on Sept. 23 and 24—not after the Lehman failure.

The risk of Citibank failure (the Citi-CDS spread) and the cost of interbank lending (the Libor-OIS spread) rose dramatically after Ben Bernanke and Hank Paulson spoke to Congress. (In basis points.)

On Sept. 22, bank credit-default swap (CDS) spreads were at the same level as on Sept. 12. (CDS spreads are the cost of buying insurance against default.) On Sept. 19, the S&P 500 closed above its Sept. 12 level. The Libor-OIS spread—which captures the perceived riskiness of short-term interbank lending—rose only 18 points the day of Lehman's collapse, while it shot up more than 60 points from Sept. 23 to Sept. 25, after the TARP testimony. (Libor—the London Interbank Offer Rate—is the rate at which banks can borrow unsecured for three months.)

Their argument is that these speeches were announcements that we had a real financial crisis, we are in desperate shape and we need emergency help. So investors believed banks were in even worse shape than they turned out to be. As I noted in a previous post, Lehman was Pearl Harbor. We wanted to fight the Germans, but we needed the Japanese to bomb Pearl Harbor before we could attack. Cochrane and Zingales are arguing that the speeches of Bernanke and Paulson were like FDR announcing the attack and calling for a declaration of war.