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.

Lehman and Pearl Harbor

Joe Nocera writes in the NYTimes that the failure of Lehman Brothers, one year ago, actually saved the global financial system. Basically, the consequences shocked the authorities so much they made sure that AIG and then Citigroup were bailed out.

Part of the explanation is that the aftershock of Lehman's failure jarred Paulson and Benanke sufficiently that any worry about moral hazard was pushed away. More important, however, was the impact on Congress, which made it possible to get the TARP passed.

In the months between Bear Stearns and Lehman Brothers, Mr. Paulson and Mr. Bernanke had approached Congressional leaders about the need to pass legislation that would give them a handful of additional tools to help them deal with a larger crisis, should one ensue. But they quickly realized there was simply no political will to get anything done. After Lehman, however, Mr. Paulson and Mr. Bernanke were able to persuade Congress to pass a bill that gave the Treasury Department $700 billion in potential bailout money — which Mr. Paulson then used to shore up the system, and help ease the crisis. Even then, it wasn’t easy; it took two tries in the House to pass the legislation. Without the crisis prompted by the Lehman default, it would have been impossible to pass a bill like that.

In a sense, Lehman's collapse was like Pearl Harbor. Despite the Nazis trying to take over the world Congress would not allow the US to enter the war. Pearl Harbor shocked the political system sufficiently to get the US to enter in time.