Monday, November 3, 2008

Verdict on Lehman failure

Look's like the verdict is in. From Economist:
CONFRONTED by blaze after blaze in recent weeks, America’s financial firemen have rushed to douse the flames—with one exception. Unable to persuade any rival to take on a battered Lehman Brothers, the government was left with a hard choice: spray the investment bank with public money or let it burn. In choosing destruction, the government has provided a painful lesson in the dangers of doing the right thing at the wrong time.

In a sense, Lehman’s misfortune was not to have hit trouble earlier. After broking the sale of Bear Stearns, another Wall Street firm, and nationalising the country’s mortgage agencies, officials felt an example needed to be made so as to combat “moral hazard”, or the risk that banks will act recklessly if they know they will be bailed out when their bets sour. Hank Paulson, the treasury secretary, believed Lehman’s problems were sufficiently well advertised to have given derivatives markets time to prepare for the worst.

He was partly right: the credit-default swaps market has buckled but not broken. But Lehman’s bankruptcy shredded the last remnants of confidence in American International Group, an insurer, and crystallised fears over the stability of the remaining free-standing investment banks, Goldman Sachs and Morgan Stanley. Alarm over “counterparty” risk—the risk of a borrower or trading partner failing to cough up—turned into outright terror, paralysing money markets. “It was the mistake of a lifetime,” says one senior bank executive, echoing the view across Wall Street.

What lessons can be taken from this for future financial crisis?
1. Make clear from the outset which institutions will be saved and which won't. The price of uncertainty is more uncertainty and the cost of uncertainty can be higher than a bailout. Thus, it is sounding like the government needs to either make it clear from the start that it is all or nothing. All will be saved or no one. The latter is unlikely due to systemic risks. Case by case treatment only increases uncertainty - plus the process is very non-transparent.
2. No institution is too small to fail. Interlinkages can be disastrous so perhaps the prudent thing to do is to save them all.
3. Moral hazard can still be averted by nationalization.

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