Monday, February 15, 2010

Lehman failure redux

My original thoughts are here and they haven't shifted much despite comments by Economics of Contempt who was responding to John Cochrane's analysis of the Lehman failure.

Nothing technical in the Lehman bankruptcy caused a panic. The usual "systemic" bankruptcy stories did not happen: We did not see a secondary wave of creditors forced into bankruptcy by Lehman losses. Most of Lehman's operations were up and running in days under new owners. Lehman credit default swaps (CDSs) paid off. Sure, there was some mess — repos in the United Kingdom got stuck in bankruptcy court, some money market funds "broke the buck" and had to borrow from the Fed — but those issues are easy to fix and they do not explain why Lehman's failure would cause a widespread panic. What is more, Lehman's failure did not carry any news about asset values; it was obvious already that those assets were not worth much and illiquid anyway.

Let's start with Cochrane's claim that there wasn't a secondary wave of failures after Lehman's bankrtupcy. First of all, that's not even true. Plenty of hedge funds failed as a result of Lehman-related losses. However, since they were generally structured as LLPs, they went into pre-defined liquidation procedures rather than filing for bankruptcy. But that doesn't make those failures any less real. Second, Cochrane, like Taylor, inexplicably ignores the fact that Lehman's biggest counterparties — the other dealers — were virtually all bailed out by their governments

Next, let's take Cochrane's bizarre attempt to minimize the importance of the obvious knock-on effects from Lehman's bankruptcy — namely, the problems at Lehman's European broker-dealer (LBIE), and the run on the money markets. Contrary to Cochrane's assertion, it wasn't just "repos in the United Kingdom" that were affected by LBIE's failure. In addition to the 140,000 failed trades, over $40bn in prime brokerage client funds and assets were frozen by LBIE's administrator. That's $40bn that was suddenly and unexpectedly unavailable to hedge funds — and when you consider that hedge funds use their prime brokers to lever up, that end result is that LBIE's failure caused hundreds of billions in liquidity to suddenly vanish from the markets. It also caused other hedge funds to pull their money out of their prime brokerage accounts at Morgan Stanley and Goldman (the two biggest prime brokers), since they were now scared that they wouldn't be able to access their funds if either of the prime brokers failed. Investment banks used clients' prime brokerage accounts for funding (which is why prime brokerage account are called "free credits"), so when hedge funds started pulling their prime brokerage accounts, that was the equivalent of having counterparties stop lending to them.

My own view is that the Lehman failure caused great uncertainty which resulted in an unforeseen freeze-up in the commercial paper market. So, yes I believe the Lehman failure had a large effect but not for the reasons outlined above - so in a sense I do agree with Cochrane and disagree with EOC on the impact of the ripple of bankruptcies that followed.

EOC later says (which I am in agreement):
And there was absolutely nothing minor about the run on the money markets. One of the biggest money market mutual funds, the Reserve Primary Fund, "broke the buck" because of losses on Lehman commercial paper. This caused a massive run on money market mutual funds, with redemptions totaling over $100bn. So the run on the money markets was directly attributable to Lehman's bankruptcy. As to why the run on the money markets would cause people to stop lending to banks like Citigroup, there are several reasons. The biggest reason the run on the money markets affected Citi's (and other banks') wholesale funding was that to meet the massive redemptions, money funds all drew down their backup lines of credit with banks at the same time. Institutional investors knew this, and started to pull back aggressively from the big banks in the wholesale funding markets. And then there were all the asset firesales by money funds...

From Business Insider:

One of the most virulently defended propositions coming from the Lehman Orthodoxy crowd is that the government's failure to rescue Lehman brothers caused a disaster in the commercial paper market. The evidence for this proposition is that in the two days following Lehman's bankruptcy, the market for commercial paper issued by banks collapsed. Within a week, $500 billion of short-term funding was removed from the market place.

However, they hold the opposing view and argue (not very convincingly in my mind):
So doesn't this mean that letting Lehman go into bankruptcy without government support was a huge error? At the very least, doesn't this chart show that not rescuing Lehman had dire consequences for the short-term funding of banks?

The answer to both questions is "Nope."

Although the disaster in the commercial paper market immediately followed Lehman's bankruptcy, it does not follow that this was triggered by the government's refusal to rescue Lehman. It seems far more likely that the panic in commercial paper was the result of the scales falling from the eyes of financial professionals. The collapse of Lehman and Merrill Lynch, which had fled into the arms of Bank of America, revealed the terrible state of the financial sector.

This revelation of the widespread weakness of banks would not have been avoided by having the government rescue Lehman, unless the terms of the rescue were somehow kept secret and the public deceived about the firm's terminal state.

We should note that, in a boring sense, the commercial paper market was diminished by Lehman's collapse because Lehman was a major supplier of commercial paper. But, if not for the widespread financial fear triggered by the new information entering the market, that role would easily have been filled by other banks. (As, indeed, it has been since.)
.... What actually restored liquidity was the decision by the Federal Reserve to directly step into the market, offering to buy commercial paper through a special purpose vehicle. This might not have relieved all the pressure on borrowers, especially those whose solvency is in doubt, but it did allow borrowers with healthy collateral to borrow. That is, it provides liquidity to healthy businesses without propping up unhealthy companies.

The problem with most of the arguments for the Lehman Orthodoxy is that they rest on the unstated assumption that the market would not have panicked if Lehman had been rescued by the government. But viewed in the context of what happened in the markets after the government did announce a broad financial rescue package, that assumption seems unwarranted.

The crucial "what if" here is: Would the commercial paper had locked-up even if Lehman had been rescued? I'm convinced (with no evidence whatsoever that the answer is "No - at least not by as much", but without good solid analysis we could argue with one another until we're blue in the face as Cochrane-Taylor and DeLong are apparently willing to do. After all, healthy disagreements among economists tend to generate more grants to study the crisis for the next decade.

1 comment:

CrisisMaven said...

When politicians talk about the latest fad in economics to enhance their policy toolbox you should always head for the exit. You don't need behavioural economics to forecast how people react unless you want in an oppressive manner shape your policies so that people are forced to react in ways they otherwise wouldn't - that is tyranny, plain and simple. Polticians, Cameron too, can't stand not having power and something big to meddle with. However, they are already beyond the point of no return - governments are now set to default across the board, Britain at the forefront!