"Here’s an interesting thought: saving Bear Stearns increased risk in the financial system"

From Alphaville, an excellent and very important post by Sam Jones:

"A systemic risk counterfactual

Here’s an interesting thought: saving Bear Stearns increased risk in the financial system.

From Bank of America:

…the support of Bear Stearns appears to have unintentionally exacerbated the systemic risk of the Lehman Brothers’ default as short-term investors did not reduce their exposures leading up to the default despite the steady erosion in Lehman’s stock price and CDS spreads.

That leaves the potential interpretation that by supporting Bear Stearns, systemic risk from its default was postponed, but in having done so, unintentionally that action exacerbated the systemic risk resulting from the Lehman Brothers’ default.

After Bear Stearns, counterparties to banks were lulled into a false sense of security — assuming that default risks were reduced - or at least recovery rates increased - by a sort of faintly implicit guarantee from the US government against too-big-to-fail banks.

The principle example that would support that being the collapse of Reserve Primary — the money market giant which broke the buck the week LEH went under. Reserve Primary failed because it had bought a lot of commercial paper issued by Lehman. Commercial paper is, of course, unsecured.

Anyway, here’s what happened to the commercial paper issuance of both Bear and LEH in the runup to bankruptcy:

And the after-effects of Lehman’s collapse:

…money fund investors responded to the “breaking of the buck” issue at the Reserve Fund by withdrawing funds from “Prime” funds and placing most of those proceeds in Treasury or Government-only money market funds. That’s the 21st century equivalent of a “bank run,” and its consequences contributed to the severe freezing up of interbank lending in September and October.

Here's my comment:

1. Nov 27 16:27Posted by Don the libertarian Democrat [report]

   "After Bear Stearns, counterparties to banks were lulled into a false sense of security — assuming that default risks were reduced - or at least recovery rates increased - by a sort of faintly implicit guarantee from the US government against too-big-to-fail banks."

   My only disagreement with this is that the implicit guarantee had been in effect since the S & L Crisis. Although there was a chance of not being bailed out, as Lehman showed, the underlying belief was that the government could not allow large and interconnected financial institutions to fail. This was so well understood, that there was really no Plan B for these large institutions.

   From my perspective, the reaction to Lehman was panic at the thought that the government wouldn't intervene, and that there was no real Plan B.

   I think that the idea that the people involved in this belief were adherents of zero government intervention on principle has been proven false. Rather, they believe that the government and Fed are an essential backstop to our financial system. Simply because people try to get around regulations or have them abolished for their own ends, doesn't entail that they don't welcome and depend upon government when it suits their interests. Free market rhetoric is very useful when you're trying to get the government out of your way, but it's not a binding contract on future behavior or behavior in other circumstances.

   Phil Gramm and others might have actually believed their rhetoric, but the people with the real money are not so foolish as to not believe and expect that when they could really use government help, they damn well better get it. Surely actions speak louder than words, and the actions, after Lehman, said, "For God's sake help us, and don't bother mouthing nostrums about the free market, because if we go down we're taking you with us. Did you think we gave you all those donations for your eloquent defense of principles?"