"The New Yorker's Economics Dude: Lehman Matters!
Surowiecki takes as his starting point the paper from Stanford economist John Taylor that argues that the credit market crisis last fall was not spurred by Lehman going under so much as uncertainty about the effects of government action. Taylor's central piece of evidence is the movement of 3-Month Libor, which didn't go into panic mode until well after Lehman collapsed. The timing, he argues, is more closely linked to the bailout than Lehman's collapse.
Surowiecki thinks that Taylor's evidence doesn't support this conclusion.
"Taylor’s assumption in his paper is that investors would have known right away how severe the repercussions of Lehman’s bankruptcy would be. But this is simply untrue—for whatever reasons (some suggest fraud, others panic), the hole in Lehman’s balance sheet was much bigger than people initially thought it would be, which meant that the losses its lenders suffered were much bigger than anticipated. (One study suggests that the chaotic nature of Lehman’s bankruptcy alone cost creditors tens of billions of dollars.) As the magnitude of the losses became clearer, so too did banks’ risk aversion, since Lehman’s failure seemed to demonstrate starkly the risks of lending to any other big financial institution."
As regular readers know, we've been making the lonely argument that the government's failure to rescue Lehman was not a disaster. We think Surowiecki's point here actually supports our case. The only problem is that he construes the revelation of "the magnitude of the losses" too narrowly. What caused the panic was that the collapse of Lehman signalled to market participants that the magnitude of losses throughout the financial sector was far greater than had been anticipated.
Importantly, nothing about a rescue of Lehman would have avoided this outcome. Lehman's collapse into a government rescue or bankruptcy would still have set off the alarm signals. The simultaneous collapses of AIG and Merrill Lynch were also occurring, and Citigroup was soon viewed to be in critical condition. In short, it was the desperate situation of the financial sector rather than the failure to rescue Lehman that almost destroyed the financial system.
Surowiecki seems to disagree. He writes that "thinking about what Lehman’s failure tells us about how we should deal with tottering financial institutions today," concluding that we must stop implosions at all costs.
This debate matters because Lehman is constantly invoked by those who want to convince us that Lehman’s failure was a catastrophe and want to encourage us to avoid "No Failure" as our future policy. In other words, they are arguing that the risks of allowing failure are far greater than the damage to markets caused by propping up failed firms. We have our doubts, although we're willing to acknowledge that this could be the correct view. In any case, Lehman's collapse is not evidence for the No Failure policy."
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Don the libertarian Democrat (URL) said:
"It seems far more likely that what was occuring prior to the collapse of Lehman fed by a lack of information about the dire financial condition of the financial sector."
From the Sunday before the Lehman bankruptcy:
"The head of bond fund Pimco, Bill Gross, said a Lehman bankruptcy risks an "immediate tsunami" because of the unwinding of derivative and credit swap-related positions worldwide in the dealer, hedge fund and buyside universe."
"If Lehman were to file for bankruptcy, credit spreads for all corporates are expected to widen dramatically, causing large losses to investors, including those without any direct exposure to Lehman."
"Update 4:50 PM: Cash Mundy in an earlier comment highlighted Nouriel Roubini's reading on the consequences of a Lehman unwinding:
It is now clear that we are again — as we were in mid- March at the time of the Bear Stearns collapse — an epsilon away from a generalized run on most of the shadow banking system, especially the other major independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley, Goldman Sachs). If Lehman does not find a buyer over the weekend and the counterparties of Lehman withdraw their credit lines on Monday (as they all will in the absence of a deal) you will have not only a collapse of Lehman but also the beginning of a run on the other independent broker dealers (Merrill Lynch first but also in sequence Goldman Sachs and Morgan Stanley and possibly even those broker dealers that are part of a larger commercial bank, I.e. JP Morgan and Citigroup). Then this run would lead to a massive systemic meltdown of the financial system. That is the reason why the Fed has convened in emergency meetings the heads of all major Wall Street firms on Friday and again today to convince them not to pull the plug on Lehman and maintain their exposure to this distressed broker dealer."
"NEW YORK -- A rare emergency trading session opened Sunday afternoon to allow Wall Street dealers in the $455 trillion derivatives market reduce their exposure to a potential bankruptcy filing by Lehman Brothers.
U.S. regulators and bankers were making last-ditch efforts on Sunday to prevent toxic assets from ailing Lehman Brothers spilling into global markets and rupturing investor faith in the international financial system.
"This is an extremely, and I stress extremely, rare event. It also speaks to the more general notion that, in today's highly disrupted financial markets, the unthinkable is thinkable," said Mohamed El-Erian, the chief executive of Pimco, the world's biggest bond fund, based in Newport Beach, California."
Where, in any of this, do you find a lack of understanding how dire the situation was? As near as I can tell, before the bankruptcy, people were saying that Lehman going bankrupt mattered because of the consequences of Lehman going bankrupt. I can't find anyone saying that if Lehman goes Bankrupt, then we'll know things are bad. They knew how bad things were.