he wants to push fiscal sustainability issues clearly away from the Fed’s domain and back where they belong, with Congress and the administration

From Alphaville:

"El-Erian: Bernanke and the “new normal” Posted by Paul Murphy on Jun 03 17:38.

Pimco’s Mohamed El-Erian kindly provided FT.com with a snap commentary on Ben Bernanke’s congressional testimony on Wednesday.

Extract:

The bottom line is that we should come away from Mr Bernanke’s testimony with at least two conclusions: the chairman seems more cautious about the growth outlook when compared with other recent public statements; and he wants to push fiscal sustainability issues clearly away from the Fed’s domain and back where they belong, with Congress and the administration.

Related links:
Why Bernanke is right to be worried - FT
Bernanke calls for action on deficits - FT

This entry was posted by Paul Murphy on Wednesday, June 3rd, 2009 at 17:38 and is filed under Capital markets, People. Tagged with ben bernanke, mohamed el-erian."

Me:

Don the libertarian Democrat Jun 3 22:48

The import of Bernanke's statement is not what El-Erian says. That's what he and William Gross seem to believe. Instead, Bernanke is saying that QE or CE and the Stimulus are working, and reinforcing each other. The fact that we have low short term rates and rising longer term rates is how it's supposed to work. It's even a net positive to have the hyperventilating on hyperinflation, since it signals that we will have some inflation going forward. We need the perception of some inflation going forward for QE or CE to work.

Of course, down the road, inflation will be the worry, not, thankfully, deflation. Dealing with the issue will involve three possibilities:
1) Default
2) Printing Money Excessively
3) Having Congress deal with tax increases, spending cuts, selling assets, etc.
Clearly, he would like to see 3 be the answer going forward. Many of us do. Bernanke and Geithner are both saying the right things. Namely, it's really up to Congress to deal with this problem going forward. It's not a big economic conundrum, but it is a big political problem. That's what Bernanke actually said.

If you receive no post from Bernanke denying my theory, you can infer his implicit, if not explicit, agreement with my interpretation.

From the FT:

"Why Bernanke is right to be worried

By Mohamed El-Erian

Published: June 3 2009 17:21 | Last updated: June 3 2009 17:21

Fed chairman Ben Bernanke’s congressional testimony on Wednesday warrants careful attention by market participants – this at a time when policy measures play an unusually large role in determining both absolute and relative values in many markets.

In his prepared written remarks, Mr Bernanke correctly points to the ongoing healing in critical elements of the financial markets, including inter-bank and commercial paper transactions. He also notes the improved functioning of the corporate credit market which has enabled many companies to raise needed and precautionary capital.

Yet, the most interesting aspects of his testimony are elsewhere. They relate to his more nuanced outlook about the economy and his attempt to place fiscal issues in their proper place.

Mr Bernanke acknowledges that, despite the ”green shoots”, there are still question mark over which components of demand will kick into gear once the cyclical inventory pick-up runs its course, as it will inevitably do so over the next few months. Indeed, the chairman notes that ”businesses remain very cautious and continue to reduce their workforces and capital investments.”

Concerns about a sustainable recovery are not limited to the dynamics of the immediate cyclical recovery. Mr Bernanke also notes that ”even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilisation will increase further.”

Yet he stops short of addressing what, increasingly, will be on many people’s minds going forward. Specifically, the longer-term question goes well beyond the notion of a prolonged period of below-potential growth. The level of potential growth itself is likely to decline. Indeed, this is a central element of what we, at Pimco, call the ”new normal”.

When it comes to fiscal issues, the chairman is not timid about worrying about longer-term questions – and rightly so. He is explicit about the need for greater clarity on how fiscal sustainability will be restored after this period of emergency policy actions.

Mr Bernanke states that ”even as we take steps to address the recession and threats to financial stability, maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and continued increases in medical costs.”

He does not stop here. He goes on to warn that ”near-term challenges must not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances. Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth.”

These are strong words, and appropriately so given the worrisome fiscal outlook facing the US. By necessity, Mr Bernanke will increasingly be in the business of countering monetisation and inflation concerns.

Indeed, the markets have already fired a couple of clear warning shots in the last couple of weeks, as illustrated by recent moves in US bonds and the dollar.

The chairman’s challenges on this count are neither easy nor amenable to quick solutions. Moreover, as markets increasingly look into the underlying factors, as inevitably they will, they will recognise the difficulty that the government faces in credibly committing to the needed primary fiscal adjustment in the absence of high economic growth.

The bottom line is that we should come away from Mr Bernanke’s testimony with at least two conclusions: the chairman seems more cautious about the growth outlook when compared with other recent public statements; and he wants to push fiscal sustainability issues clearly away from the Fed’s domain and back where they belong, with Congress and the administration. He is correct on both counts. He would have been justified on Wednesday in being even more forceful; and he mostly probably will be in the next few months.

The writer is chief executive and co-chief investment officer of Pimco. His book ‘When Markets Collide: Investment Strategies for the Age of Global Economic Change’ won the 2008 FT/Goldman Sachs Business Book of the Year

Copyright The Financial Times Limited 2009"

Ben Bernanke presented testimony this morning in which he seconded some of Wolf’s points

From The Bellows:

"What’s Bernanke Getting At?

• Posted by ryan on June 3rd, 2009 filed in Economics
• 
  

As you know, I’ve been following the ongoing debate over the extent to which markets are nervous about American government debt levels, which may or may not betoken inflation to come and/or a crowding out of private investment and/or a dollar run. Martin Wolf has a relatively new column up which, in my view, levels the arguments of those like Niall Ferguson and John Taylor, who see disaster at the doorstep. As Wolf says, there is very little in interest rates to indicate a fear of runaway inflation or a crowding out of private investment.

Ben Bernanke presented testimony this morning in which he seconded some of Wolf’s points — most notably, he suggested that slack in the system would persist for some time, making near-term inflation extremely unlikely. But he also attributed the recent rise in long-term Treasury to concern over deficits, at least in part. And, he had this to say:

Certainly, our economy and financial markets face extraordinary near-term challenges, and strong and timely actions to respond to those challenges are necessary and appropriate. Nevertheless, even as we take steps to address the recession and threats to financial stability, maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance. Prompt attention to questions of fiscal sustainability is particularly critical because of the coming budgetary and economic challenges associated with the retirement of the baby-boom generation and continued increases in medical costs. The recent projections from the Social Security and Medicare trustees show that, in the absence of programmatic changes, Social Security and Medicare outlays will together increase from about 8-1/2 percent of GDP today to 10 percent by 2020 and 12-1/2 percent by 2030. With the ratio of debt to GDP already elevated, we will not be able to continue borrowing indefinitely to meet these demands.

Addressing the country’s fiscal problems will require a willingness to make difficult choices. In the end, the fundamental decision that the Congress, the Administration, and the American people must confront is how large a share of the nation’s economic resources to devote to federal government programs, including entitlement programs. Crucially, whatever size of government is chosen, tax rates must ultimately be set at a level sufficient to achieve an appropriate balance of spending and revenues in the long run. In particular, over the longer term, achieving fiscal sustainability–defined, for example, as a situation in which the ratios of government debt and interest payments to GDP are stable or declining, and tax rates are not so high as to impede economic growth–requires that spending and budget deficits be well controlled.

I’m not quite sure how to interpret this. On the one hand, it seems clear that reduced debt levels would make his life easier, and politically speaking, it will be difficult (in my view) to pass additional deficit-funded measures in the short-term without identifying some clear new revenue stream to be tapped to eventually pay for the program. On the other hand, Bernanke sure does seem to be making his policy preferences known in ways I don’t much like. This testimony will be ammunition for the Fergusons out there, who have failed to find much support in bond markets. If it seems clear that current deficits aren’t excessively inflationary and aren’t crowding out private investment, and new stimulus — in the form of unemployment benefit extensions, say — is deemed necessary to prevent the economy from tipping once more into a rapid rate of decline, then I’d like the government to have a free hand to do what needs to be done. Instead, we’ll have a bunch of blue dogs out there waving the text above.

The bottom line is this — the issue of long-run budget sustainability is actually of crucial importance. It should be part of the ongoing policy conversation. It should not be the beginning and end of the conversation, given the broader problem of economic weakness. But that’s increasingly the way these discussions are playing out. Bernanke must have known that his take on deficits would be splashed across news sites everywhere, reinforcing a meme that’s been pushed by conservatives in recent weeks. He must have known that his advisement that debt levels could be a major problem in the future would be interpreted by the press as a belief that debt levels are a major problem right now.

For someone with his background, and his awareness of the history of the Great Depression, I find this to be a very confusing and unfortunate move."

Me:

1. Don the libertarian Democrat Says:
   June 3rd, 2009 at 3:22 pm

   In order for QE to work, people must believe that Inflation is coming. That’s more important than worrying about Hyperinflation or its trumpeters, at least at this point. What he’s doing and saying makes sense.

1. Don the libertarian Democrat Says:
   June 3rd, 2009 at 3:30 pm

   I should have said that we want people to believe that inflation is coming down the road a ways. The trumpeters are serving a useful purpose, by going on about runaway inflation down the road. Right now, we want low interest rates. The current spreads are the desired result that we’re looking for. That’s why QE is working.

For all the computerized financial engineering that preceded the meltdown, he thinks it resembled a classic 19th-century bank panic

TO BE NOTED: From the WaPo:

"Quiet Tiger at the Fed

By David Ignatius
Thursday, May 28, 2009

Sometime this summer, President Obama will have to start thinking about one of the big decisions of his presidency -- whether to reappoint Ben Bernanke as chairman of the Federal Reserve when his term expires next January. What complicates the choice is that the other obvious candidate is Lawrence Summers, the White House economic czar.

Bernanke has emerged as one of the few heroes of the financial crisis, widely praised for his innovative stewardship of the Fed. He's still something of a sleeper in Washington, so low-key that the frequent descriptions of his "soft-spoken" manner don't do justice to just how quiet he is. But in fixing the financial breakdown, he has been a veritable tiger. The Bernanke Fed is so much more powerful than its predecessors that it's almost a different institution.

Bernanke agreed to sit down for a luncheon interview last week to talk about lessons learned. Behind him through the picture window of his private dining room was a majestic view of the Mall, but the Fed chairman was as reserved and fastidious as ever -- even as he described his battle to contain the greatest financial crisis of the past half-century.

I asked him what message he might leave for his successor to explain what these two tumultuous years have taught him. Bernanke offered a surprising answer: For all the computerized financial engineering that preceded the meltdown, he thinks it resembled a classic 19th-century bank panic. Investors thought their money was parked in securities that were as safe as bank deposits. When these securitized assets proved to be riskier than expected, investors panicked.

"We were seeing variants of classic panic behavior," Bernanke said, remembering the wild days of 2007 and 2008, when supposedly safe markets suddenly locked up as frightened investors rushed to get their money out.

Bernanke recommended studies by Gary Gorton, a Yale economist who has analyzed the ways the recent panic resembled those of the late 19th century. In his latest paper, "Slapped in the Face by the Invisible Hand," Gorton explains that the long-ago panics typically came at the height of the business cycle and involved new information that frightened depositors into withdrawing their money. Such bank panics disappeared for nearly 75 years after the enactment of federal deposit insurance in 1934.

The panic psychology returned with stunning force in 2007, when Wall Street suddenly lost confidence in new instruments created by the shadow banking system, such as mortgage-backed securities. It's hard to imagine now, but these exotic instruments were embraced by risk-averse investors such as money-market funds, pension funds and corporate treasuries. When that safety proved illusory, people rushed for the exits.

As Fed chairman, Bernanke scrambled for innovative ways to pump money and confidence back into these markets. If one tactic didn't work, he quickly tried another. When the panic first hit in August 2007, Bernanke took the unusual step of sharply cutting the discount rate for lending directly to banks. Banks proved wary of using the discount window, so Bernanke created a less-stigmatizing "Term Auction Facility."

Next came special Fed facilities to bolster money-market funds, the commercial-paper market, mortgage-backed securities and asset-backed securities -- all with complicated names and strategies. But the mission was consistent: to lend into the panic, and to reassure the markets that the Fed was really, truly committed to maintaining liquidity, no matter what. Gradually, the panic eased.

More jury-rigged rescue programs may be on the way. Barney Frank, chairman of the House banking committee, is drafting a bill to provide federal insurance for the municipal bond market, which could add hundreds of billions of dollars in new federal obligations. The Fed hasn't objected, saying this is a fiscal problem for Congress, not a monetary issue. A muni bailout would increase the immense debt hanging over the economy and the risk of future inflation.

The challenge ahead for the Fed is to clean up the debris -- including all the special structures created to contain the crisis. Obama will want a Fed chairman who can convince the markets that the central bank will crush inflation, regardless of the short-term pain or the howls from politicians. He will need someone who can reverse gears in a hurry and who can say no convincingly.

Is that person likely to be the quiet radical, Bernanke; or the outspoken, market-savvy former Treasury secretary, Summers; or some dark-horse candidate? Each would have strengths and liabilities at a post-crisis Fed, but there's a strong argument for not changing what, right now, looks like a winning team.

The writer is co-host of PostGlobal, an online discussion of international issues.

His e-mail address is davidignatius@washpost.com."

if the Geithner-Summers-Bernanke strategy of low-balling the scale of the banks' problems and inviting speculators to bail them out actually worked

TO BE NOTED: From HuffPo:

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Robert Kuttner

Co-Founder and Co-Editor of The American Prospect

Posted May 10, 2009 | 07:10 PM (EST)

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Collateral Damage and Double Standards

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Read More: Ben Bernanke, Economy, Gop, Stress Tests, Wall Street, Wall Street Crisis, Zombie Banks, Politics News

I recently spoke at a Federal Reserve conference in Chicago, on financial regulation. The keynote speaker was Ben Bernanke. Chairman Bernanke was unable to leave Washington, so he spoke live, via a giant TV screen, giving his speech a fittingly Orwellian cast.

This was the day that the results of the so called stress tests were released. Not surprisingly, Bernanke was upbeat, since restoring confidence was the whole political point of the stress-test exercise. No major bank was insolvent, and the 19 largest banks collectively needed to raise only about $75 billion in additional capital, although their losses might total as much as $599 billion. Citigroup, queen of the Zombie Banks, remarkably enough, was said to need only $5.5 billion in additional private capital. You could almost make up that paltry sum with executive bonuses.

At one point in his remarks, Bernanke, recounting just how rigorous the stress tests were, explained that "More than 150 examiners, supervisors, and economists" had conducted several weeks of examinations of the banks. That kind of let the cat out of the bag. If you do the arithmetic, that is about seven supervisors per bank, and all of the stress-tested 19 banks were hundred-billion and up outfits. When an ordinary commercial bank, say a $10 billion outfit, undergoes a far less complex routine examination of its commercial loan portfolio, it involves dozens of examiners.

So the stress test was not a set of rigorous examinations at all, but a modeling exercise using the banks' own valuations of their assets. The most serious outside observers think the hole in the banks' balance sheets is much larger than $75 billion or even the Fed's worst-case estimate of $599 billion in losses. The International Monetary Fund estimates the hole as more like 2.7 trillion dollars, and informed economists like Nouriel Roubini put the number at as much as 3.6 trillion.

Why is the Fed low-balling the problem? The hope is that by keeping the banks afloat for a few more months, and trying to entice private capital back to the table, the recovery in other parts of the economy will spill over onto the banks. But the greater likelihood is that weakened banks will continue dragging down the rest of the economy.

Despite talk of "green shoots," - economic indicators not being quite as bad as expected, and the stock market up - most of the news is still pretty grim. Unemployment was up in April by "only" 539,000 jobs. Home foreclosures keep rising, with a total of eight million projected this year. Manufacturing is dead in the water. The administration's voluntary (to the banks) mortgage relief program will address only a fraction of the problem; and 12 Senate Democrats voted with the banking industry to deny bankruptcy judges the ability to modify the terms of a mortgage as a last resort - thus killing the one proposed stick in a program that is all carrots.

I also recently spoke at a convention of industrial construction companies. These are the people who build and maintain factories, power plants, and do other heavy industrial construction. I asked a room full of hundreds of executives how many saw signs of improvement in their order books. Not a single hand went up. Then I asked how many had had projects deferred because of difficulty getting financing. About two thirds of the people in the room raised their hands.

My guess is that the Obama administration will be back next fall, asking Congress for the money and authority to do the bank rescue right, after the current policy proves inadequate to restore the banking system and the economy to health. That would mean taking the insolvent banks into receivership, deciding how much public capital was required and where to get it, and then returning the banks to private ownership. Better late than never, but it's a pity to waste six months.

Chatting with the bankers in attendance at the Fed conference, mostly bankers from the heartland of the Midwest, I encountered resentment bordering on fury at the double standard. The big Wall Street banks are getting propped up with literally trillions of dollars in aid from the Treasury and the Federal Reserve, while community bankers that stuck to their knitting and did not go in for the sub-prime swindle are suffering collateral damage. That's a pun, by the way.

Because of the huge losses to the FDIC's insurance fund, small and medium sized healthy banks are having to pay increased premiums. And while the Fed and the Treasury are being extremely gentle in letting the big money-center banks like Citi value their distressed securities with great charity and forbearance, the community banks are having their loan portfolios examined with fine-tooth combs. With regulators breathing down their necks, and fewer sure-thing businesses in a position to borrow, the community banks are being made to raise their lending standards, contributing to the vicious circle of reduced business activity and reduced credit.

Why had the administration made this perverse alliance with Wall Street, and decided to prop up large zombie banks rather than taking them into receivership and getting on with it? You could blame it on campaign finance, or you could blame it on the quirk of history that Obama, once he became the nominee, decided to hire the Wall Street-oriented Clinton economic team.

The most hopeful and elegant theory I've heard is that for now, Obama's main political project is to let the Republicans self-destruct; co-opting Wall Street (for now) is part of that game plan. He'll get around to reforming Wall Street next year. Even Roosevelt had to take things one step at a time, as public opinion moved. The Second New Deal was more radical than the first. I've often said that Obama is smarter than I am, and if he is politically shrewd enough to have come up with that strategy, hats off to him. I'm also a Red Sox fan, and anything is possible. But for the moment, it looks more like a case of political expediency and even political capture.

I could excuse all that if the Geithner-Summers-Bernanke strategy of low-balling the scale of the banks' problems and inviting speculators to bail them out actually worked. But the greater likelihood is that the economy will tread water at best for the remainder of this year, losing both precious time and political credibility in America's heartland.

Robert Kuttner is co-Editor of The American Prospect and a senior fellow at Demos. His recent book is Obama's Challenge: America's Economic Crisis and the Power of a Transformative Presidency."

I am sticking to my story: stocks will chop sideways forever

TO BE NOTED: From Inner Workings:

"US Credit Protection at “Only” 44 bps May 5th, 2009
By David Goldman

Now it costs only LIBOR +44 bps to buy credit protection for five years against a default by the United States of America. That’s slightly more than half of the peak level of March, when the prospective collapse of the banking system persuaded the market that the US Treasury and Fed might go down with the banking system.

It’s hard to be angry at Ben Bernanke for diving into the water to rescue the US economy when it seemed to be drowning. The Fed extended nearly $4 trillion of its balance sheet to buy dicey mortgage and credit risks, and kept the financial system afloat. By shoving mortgage money into the banking system it helped established a minimum bid for depreciated houses. On the other hand, it is now joined at the hip to a zombie banking system. That’s why the credit of the United States of America fluctuates with bank stocks, a phenomenon few of us could have imagined only a year ago.

What we have in response is neither a bull market, nor a bear market rally, but exactly the opposite: it is nothing in particular. The US economy has nowhere to go. The Fed will not let the financial system dissolve. It is in too far already. It has to keep throwing good money after bad because the weight of the Fed’s balance sheet will drag it down if the rest of the system goes. But the ever-present demand for savings by aging boomers, the depressant wealth effect, and the zombie character of the financial system all militate against a real recovery.

I am sticking to my story: stocks will chop sideways forever, as I wrote on Jan. 8 when the S&P was exactly where it is now. I didn’t believe the crash, and I don’t believe in the upside. What I expect to continue is the volatility implosion.

I expect VIX to settle down into the high ’20s during the next several weeks. Zombies aren’t volatile.

The collapse of volatility is most noticeable in the most volatile stocks, e.g., Citigroup;

The above chart from ivolatility.com shows the plunge in implied volatility on C by roughly half.

For those unclear about how to trade volatility under these circumstances, this instructional video is recommended."

Back now, though, to the specifics of Lehman’s collapse.

TO BE NOTED: From the FT:

"Why letting Lehman go did crush the financial markets Posted by Sam Jones on Mar 12 12:48.

For some time now, the folks over at Clusterstock - notably John Carney - have led a challenge to a particularly virulent piece of received wisdom: that the failure of Lehman was necessarily an inflection point that took the severity of the financial crisis to a whole new level.

And with that the implication that the government’s decision to let Lehman fail was, in itself, a failure.

Until now, that kind of debate might have seemed a little academic - a question for historians. But day by day; bailout by bailout, its pertinence to current events and future policy is growing: politicians and regulators are going to find themselves increasingly under pressure to account for the growing number of expensive opportunities they are being occasioned with to Save The World.

Loath as we are to turn again to the “Japanese Scenario” for appropriate lessons, it’s worth bearing in mind that in Japan, it was ultimately the weight of public opinion, as much as it was economic or financial considerations, that came to shape the way the crisis played out. Distaste for spending taxpayers’ money grew extreme: bailouts became taboo. The way Japan’s authorities consequently pussy-footed their way around problems rather than tackling them head on drew the crisis out for nigh on a decade - dare we now even say, two.

_______

Back now, though, to the specifics of Lehman’s collapse.

The broadest and most challenging question, we suppose, is whether in the long run, the whole banking system was set for failure anyway. Or to rephrase it: from a counter factual point of view, would a world in which Lehman was propped up necessarily be a safer one? As the FT’s own John Gapper has argued, it would not. The locus of panic would simply have shifted onto the next institution:

I’m not convinced that, even if Lehman had been rescued, that would have averted the problem since the weight of selling and panic would have moved on to the next financial institution and then the next. So the world would probably have ended up in the same position it is in today, with a broad financial sector bail-out.

Wedded to this is the assumption that bailing out Lehman would have had nothing to do with actually cauterising the root cause of the crisis: the US housing market.

But…

The collapse of Lehman did create panic among the world’s financial institutions, and it did significantly increase “risk” in the system, not just redistribute it. And it seems likely that it did indeed make it more reasonable to expect that other institutions would fail - because it created generalised panic in the funding markets which every bank - irregardless of their pedigree or resilience - was dependent upon.

After Lehman collapsed, Morgan Stanley and Goldman Sachs very nearly did too.

While a Lehman bailout would not, as Gapper, Carney and others have noted, have solved the solvency crisis that faces banks currently, it would have averted the extremely violent - though short - liquidity crisis that the financial world experienced in September and October.

Whether that perfect September storm counts as a hastening of the crisis which in the long run may come to be seen as a good thing, the jury is still out on. We here at FT Alphaville though, think that the damage it wrought - damage which totally caught the US authorities by surprise - should not be underestimated.
_______

First though, a little more on that post-Lehman liquidity crisis itself - and whether, indeed, per Clusterstock’s latest post, it was caused by Lehman at all.

Stanford University’s John Taylor has authored an “event study” that suggests that it was not the inability or unwillingness of regulators to save Lehman over the weekend of September 13-14 2008 that led credit markets to seize up around the globe. “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong” demonstrates that the credit markets actually did not actually go into cardiac arrest after Lehman declared bankruptcy. Rather, it was the dithering and incoherent government reaction that brought on the crisis.

In support of that, here, from Taylor’s paper, is this key graph:

It shows the Libor-OIS spread - a key measure of perceived counterparty risk in the market. You can see just how egregious that widening was, in context, by looking at the spread over a longer period. And as Carney notes, it apparently also shows that it was government dithering after the collapse, rather than the collapse itself, that prompted the widening. Writes Taylor:

On Friday of that week the Treasury announced that it was going to propose a large rescue package, though the size and details weren’t there yet. Over the weekend the package was put together and on Tuesday September 23, Federal Reserve Board Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified at the Senate Banking Committee about the TARP, saying that it would be $700 billion in size. They provided a 2-1/2 page draft of legislation with no mention of oversight and few restrictions on the use. They were questioned intensely in this testimony and the reaction was quite negative, judging by the large volume of critical mail received by many members of the United States Congress. As shown in Figure 13 it was following this testimony that one really begins to see the crises deepening, as measured by the relentless upward movement in Libor-OIS spread for the next three weeks. Things steadily deteriorated and the spread went through the roof to 3.5 per cent.

The problem here is that the Libor component of the Libor-OIS spread, is not really a wholly useful indicator of the state of the credit markets. It’s a reality-based fiction based on the aggregated opinions of individual banks as to the cost of unsecured interbank lending. What it is not is an actual demonstration of market movements. It does not necessarily actually reflect the rates banks are lending to each other at.

More to the point, Libor is calculated from an aggregate of individual banks’ guesses as to what rate at which other banks are likely to lend to them. Libor is a proxy metric.

In the wake of a collapse like Lehman, there is thus naturally a margin for significant statistical lag with Libor: no bank would wish to stand out by submitting the highest number, for it would show them to be the most at risk of failing next. At individual banks, those responsible for guestimating the daily Libor figure they will submit to the BBA are indeed very wary of what the previous day’s Libor figure revealed. Libor has path dependency.

While this odd Libor psychology doesn’t wholly explain the lag identified by Taylor and Carney, there is more compelling hard evidence.

If Libor is a proxy, here’s some compelling hard evidence. In a technical sense, interbank lending is typically done so that banks are able to meet their solvency requirements at the close of their books each day. At the Fed, banks lend money to each other by transferring it between their accounts in order that they might meet their close of trade reserve requirement.

What’s telling then, is what happened to banks’ reserves held at the Fed immediately after the Lehman collapse.

The weekly data behind the above graph (monetary base, which is banks’ Fed-held reserves plus coinage) shows that in the five days following the LEH demise, banks more than doubled their cash held in reserve at the Fed - cash way in excess of their reserve requirements.

In other words, clearly the banks anticipated - or were already experiencing - an interbank lending collapse straight after Lehman, even if it wasn’t immediately shown in the Libor figures they reported. (One explanation for the discrepancy is perhaps that because no interbank lending was actually taking place, Libor calculations became even more path dependent than normal- the calculations had nothing else of empirical worth to be based on).

To boot, there are hard statistics on another, arguably even more important, source of short-term wholesale financing for the banks that dried-up straight after Lehman: the commercial paper market.

The most immediate disaster for banks after Lehman’s collapse was the failure of Reserve Primary - a huge money market fund which broke the buck on September 15th after it suffered losses on unsecured commercial paper it had bought from LEH.

What happened in the commercial paper market - or “money market” as it is colloquially often known- really shows the true scale of the Lehman disaster: an electronic run on the banks. In graphical form:

The red line shows the collapse - in the two days following Lehman’s bankruptcy - of the market for commercial paper issued by banks. Within a week, $500bn of short-term funding had dried up. Then there is the asset-backed CP market, which fared equally badly. Credit lines banks had supplied to asset-backed conduits became less reliable and so too, therefore, did CP issued by those conduits, in turn making it more likely that such credit lines would be drawn down upon - a vicious cycle worse than that seen for ABCP structures when the crisis first hit them a year earlier.
________

It was thus in context that the decision to allow Lehman to collapse was a failure. A Lehman failure didn’t have to spell disaster- it could, perhaps should, have occurred alongside an announcement of a generalised guarantee on money market funds - as well as a broad commitment from the Fed to extend its liquidity facilities. That such announcements in reality, came a week later was no good.

In the context of what happened with Bear Stearns too, not bailing out Lehman was a mistake. The Bear decision introduced huge moral hazard, as John Carney at Clusterstock earlier noted:

… the bailout of Bear Stearns had in fact introduced massive moral hazard into the markets, allowing investment banking executives and their boards to believe that they wouldn’t be allowed to fail.

Lehman’s failure though realised that hazard. This Bank of America graph is particularly revealing:

In the world before Bear, CP investors had their wits about them. The CP they bought from the ailing bank decreased sharply as concerns about its health grew. In the world after Bear, the opposite was the case. Investors were more than happy to buy Lehman CP: lulled into a false sense of security by a sort of faintly implicit guarantee from the US government against too-big-to-fail banks.

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Arguing counterfactuals is always problematic. In a world in which Lehman had survived, would a TARP ever have made it through Congress? After a Lehman bailout, would AIG have ended up a victim: a bailout too far? (If so, the consequences would have been far worse.)

There is - in spite of all the above - a lot to be said for the fact that a bailout of Lehman would have led to much more protracted, if less severe, financial malaise.

This entry was posted by Sam Jones on Thursday, March 12th, 2009 at 12:48 and is filed under Capital markets. Tagged with Bailout, ben bernanke, Lehman Brothers, moral hazard, Reserve Primary, TARP.