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.
This graph nicely illustrates this movement of funds away from the commercial paper market in into safe government issued debt.
Sam Jones at FT Alphaville correctly describes this as an “electronic run on the banks.” Panic had taken over when the world woke up to realise that Lehman was bankrupt.
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.)
To demonstrate this, let’s look at the debt markets following the announcement of the $700 bailout from the Treasury. After the TARP was announced, it was clear that the government was not going to let a major financial firm simply collapse. Nonetheless, investors remained nervous about lending to banks.
The chart below (click for bigger version) shows the movement of credit default swap prices on Citi. There is an initial spike right around the time of Lehman’s collapse but shortly after the price drops back down to where it was earlier. As the bailout plans are announced, the price climbs again. It remains elevated until mid-October, when the government actually injected billions of dollars into the bank. This pattern recurs again and again, with the price of CDS climbing as concerns about Citi’s financial health grow and then dropping when new government capital injections are made.
The point here is that following the collapse of Lehman Brothers, when the world woke up to the fact that the financial sector was far sicker than previously thought, even a government policy of bailouts to avoid bank failures did not ease fears in the credit market. This suggests that a bailout of Lehman would have done very little to preserve liquidity in the commercial paper market.
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.