One of the most pervasive myths of last year’s financial calamity is that investors panicked following the collapse of Lehman Brothers. The idea is that the collapse triggered some kind of psychological risk aversion. But that’s not really what happened at all.
The evidence for the idea that investors became risk adverse last fall usually boils down to the return on Treasuries, which turned negative as people snapped up government bonds. This means that people were willing lock in a known loss to avoid unknown losses. Much of the money that went in to Treasuries was withdrawn from money market funds. The pace of money market withdrawals was so swift it threatened to crater many funds. Finally the government stepped in to guarantee the funds and stop the “run on the bank.”
To many market watchers, this looks like an extreme version of “flight to safety.” But that’s not really what was happeneing. It’s just not true that investors in money market funds were knowingly taking on risk before Lehman Brothers collapsed and afterwards became risk adverse.
What really happened is that investors in money market funds suddenly realised that money they had thought was invested in safe, virtually risk-free funds was actually at risk. The money market funds were exposed in the worst way to the collapse of the financial sector. What’s worse, few funds were transparent about their exposure, meaning that even money market funds well-positioned to weather the storm couldn’t be trusted. Rather than being a safe place to store cash, they were exposed as specualtive bets.
Money poured into Treasuries not because investors changed their tolerance of risk but because they did not. What changed was their perception of risk in other investments. And this wasn’t an irrational panic. It was a sensible reaction to facts that were suddenly in evidence thanks to the collapse of Lehman Brothers.
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