Was Letting Lehman Fail Really Such A Bad Idea?

We’re not sure invoking two guys whose final escape plan is a potentially suicidal jump off a cliff into unknown waters below as a metaphor for the experience of being Treasury Secretary during a financial crisis is such a good idea. But that’s exactly what Hank Paulson does in the tough interview with the New York Times today.

“I feel like Butch Cassidy and the Sundance Kid. Who are these guys that just keep coming?” he tells Joe Nocerra and Ed Andrews.

But is Paulson as wrong as everyone seems to assume about the wisdom of letting Lehman Brothers go? The general consensus seems to be that not letting Lehman fall into bankruptcy was a disaster. But the evidence for this may not be a persuasive as many assume.

Let’s look at the main “disaster” that many say was caused by the collapse of Lehman: the freeze-up in the commercial paper market. Here’s how the Times puts it:

The aftermath of the Lehman bankruptcy was disastrous. “Lehman was one of the single largest issuers of commercial paper in the world,” said Joshua Rosner, a managing director at Graham Fisher & Company, referring to short-term debt issued by companies to finance day-to-day operations; this market locked up in the wake of Lehman’s failure. “How could you let it go bankrupt and not expect the commercial paper market to be completely crushed?”

But it turned out to be unnecessary to save Lehman to restore liquidity to the commercial paper market. The Federal Reserve was able to accomplish this by directly stepping into the market by 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 does allow borrowers with healthy collateral to borrow. That is, it provides liquidity to healthy businesses without propping up unhealthy companies.

This is arguably exactly what the market needed: targeted relief that doesn’t create further opacity about which borrowers are solvent.

Earlier: Our Broken Bailout.

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