The consensus that has hardened around the notion that letting Lehman go into bankruptcy was a huge mistake is surprisingly resilient. We’re tempted to say it is almost immune to evidence and argument. Just the other day, Fed chair Ben Bernanke implied that the lesson of Lehman–that major financial institutions should not be allowed to failed–was basically unquestionable by reasonable people.
We remain sceptical. In fact, we’re growing more sceptical. Which is saying a lot since we’ve already argued that letting Lehman fail may have saved the markets from an even worse disaster. So far, we’ve been lonely soldiers holding up the black flag of dissidence on this point, joined only by John Gapper of the Financial Times and Jeremy Warner of the Times of London.
Now 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.
Taylor’s evidence is the movement of 3-month Libor before and after Lehman’s bankruptcy. Taylor looks at the spread between Libor and and the overnight index swap rate, the so-called Libor OIS spread. This is usually taken as an indicator of counter-party risk, which is to say the confidence banks have that they’ll be paid back on loans they make to each other.
So what happened after Lehman Brothers went under? It is, basically moved a bit on Monday, September 15th but then bounced down the next day. Throughout the following week the spreads were elevated, as they had been since the year prior, when they first blew out in a movement that quants call a 9.7 sigma event, or something that should never happen in thousands of years but did anyway.
At the end of the week the Treasury Department announced it would soon propose a large rescue package. It was one of those “rescue weekends” with which we’ve now become familiar, with the Treasury and the Fed pulling Diet Coke fuelled all-nighters to craft a plan. They emerged on Tuesday, September 23, with that famous 2 1/2 page draft that prohibited courts or Congress from overseeing the use of the TARP and contained virtually no restrictions on its use. The public and political backlash was immediate. As were the financial consequences: that’s when the Libor-OIS spread jumped up to 3.5 per cent.
Taylor argues that “it is plausible that events around September 23 actually drove the market, including the realisation by the public that the intervention plan had not been fully thought through and that conditions were much worse than many had been led to believe.”
To put it slightly differently, the credit markets didn’t freeze up because Lehman was allowed to fail. They were already in the process of freezing. In the wake of Lehman’s failure, that process continued but didn’t greatly accelerate. What really put the fear of death into the markets was the hastily thrown together bailout, which suggested (a) that banks were far less healthy than previously known, (b) that authorities were making it up as they went along and (c) that the rules of the game could suddenly change.