We’ve noted before the remarkable resilency of the prevailing orthdoxy on the collapse of Lehman Brothers. Many market watchers are absolutely unshakable in their belief that the government’s failure to arrange a rescue of Lehman precipiated an financial calamity. So time and again, we’ve found ourselves in the lonely role of attempting to exorcise this idea from our bewitched friends.
Sam Jones at the Finacial Times’ Alphaville is the latest to mount a defence of orthodox view. His best piece of evidence is a graph showing that banks more than doubled the cash they held in reserve at the Federal Reserve. In ordinary times, banks are loathe to hold much cash beyond regulatory requirements because they earn so little (often nothing) on that money. They’d rather put it to work. So the cash hoarding Jones shows does indicate that the bans were racked with fear after Lehman collapsed.
So we have no argument when Jones says that the banks anticipated – or were already experiencing – an interbank lending collapse after Lehman went down.The question, however, is not whether Lehman’s collapse put the fear of God into the markets. It whether is the government’s failure to rescue Lehman caused the panic.
We have a different interpretation of events. It seems far more likely that what was occuring prior to the collapse of Lehman fed by a lack of information about the dire financial condition of the financial sector. Many banking executives and investors had convinced themselves the Bear Stearns had been brought down by a liquidity shortage and a “bear hunt” by short sellers. They were complacent about the huge balance sheet holes in the financial institutions.
The collapse of Lehman was like a beacon of truth about the financial sector. The long dishonesty or delusion collapsed, and brought down banks’ confidence in each other with it. AIG and Merrill Lynch were also revealed, at the same time, to be financial cripples. Citigroup became suspect, in part because regulators had apparently concluded it couldn’t possibly bailout Lehman or Merrill.
Importantly, nothing would have changed if Lehman had been rescued. The bailout of Lehman Brothers would not have concealed the deep disfunction that head spread throughout the banking system. It would simply have encouraged the disfunction in the way Bear Stearns had. Banks would still have been distrustful, panicked even. They would have demanded that the implicit guarantee of the financial sector become explicit, which is what wound up happening anyway.
That is to say, it was the colllapse of Lehman that set off the problems in the sector. But it was not the failure to mount a rescue. Lehman’s collapse was a signal that would have sounded just as loudly even if it had been bailed out by the government. Credit markets froze because banks realised the banking system was sick almost to death. Rescuing Lehman would have done little, probably nothing at all, to alleviate this.
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