No More Lehmans?

With some rare exceptions (Stanford economist John Taylor), most people agree that the meltdown of Lehman (i.e. allowing LEH to fail without some sort of government rescue) was responsible for the September-October meltdown in the credit markets, which in turn was responsible for the meltdown of the stock markets.

As such, “No More Lehmans” has become government policy. On October 10, the Group of Seven pledged to stabilize markets and prevent systemically-important financial companies from collapse: G7 finance ministers and central bankers agreed to “use all available tools to support systemically important financial institutions and prevent their failure.”

While I don’t agree with Taylor that the credit markets actually did not react all that badly to Lehman going under, and that the crisis was really the product of market uncertainty about the effects of government action, I also disagree with the apparent prevailing wisdom.

James Surowiecki and Mark Thoma certainly believe that letting Lehman fail was a mistake and, as best I can ascertain, their views fairly well represent common wisdom.

But have those who take that position considered counterfactual hypotheses? I find it terribly odd that people who believe this seem to believe that the credit crisis and stock market collapse would not have happened had the government perhaps done for LEH what it did with any of BSC, AIG, FRE, FNM, WAMU or Wachovia (take your pick) -- each of which was handled differently, none of which was handled transparently, fairly or well.

Remember, in July we were assured over and over that MER would be fine, and that FNM and FRE were fine; and in less than two months we find out that the distinguished MER was in such desperate shape it could no longer go it alone, and that the GSEs were on life-support. And what happened to WAMU, as John Hempton has so convincingly described here and here and elsewhere, and is also described here, with pretty arbitrary FDIC action, had its own host of consequences.

The crux of the matter is NOT that LEH was allowed to fail; the crux of the matter is that LEH was in such bad shape that it DID fail! (and failed spectacularly -- Lehman CDS set a value of under 10 cents on the dollar for LEH debt)

The confluence of the revelations of the disastrous states of AIG, LEH, FRE and FNM, among others, was reason enough for credit markets to say “Holy Shit, we can’t trust any of these guys – whose next? Who knows? Shit, I’m not getting paid enough for this f’g risk”. Result: Spreads blow out.

And, clearly, both the revelations themselves and the credit market reaction were enough for equity investors to say “Holy Shit, the good old days of corporate profitability that we thought we would soon be able to go back to were a mirage! Corporate claims about their health mean nothing! Balance sheets suck, and who the hell knows about income!” (as an example, MER’s recent earnings surprises have wiped out all of its retained earnings accumulated since 1972). Result: Stocks tank.

But now government policy is being based on a flawed hypothesis, that the failure of LEH is what caused our mess.

Incorrectly diagnosing the root cause of a problem tends to lead to improper and ineffectual attempted “solutions”. All along throughout this crisis, authorities have failed to understand the underlying causes of our problems (unrealistic asset values that have been propped up by unsustainable levels of debt and leverage, both of which were/are endemic as opposed to contained), and have thus failed to come up with realistic solutions (for instance, the remedy of more debt (government / taxpayer) will cure us of too much debt (household debt / financial sector leverage); forcing all banks to accept TARP funds to disguise whom among them is desperately needy, and giving forebearance on things like mark-to-market rules hardly solves the problem of opacity and engenders confidence in the state of our financial institutions).

The belief that we cannot allow another financial institution to “fail” has led government to an approach to string along zombie companies with taxpayers footing a huge bill to prop these failed companies up, with no obvious benefits (certainly not relative to alternative policy approaches, such as Willem Buiter’s Good Bank recommendation), but all-too-already-obvious costs (the looting at AIG being the contemporary popular example), and this before the inevitable but as-yet rarely recognized cost that the U.S. financial system is becoming very Japanese, with all the longer-term ramifications that that entails.