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Two Observations on the Financial Crisis

By Anonymous

Having spent the past two months at hedge funds and money center banks, let me offer a couple broad observations about the financial crisis.

First, Wall Street and Greenwich were absolutely convinced that the government would save Lehman. They interpreted the Bear Stearns rescue as a signal that no major financial institution would be allowed to fail. This view was only reinforced by the Fannie & Freddie rescues. If Bear was too systematically important to fail, the thinking went, then Lehman was definitely too important to fail. The fact that there was no political will for a Lehman bailout didn't even cross the mind of most people on Wall Street. If it did cross their mind, they usually used it to dismiss Paulson's hard-line public statements as mere political posturing. (And let's be honest: despite Paulson's ever-shifting stories, the lack of political will was the reason the government didn't save Lehman.)

A May report by Moody's on systemic risks in the CDS market shows how deeply ingrained the idea that the government would save Lehman was:

It should be said at the outset that the actual likelihood and systemic consequences of a default by a major counterparty, would depend, to an important degree, on the systemic importance of such a counterparty. The more important the function played by an institution, the more likely it is to be considered by regulators to be "too big to fail" or "too complex to unwind". Thus, a systemically important institution would be more likely to trigger intervention from the regulatory authorities to prevent a disorderly liquidation that may imperil the broader financial system. Indeed, this is what happened with Bear Stearns, when the Federal Reserve and JPMorgan Chase stepped in to save it from collapsing.

The largest CDS dealers are highly rated securities firms and banks, which play systemically important roles in the efficient functioning of the financial markets. ... In Moody?s opinion, the systemic importance of these firms [which included Lehman] therefore provides meaningful incentives to regulatory authorities to prevent such firms? disorderly failure, given the disruptive effect this would likely have on the derivatives market.

Needless to say, when Lehman actually failed, the financial markets were completely unprepared, and therefore panicked.

My second observation: This financial crisis was inevitable; saving Lehman would not have averted a financial panic. There's simply no way the financial system could have fully deleveraged without a full-scale financial panic. The financial markets are so complex and interconnected, and the problems were already hidden across so many asset classes, that a deleveraging process was guaranteed to lead to uncontrollable fear at some point.

The Lehman failure led to a full-blown panic primarily because it hurt the money market funds so hard. No one thought that the once-sleepy world of money market funds had so much exposure to Lehman. When the Reserve Primary Fund broke the buck, everyone collectively realized just how interconnected?and therefore unpredictable and uncontrollable during a deleveraging cycle?the financial markets really are.

My point is that the deleveraging process would have eventually caused large losses in a completely unexpected area of the financial system whether we saved Lehman or not. When contagion can spread faster than investors can get their minds around it, fear replaces rational analysis. So yes, letting Lehman fail was a mistake. But anyone who thinks that if we had just saved Lehman, we could have maintained the necessary trust and confidence in the banking system throughout the entire deleveraging process, is frankly delusional. This financial panic was bound to happen. The fuse was lit years ago.

Full post as published by Economics of Contempt on November 24, 2008 (boomark / email).