GFC confusion, part 1: Lehman collapse

There has been a lot said about the global financial crisis (GFC) and the subsequent recession. Some good. A lot of it quite bad. One of the better overviews of the GFC was done by Stacey & Morris. I think it’s important to directly address some of the confused arguments about the GFC and show why they’re not correct.

One commonly repeated idea is that the financial markets went in a spin because of the collapse of Lehman Brothers. This talking point generally goes on to suggest that the government should have bailed-out Lehman Brothers and should always bail-out delicate businesses otherwise you will get such a collapse. Not true.

First, it needs to be noted that it was the bail-out culture that lead Lehman Brothers (and other businesses) to not accept non-government solutions. Lehman Brothers rejected a takeover offer because they thought they could wait for a better one.

But more to the point, it is simply untrue that the Lehman collapse lead to the financial market problems. The problem is question is the rise in the money market interest rates (the Libor-OIS spread which measures risk assessment). In August 2007 this jumped from 0.1% up to about 0.8%. This was the start of the financial problems.

When Lehman collapsed (15 Sept 2008) the Libor-OIS spread ticked up to about 1%, and then shifted up to about 1.3% over the following days. Then on the 23rd of September 2008, a week after the Lehman collapse, the Libor-IOS spread suddenly shot up until it hit 3.5% in mid-October.

What happened on Tuesday 23 September that caused the change? Certainly not the Lehman collapse. Markets adjust to new information and the Lehman information was old. It is hard to believe that market players were sleeping for a week and then woke up on Tuesday morning and suddenly exclaimed “damn, Lehman collapsed, why didn’t anybody tell me?”

What did happen on that day is that Bernanke & Paulson testified at the Senate Banking Committee about their “rescue package”, asking for $700 billion and only providing a 2.5 page piece of legislation with no mention of oversight and few restrictions on the use. This seems to indicate that it was an increase in political risk that caused the financial market troubles. This is the conclusion from John Taylor, who provides further evidence in his book ‘Getting Off Track’.

7 thoughts on “GFC confusion, part 1: Lehman collapse

  1. On black Tuesday in 1929 the New York times lead that mornings news with the story that it looked likely that the Smoot Hawley tariff act would get an easy run through congress. Yet people repeatedly dismiss Smoot Hawley as a cause because it did not become law until much later. In that example many people seem very inclined to dismiss either political risk or the notion that markets move on the basis of outlooks about the future rather than actual events. I suspect that blaming the US fed and treasury for making the GFC worse will also suffer similar criticism. Especially by those who think greed descended from the clouds to deliver us a financial apocalypse.

    Can somebody give us a bit more background on what the Libor-OIS spread actually is?

  2. Over night swap rate is the market in which people trade the over night rate for a term asset or liability.

    You can lend/borrow overnight against a borrow lend forward on a simulated basis and simply settle the difference. It’s a truly wonderful innovation that has been around since the 80’s. It just forms part of what is known as the the Swap market…. an older sort of derivative.

    That’s the sort of innovation dinosaurs like some second rate economists and denialist types would like to see heavily controlled.

    I’m surprised people would use this as the barometer, although you can basically use a lot of markers to gauge market liquidity.

    I use 3 month libor, the TED spread and the best one for these times , the Aussie/USDollar and the Aussie yen rate.


    The guy may be right, but i think the market simply went to where it needed to go as a result of the Lehman failure. A lot of eventful things happened that week that indicated there was a serious risk of systemic failure. Merrill, Goldman and Morgan Stanley all looked like failing that same week.
    In other words spreads were going up with or without the Lehman collapse.

    I think the Lehman failure also showed that the governments decision making process was really haphazard and there was a lack of process as people thought the too big to fail policy was still in operation.

  3. The delay argument doesn’t stand up. What wasn’t known at the time of the Lehman collapse was the number of CDS’s that AIG-FP had written on Lehman’s over the previous few weeks.

    The Fed tried to negotiate a bailout of Lehmans but when that failed they thought they could let them go as the market would be resilient enough to withstand the systemic effects.

    Because of AIG-FP’s actions they were wrong and it took a while for that to become apparent. Once it was, and it was realized that the systemic effects were far worse than originally thought, that’s when Bernanke and Paulson went to congress.

    Or to put it another way, information may not be available all at once, it often takes a while for people to discover it all and assess the impact.

  4. Lehman collapsed because of financial market problems – onset by larger macro problems which put pressure on well intentioned but ultimately reckless social equity policies.

    The US went into a very sharp and short decline in growth in early 2007 – if you look at GDP figures. A graph of this is very illuminating.

    However, of you look at say, labour productivity growth since 2003, the short, sharp recession was an inevitable product of the macro environment – high oil prices, high inflation, loose credit policies of central regulators and the costs of the Iraq War.

    When the small recession came, this set up a wave of defaults that cascaded into a solvency crisis and thus the credit crunch – even with bad debts written off, banks were worried about each other’s balance sheets.

    Lehman was simply the first bank to go. The credit crunch repriced risk since this was forced savings to subsidise the earlier policies of loose credit and forcing banks to make unsustainable loans, and then by legislation having these passed on to Freddie and Fannie. FMAC, FNMC, GMAC were basically clearinghouses for debt with a high variance risk profile.

  5. Pingback: GFC confusion, part 2: caused by ‘greed’ « Thoughts on Freedom

  6. Pingback: GFC confusion, part 3: caused by savings glut « Thoughts on Freedom

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