Russ Roberts told it with great passion today. I'm hoping an audio will be available tomorrow. But he should not feel lonely. Simon Johnson and James Kwak write,
creditors had only limited incentives to watch over major banks. Ordinarily, creditors should demand high interest rates on loans to highly leveraged institutions. However, the expectation that large banks would not be allowed to fail made creditors more willing to lend to them. This is why the failure of Lehman was such a damaging blow: It shattered market expectations that the government would not let a major bank fail. The massive flight of money out of the banking system can be seen only as the result of an enormous shock. The next several months, up through the third bailout of Citigroup in February, can be seen as the government's attempt to undo the damage by repeatedly saying "No more Lehmans" -- which has made the implicit government guarantee stronger than ever before.
Kwak and Johnson are way more optimistic than I am about the ability to use regulation to overcome moral hazard. I call this the "too regulated to fail" approach, and I think it is self-defeating. What is needed, in my opinion, is a credible way to make lenders lose money when they lend to risky institutions. That means coming up with a definition of systemically important transactions that includes only everyday check clearing and ATM withdrawals, not credit default swaps and repo agreements.
I should note that John H. Cochrane and Luigi Zingales dispute the significance of the Lehman failure. They write,
the main risk indicators only took off after Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke's TARP speeches to Congress on Sept. 23 and 24--not after the Lehman failure...
Why? In effect, these speeches amounted to "The financial system is about to collapse. We can't tell you why. We need $700 billion. We can't tell you what we're going to do with it." That's a pretty good way to start a financial crisis.
As Russ points out, the media are now honoring Paulson, Bernanke, and Geithner for transferring hundreds of billions of dollars from ordinary Americans to some of the richest people on earth. And, if Cochrane and Zingales are correct, we are honoring them for putting out a fire that they started.
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I'm having a hard time understanding the Cochrane and Zingales story. It looks a lot like the paper I read by John Taylor, who based his argument on the VIX. I hope that their argument is similar.
Firstly, this is the best analysis that I've read about the charts:
"Financial crisis, global conditions, and regime changes
Heiko Hesse Brenda González-Hermosillo
21 April 2009"
Here's the conclusion:
"This article presents a Markov regime-switching technique to examine when key global market conditions variables such as the VIX, forex swap or the TED spread moved into a high-volatility regime. The findings support the view that the Lehman failure was a key watershed event in the crisis, but periods of high volatility were also present before Lehman’s failure. In particular, based on the VIX SWARCH model, these earlier episodes of distress include the Shanghai stock exchange crash and the ABX (BBB) price decline in February 2007, the beginning of the subprime crisis in August 2007, and the Bear Stearns rescue in March 2008. The results suggest that the bankruptcy of Lehman Brothers aggravated what appeared to be already a crisis, characterised by persistent (albeit at times noisy) signs of a high-volatility state. High-volatility states can be viewed as a potential manifestation of systemic risk."
So, now I'm looking at a day by day VIX chart from Sept. 13 to Dec. 1st, 2008. Here's what I see:
On Sept. 15th, there's a big jump. That week peaks on Wed. On Friday, it's gone down a bit, but it's still way up from the previous week. On the 24th of Sept. it's up, but lower than the previous Wed. On the 29th, it shoots up. It peaks on Nov. 20th, and then starts to decline.
My story is that the govt allowing Lehman to fail caused it to shoot up. On Thurs., there's a brief rally, based upon the govt bailout out AIG, getting the B of A to buy Merrill, and MMFs are guaranteed by the govt. Following WaMu bondholders getting wiped out on the 26th, or the expectation of that, and the govt guarantees being doubted again, it shoots up on the following Mon. On Nov. 23rd, Citi is saved, and the policy of No More Lehmans is understood, meaning that the govt will bailout whomever it needs to, and the VIX begins its descent.
Now, the alternative argument is based on the fact that the VIX rallied on Thurs. of Lehman week. Hence, that week doesn't look like the worst week. So, the question is: Would the VIX have gone much higher if AIG wasn't saved, Merrill wasn't bought, and MMFs were guaranteed. In order for the Taylor, Zingales, and Cochrane view to be correct, the actions of the govt could not have averted a major jump in the VIX. In fact, they have to believe that either the govt's actions had no influence on the VIX, or they believe that the VIX would have gone down if the govt allowed AIG and Merrill to fail, and MMFs to break the buck. So this view must be wrong:
"The panic was averted only after the Treasury Department on Sept. 19 stepped in and announced it would backstop money-fund assets, in a series of measures that slowly restored investor confidence. But industry officials are under no illusions about what might have happened."
So, who are the people that believe that allowing AIG and Merrill to fail, and the MMFs to break the buck, would have had no influence on the VIX that week or believe that it would have gone down?
Again, I believe that it would have gone way up, making the later comparisons moot. But I could be wrong, and would welcome help understanding their position, since they're smart men.
I'm not sure moral hazard is really meaningful at the level these multinational companies are playing at; The game just gets too big. That said if you dont want to reward systemic risk, perhaps the better solution would be to simply nationalize the failing firms, absorb their liabilities, and auction off the assets over the next several years, and fire everyone as fast as possible.
But I dont know the risks involved in that. During the transition there might be a liquidity trap that turns into massive deflation.
Perhaps we need some sort of systemic insurance policy for absorbing liabilities and assets of companies that induce massive systemic risk when they fail. Of course, this wont sit well with pure ideologues.
How about smaller banks, with more transparent financial statements?...but then their corporate customers would be too big..so what about more and smaller corporations?...but then who would be there to pay for the massive government?...
In 2ooo the head of Fixed Income trading came to corporate risk where I was working looking for insurance...
It occured to me that where there's no risk there is no responsibility.
We should have made it hurt more.