Arnold Kling  

What if Lehman had been Bailed Out?

Some Pushback to Krugman... "All Theories Are False"...

Joe Nocera speculates,

In truth, a Merrill or A.I.G. default would have created something akin to a financial nuclear bomb -- much worse than Lehman's filing for bankruptcy. Merrill was a much bigger firm, with deep roots on Main Street thanks to its "thundering herd." A.I.G. was the world's largest insurance company, whose credit-default swaps were propping up half of Europe's banks. (By buying A.I.G.'s swaps, European banks could evade their capital requirements.) Lehman, by contrast, was a smaller firm, with practically no ties to Main Street. The risks it posed to the system were real -- but smaller.

Almost everyone I've ever spoken to in Hank Paulson's old Treasury Department agrees that without the immediate panic caused by the Lehman default, the government would never have agreed to make the loans needed to save A.I.G., a company it knew very little about. In effect, the Lehman bankruptcy caused the government to panic, which in turn caused it to save the firm it really had to save to prevent catastrophe.

Pointer from Tyler Cowen. I am not ready to revise my view that the bailouts served special interests and were not necessary to keep ordinary financial operations running.

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COMMENTS (13 to date)
Troy Camplin writes:

Enron filed bankruptcy and, though the largest energy company in America, caused nary a ripple. My guess is the same thing would have happened with all the bailed-out companies. After all, the bankruptcies wouldn't have made them go away, just have new managers of their assets. Which would have no doubt been beneficial.

Nick writes:


Enron had only $50bn in assets when it filed for bankruptcy. Lehman had over $600bn in assets when it filed, and probably had over 50x more trades outstanding than Enron. Lehman's bankruptcy was an unmitigated disaster.

Next in line after Lehman was Merrill, which had over $1 trillion in assets. Then it was Morgan Stanley, with about $900bn in assets. And finally, if Merrill and MS had gone under, even the mighty Goldman Sachs would have failed -- and that's when it goes Mad Max.

The burden of proof is on the people who think the bankruptcy of a money center bank would be quick-and-easy.

Drewfus writes:

"Lehman's bankruptcy was an unmitigated disaster."

how much of a disaster was it for the rest of the economy that had to, effectively, pay for the bailouts?

Do you realise that the bailout money wasn't manner from heaven?

An unmitigated disaster - compared to what? The deep recession that we've had anyway?

Would things have been worse otherwise? How could you possibly know that?

You're guessing.

Let them fail.

Joe Cushing writes:

The only reason the bankruptcy was a disaster was because it introduced uncertainty into the marketplace. If the fed had been standing on it's soapbox for 5 years telling us it would not bail out banks, then it would not have been as much of a problem. It would also help if we had a faster system of bankruptcy for financial institutions other than commercial banks--something like the FDIC method of closing banks minus the insurance part.

Dezakin writes:

Seriously, just because these bailouts sucked doesn't mean they weren't absolutely necissary. Can you honestly imagine what happens to the economy when the debt market completely freezes? I dont think any of the naysayers here have even the slightest notion of the vast scope of the danger we very narrowly avoided. Being opposed to government intervention is fine. But the maelstrom that would have ensued in the absense of priming liquidity would have all but ensured a complete government takeover of the entire economy as the last entity with the ability to create debt.

It would have been a global catastrophe.

Vincent Poncet writes:

Bailouts are not needed, even for system risky firms.
Just create a flash capital structure reorganization for all systemic risky firms. shareholders slashed, bondholders slashed, and leverage go down. All of that without any business disurption (derivatives, loans, etc...).
Systemic risky firms are systemic risky because of all regulations (or must say privileges) like debt tax advantage, central bank artifically low interest rates and central bank lender of last resort. Bondholders or commercial papers buyers buy the implicit bailout protection, so that is perfectly moral to cut them down instead of taking money from taxpayers.
Sure, that will touch many citizens as many have mutual/pension funds which invest in financial bonds & commercial papers. But they will loose money as investors, not paying as taxpayers. That is absolutely different from a responsability point of view.
This will automatically manage the so-called systemic risk, and will change the behavior of leverage providers in the future. They will think twice when lending money to a financial firm which is already 10 times leveraged.

Mit Shah writes:

Govt intervention was likely necessary to avoid contagion/keep money circulating; but why not nationalize to avoid future moral hazard?

Creditors being made whole is debatable, equity holders being made whole is simply preposterous. Other countries have public sector firms competing with private sector in core areas (banking/telecom/oil) where market forces alone are deemed insufficient for overall societal good.

fundamentalist writes:

"Merrill was a much bigger firm, with deep roots on Main Street...Lehman, by contrast, was a smaller firm, with practically no ties to Main Street."

No matter how twisted the logic is for the bailouts, it always comes back to main streat. We had to save main streat. However, the people understand something that none of the economists and none of the politicians and none of the finance people get, and it's this: if you wanted to bail out main street, then bail out main street; don't bail out the SOB's who caused the disaster! All the guv had to do to bail out main street was give the money to the people. Then the people could have bought cars or houses or saved the money in their own banks and rescued the banks they liked.

Instead, politicians and economists insisted that by bailing out the big investment banks who caused the problems they were helping main street. In reality, they screwed the American people with mountains of debt and rescued Paulson's and Bernanke's golfing buddies.

Shayne Cook writes:

To Dezakin:

For the sake of discussion on the "bailout" topic, I'll concede your (and others, such as Tyler Cowen's) claim that the "bailout bill" was at least helpful in minimizing or delaying what could have been a serious global financial problem. Understand that I believe there would have been serious problems in the absence of an intervention. I don't however believe they would have been nearly as catastrophic or debilitating as you or others are claiming. But we'll never know.

I also believe the "bailout bill" was a horribly ill-conceived mechanism for dealing with the crisis of the time. It is a mechanism that at best postponed the potential catastrophe you and others describe and fear, while simultaneously, 1.) increasing the probability of a financial/economic catastrophe, 2.) increasing the magnitude of that potential catastrophe, and 3.) severely impaired both the Government's and the Fed's ability to do anything to address that potential catastrophe should it occur. In short, it rendered the entire U.S./global system - not just the financial system - in a far more fragile state than previously existed.

My point to you is that currently I'm far more concerned with "what IS" than "what if", regards the bailout bill. And "what is" is decidedly unlovely.

I watched the entire Geithner required testimony to the Congressional Oversight Panel last Thursday. I don't have a link to it (either video, or text transcript) just now, but I will try to find one and post it here (with Arnold's permission, of course.) In any event, I STRONGLY recommend you and others review this testimony. You will certainly find that Geithner is "of your mind" - he also claims (repeatedly) that "catastrophe" was averted. It was the other aspects of the testimony - questions, answers and unanswered questions - that gave me pause.

A quick summary follows ...
1.) Substantially ALL of the original "toxic paper" that precipitated the financial crisis remains intact, un-retired and arguably even more "toxic" than a year ago. (Actually, Geithner was asked, pointedly, several times, by Chair Elizabeth Warren how much "toxic paper" still existed, and he never answered her question, nor did he indicate that he would provide the information at any later date.)
2.) Several Committee members posed the question of whether Geithner was prepared to shut-down the TARP and other related bailout bill spending programs anytime in the near future. (The bailout bill was established as a one year authority - ostensibly to expire this October.) Geithner's response was that he was not prepared to do so, and would not postulate a time-frame for doing so.
3.) Geithner was asked (several times) if he considered GM and Chrysler to be 'financial institutions' (by implication, thereby be "qualified" to receive funds under bailout bill authority.) Geithner averted answering the question several times, indicating that his and Paulson's use of spending authority had "averted" financial and economic "catastrophe". Eventually, when pressed, he did say that he did not consider GM and Chrysler "financial institutions" - but he quickly reminded the Committee members that Treasury Secretary spending authority under the bailout bill, although ostensibly intended to support the financial sector only, contains no such restrictions. The bailout bill placed $700 Billion at the disposal of the Treasury Secretary, to distribute, disseminate, control, etc., entirely, solely and exclusively at the discretion of the Treasury Secretary. (Geithner correctly reminded the Committee of that fact. I would remind readers that $700 Billion represents over 5% of U.S. GDP - an amount greater than the U.S. defense budget - AND that the Treasury Secretary is an appointed, not an elected official. The bailout bill is a truly extraordinary piece of legislation.)

A few logical conclusions ...
A.) Fully one year after the "financial catastrophe" was supposedly "averted", there is no element of the U.S. financial sector that is capable of standing on its own - absent "bailout bill" support, not to mention the additional extraordinary Fed support measures that remain in place.
B.) One year after the bailout bill was supposed to have reduced or eliminated the "toxic paper" at the center of financial sector problems, the "toxic paper" still exists in all its former vigor, and if anything has grown even more "toxic". The increase in "toxicity" being related specifically to the recession that was not averted, with its attendant increase in unemployment levels.
C.) One year after the bailout bill, the entire concept of "too big to fail" is in full vigor, and expanded to include at least GM and Chrysler. Note also that incidents of bankruptcies of smaller firms (not "too big to fail") in the financial sector, and in all economic sectors, are quite robust and dramatically exceed normal levels.
D.) One year after the bailout bill, the various "profits" (highly questionable), that have been returned have merely restored funds to the Treasury's $700 Billion original spending authority under the bailout bill.
E.) One year after the bailout bill, there apparently remains "no end in sight" to either the financial catastrophe or the supposed "need" for the bailout bill's perpetuation. (I have a very strong suspicion that the "need" for the bailout bill will never have an end. Politically, it is far too compelling to have 5% of the U.S. economy available for use - to any ends - by a political appointee.)

The bailout bill didn't "avert" anything - real or hypothetical.

arnie writes:

Joe Cushing above is correct.

I would go back beyond 5 years. Since the 1979 Chrysler bailout (#1 of 2) the government has made it clear that if you are big enough, you aren't going down. So, when it didn't save Lehman, (Paulson's former business competitor) THAT signalled a change in policy that markets hadn't predicted, thus causing fear.

People just want to know the rules. But that is hard to know when your parent (the government, here) is schizo.

Drewfus writes:

Shayne Cook,
great work sir!

I believe what has happened in this financial crisis is that the concept of systemic risk has been uncritically accepted to cover for one glaring omission from our economic knowledge - namely - we simply do not have a model, mathematical or otherwise, for what happened to Wall St last year.

The purpose of the systemic risk concept, now a full-blown meme, is to cover for this deficiency and maintain the illusion that we understand our economic system and consequently remain in charge of our destiny. This behaviour is simply an imperative for the left-hemisphere of the cerebral cortex, which always demands explanations for everything, and will resort to ad-hoc rationalization if necessary.

'Systemic risk' is just a means for hiding our own subjective uncertainty and ignorance by projecting it onto the financial system. As a consequence it becomes the objective world that is unpredictable and on a catastrophic knife-edge - not our own thinking that is limited and short-sighted.

Not being able to see the light at the end of the tunnel, in our own imaginations, becomes the 'abyss' that the entire human race will necessarily 'fall into it' if a single large insurance company is allowed to go bankrupt in the normal manner.

This is sheer fantasizing, and nothing more than a cover for those who cannot admit to a lack of applicable knowledge, and/or cannot explain why, when a capitalist economy starts to go south, what stops the process from being cummulative until there is nothing left. You simply don't know, do you? Hence the 'systemic risk' blather and corresponding scare campaign.

I would challenge any systemic risk believer to do two things:

1. Give a detailed account of the theory/theories behind systemic risk, with references.

2. Name and detail the historical evidence for the systemic risk thesis.

Methinks you cannot do this, since the whole notion of systemic risk is 'made up'.

Shayne Cook writes:


On models (or lack thereof) ...
I tend to agree with your statements on this. Much of the macroeconomics community is 'back to the drawing boards', so to speak, reviewing why those models didn't predict and warn. Arnold has posted several times on this subject. In a comment to one of those posts not long ago, I recall a reader/commenter mentioning a lack of "common sense" on the part of macroeconomists - that "common sense" should have led macroeconomists to know their models were indicating "false positives" (at least).

It's been my experience however, that "common sense", while being a marvelous concept, really doesn't exist - much like Santa Claus, the Tooth Fairy, Free Health Care, and even perhaps Systemic Risk. I think the commenter had the right idea, but I would have stated it a different way. I think a more rigorous statement would have been that some macroeconomists lost appreciation for the fact that all models are just as valuable for what they don't explain about a particular phenomena as they are for what they do explain.

Arnold and others (Hayeck, Nassim Taleb .... you) have noted that many macroeconomists came to erroneously accept that their models were perfect and complete. The models may be/have been perfect, but they are always decidedly incomplete - and no modeler, researcher, or practitioner in any discipline dare ever lose appreciation for that fact. It appears a dominant underlying problem in macroeconomics is one of arrogance rather than ignorance. We are all smart people, and we all have various "Certificates of Authenticity" from various universities certifying our smartness. But none of us are all that smart. And we dare not ever forget that fact either.

On terms (such as Systemic Risk) ...
It sounds like "systemic risk" is a pet peeve of yours. (heh, heh). I can't blame you. The term that has cropped up around this mess that annoys me is "moral hazard". I at least think I basically understand the concept of systemic risk - I used to be a systems engineer. I don't have a clue what moral hazard is - I've never been a morality engineer.

In any event, I can't explain systemic risk in anything like the level of rigor that you've asked for, but I'll attempt to explain my understanding of the concept. Systemic risk is present in any system when the failure of an element (or sub-system) leads inevitably to the entire failure of the whole system. The space shuttle disaster of many years ago is a good illustration - the failure of the full shuttle was finally traced to the failure of an o-ring. The shuttle designers had inadvertently designed in a systemic risk with the original approach for sealing the sections of the solid rocket booster engine, and the failure of a single (minor) part led inevitably to the complete failure. Unfortunately, the systemic nature of the risk was not discovered until after the disaster had occurred.

In the current context, the concept of systemic risk applies to the quest for explanation for why/how the failure of a single financial institution, or even several, could lead inevitably to additional failures of others, eventually the entire financial sub-system and finally the failure of entire economies. That "inevitability" artifact is what prior macroeconomic and financial models failed to predict.

I hope that helps. But then, I could explain the concept of Santa Claus as well, but that wouldn't make him exist in reality either.

But I would quickly point out the fact that terms such as "system risk", or perhaps even "moral hazard" are never intended to be "models" in and of themselves. Instead, they provide a conceptual framework within which phenomena can be studied and modeled. New terms (conceptual frameworks) are of value typically as a means of altering the conventional-wisdom perspective of observation of a phenomena.

Arnold, by the way, is marvelous at offering alternative (to conventional wisdom) conceptual frameworks - "easy-to-fix versus hard-to-break", for example.

I hope that helps - and thank you for "good stuff" comment. And incidentally, I'm not a "sir" - I was one of the "enlisted swine". I'm convinced Congress lost the Bill declaring me an Officer-and-Gentleman in some committee room somewhere, but that's another story.

Drewfus writes:

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