Should Lehman Have Been Rescued?

I have to get on plane to Chicago, so don’t expect much more here any time soon. In the meantime, here’s an IM I just had with John Carney of Clusterstock about whether Treasury was right to let Lehman fail.

I thought it was the right decision at the time, but with hindsight I think it was clearly a mistake. Even Hank Paulson seems to think that it would have been a good idea to rescue Lehman, if only he’d been capable of doing so. But Carney still thinks that letting Lehman fail was the right thing to do.

John Carney:

I personally don’t get what the problem with letting lehman go bankrupt is. Everyone keeps saying it was a disaster.

Felix Salmon:

well, it cost well over a trillion dollars

in terms of the global bailouts needed as a result

John Carney:

How so.

Post hoc, ergo propter hoc?

Don’t buy it

Felix Salmon:

What’s the probability that bailouts of this magnitude wouldn’t have been needed if the implicit Treasury TBTF backstop had been shown to exist?

multiply that probability by the global cost of the bailouts, and you still get a number much bigger than the $60 billion or whatever that Treasury would have needed to bail out Lehman

John Carney:

First, I’m not sure $60 billion would have bailed out Lehman

Felix Salmon: "Lehman officials said they believed the firm had not one but two potential buyers: Bank of America and Barclays, the big British bank. But both had conditions. Bank of America wanted the Fed to make a $65 billion loan to cover any exposure to Lehman’s bad assets, according to one person privy to the discussions who did not want to be identified because of their sensitive nature."

John Carney:

Second, I just don’t see why propping up Lehman would have avoided all the other bailouts.

That is, we don’t have a confidence crisis.

We have a solvency one.

Morgan Stanley would still have failed

Felix Salmon: You can’t say that MS would have failed in the wake of a Lehman bailout with any certainty

John Carney: I have the facts on my side: it did fail.

Felix Salmon: Letting Lehman fail undoubtedly increased the risk that MS would fail

John Carney: My version is 1/2 counterfactual. The other is 100% counterfactual.

Felix Salmon: With hindsight, letting Lehman fail was clearly a mistake

John Carney: I just don’t understand why.

Felix Salmon: because bank creditors realized they could be wiped out

so no one wanted to lend to banks any more

including other banks

John Carney: That’s good

Felix Salmon: That’s not good, that’s bad

John Carney: Bank creditors need to be aware of risk

Felix Salmon: OK, fine, if you’re a moral hazard absolutist, that’s one thing. But for those of us more interested in saving the global economy and financial system, letting Lehman fail was a bad thing

John Carney: No. I’m trying to save the system, and the main thing we need is less reckless lending.

Your position is that we need more credit to solve problems of debt.

Felix Salmon: What you’re trying to do is put interbank lending on the "reckless" list, which is unhelpful, to say the least.

Having credit seize up helps no one. Do we need more credit than zero? Yes.

John Carney: A lot of interbank lending is or was innappropriate. For instance, lending to Lehman.

Allowing insolvent banks to fail creates more confidence that existing banks are solvent.

Felix Salmon: ha!

that’s exactly wrong

John Carney: I think the continued priceiness of interbank lending is a direct result of continued opacity about solvency caused by bailouts.

Felix Salmon: the opacity about solvency has been there for ages. It’s got nothing to do with bailouts.

But look: clearly a solvent but illiquid bank can fail, if its counterparties all desert it at once. And clearly that’s more likely in a feverish atmosphere where everybody’s worried about bank failures. So letting Lehman fail put solvent banks at risk, it didn’t install more confidence in any bank.

John Carney: I disagree. It strikes me that continuing to prop up the insolvent makes it impossible for market processes to operate to make solvency thru existence transparent.

Solvent banks can meet liquidity problems by borrowing from the Fed.

Felix Salmon: I have no idea where you get this idea that the market has a clear idea of how solvent banks are. It doesn’t. It does, however, have a clear idea of what any given bank’s borrowing costs are. That’s a liquidity issue, but it’s used as a proxy for solvency, precisely because no one knows what the real solvency situation is.

Incidentally, I have to get on a plane to Chicago, can I clean up this IM and post it as a blog entry?

I’ll give you the last word

John Carney: Yeah absolutely.

Felix Salmon: So you want to make one last point?

John Carney: The view that we make the financial system more stable rather than less by propping up insolvent banks is the real disaster.