Facts and Assertions

Mark Calabria at Cato seems a little annoyed that people like Simon Johnson are hammering Mitch McConnell for his defenses of doing nothing (Brother Scott addresses here).  He blames this primarily on:

This familiar canard is based upon the oft repeated assertion that the failure of Lehman proved that we cannot simply let large financial companies enter bankruptcy.

This is too general a statement, if not a strawman.  After all, Washington Mutual, a bank with over $300 billion in total assets at its peak, a large bank by anyone’s standard, was not bailed out and was allowed to fail (that it did not enter bankruptcy and was taken over by the FDIC is irrelevant to this discussion).  The issue with Lehman Brothers was not the size per se but the interconnectedness with the global financial markets.  In my opinion, the assertion is that a globally interconnected-financial institution like Lehman Brothers should be subject to a mechanism, a resolution authority of some sort, to allow for the orderly liquidation of a firm whose failure poses a grave threat to the financial system.     Yes, Lehman’s bankruptcy proved this.

For someone who is critical of his opponents for letting simple, empty assertions passing as facts, he then accuses his opponents, of which I am now one for repeating the familiar canard, of being, at best, disingenuous or, at worst, dishonest.  I neither know nor care where I rank in his little scheme but I find his hyperbole pointless.  After all, “to prove” simply means that I have to establish a truth based on evidence and argument.  To be disingenuous or dishonest would mean that I am arguing in bad faith or, as he implies, letting simple empty assertions passing as fact.  Let’s see if this is the case:

Mark lists the facts:

1. We know none of Lehman’s counterparties failed as a result of Lehman’s failures.  Just as we know none of AIG’’s counterparties would have failed if they did not get 100 cents on the dollar from their CDS positions.  So where exactly is the proof of contagion?
2. We know we had a nasty housing bubble.  We were going to lose millions of jobs in construction and real estate regardless of what we did.  We knew financial institutions heavily invested in housing would suffer.  How exactly would saving Lehman have prevented any of that?

We don’t know that none of AIG’s counterparties would have failed if they did not get 100 cents on the dollar because AIG was bailed out.  Furthermore, on Point (2), saving Lehman would not have mitigated the damage done to businesses directly related to real estate, but the concern about a messy Lehman bankruptcy was its impact on the global capital markets.

Yes, the $400 billion settlement of the credit default swaps contracts tied to Lehman bonds was an orderly process and the market did not experience the turbulence some had expected, but just because the CDS markets functioned the way they were supposed to does not indicate all was well in the rest of the financial markets (the uncertainty that was focused on the settlement of the CDS contracts was a function of everything else going on in the capital markets at the time).  Senator George Kaufmann, in responding to Senator McConnell, describes the events that transpired as a result of the Lehman bankruptcy:

“If bankruptcy was a cure in Lehman Brothers, it was one that almost killed the patient — the U.S. economy,” Kaufman continued. “When former Treasury Secretary Hank Paulson decided to let Lehman Brothers go into bankruptcy, our global credit markets froze and creditors and counterparties panicked and headed for the hills. Instead of imposing market discipline, it only prompted more bailouts and almost brought down our entire financial system.  It ultimately took 18 months to close out the case on Lehman Brothers, an eternity for financial institutions that mark to market and fund their balance sheets on an interday basis.”

Add Justin Fox for a little more clarity:

Allowing Lehman to fail — cited often as the government’s biggest boo-boo — started a chain reaction. There was a run on money-market funds after one big money-market fund revealed that it owned a lot of suddenly worthless Lehman debt. London-based hedge funds that relied on Lehman for day-to-day financing found themselves unable to do business because their accounts with Lehman’s U.K. subsidiary were frozen. Similar dislocations played out around the world. Before long, financial institutions were paralyzed by fear. They simply didn’t trust each other anymore, and didn’t want to lend to each other. The financial system proved too fragile to handle the stress.

That The Reserve Fund broke the buck due to losses related to Lehman bonds and triggered a money market run that threatened the way that major corporations (including nonfinancial firms) funded their day-to-day operations is factual.  That market participants were hoarding cash because of uncertain market conditions.  That lenders were terrified to lend, even to other major financial institutions, for fear that borrowers would not make good on their loans is factual.  That the Lehman bankruptcy was followed by massive deleveraging in the repo markets causing asset values across many classes to plummet in value and the market to effectively seize up is factual.  None of these events are empty assertions.

I fail to see how, given the devastation that was left in its wake, those of us who look at the events that followed the Lehman bankruptcy decision and see that as a reason to push for resolution authority or other measures aimed to address systemic risk are being disingenious or dishonest about our assessments.  We watched these events play out before our very eyes.  I assume Mark did as well.

Mark concludes:

The debate over ending bailouts and too-big-to-fail will not progress, we will not learn a thing, if we let simple, empty assertion pass as fact.  Much of the public remains angry at Washington because those responsible, such as Bernanke and Geithner, have never laid out a believable or plausible narrative for the bailouts.  It always comes back to “panic.”  If we are ever to hope to return to being a country governed by the rule of law, rather than the whims of men, then we need a lot more of an explanation than “panic.”

I think that we can look at the events that transpired when the markets were near a complete meltdown and see what happens when investors, lenders and other capital sources panic.  They head for the exits.  They sell en masse into a market with few or no buyers.  They deleverage.  They hoard cash and attempt to reduce their own cash.  They refuse to allocate capital.  These things can happen in extremely volatile markets and, as the events surrounding the Lehman bankruptcy demonstrate, these events can be triggered if a firm that a market sees as posing a systemic threat if allowed to fall in bankruptcy does fall into bankruptcy.

Those concerned about financial stability and the rule of law should not support “doing nothing” when there are financial firms whose failure can spread through the financial system and the economy as a whole like wildfire.  Such an idea is dangerous, irresponsible and, frankly, stupid.  Assuming that we will still have institutions that are too big to fail, we need a way to step into a situation where such a firm is failing before the damage gets too widespread.

I may not have liked how the TARP program was implemented but I agreed with those who argued for federal intervention that ultimately became TARP.  Unlike their opposition, they seemed to have a better understanding of the perils we were facing.