After reading John Taylor and John Cochrane's analyses Lehman's failure, I'm beginning to understand how it's possible for economists to say that "we're still arguing about the causes of the Great Depression." It's generally hard to come to an agreement when one side simply lies, or refuses to acknowledge undeniable facts.
I've already dealt with John Taylor's ridiculous claim about Lehman's derivatives counterparties. John Cochrane's "analysis" of Lehman's failure is equally fictitious:
Why would Lehman's failure cause a panic? Why, after seeing Lehman go to bankruptcy court, would people stop lending to, say, Citigroup, and demand much higher prices for its credit default swaps (insurance against Citi failure)? Nothing technical in the Lehman bankruptcy caused a panic. The usual "systemic" bankruptcy stories did not happen: We did not see a secondary wave of creditors forced into bankruptcy by Lehman losses. Most of Lehman's operations were up and running in days under new owners. Lehman credit default swaps (CDSs) paid off. Sure, there was some mess — repos in the United Kingdom got stuck in bankruptcy court, some money market funds "broke the buck" and had to borrow from the Fed — but those issues are easy to fix and they do not explain why Lehman's failure would cause a widespread panic. What is more, Lehman's failure did not carry any news about asset values; it was obvious already that those assets were not worth much and illiquid anyway.This is just mind-boggling nonsense. It's genuinely frightening that a prominent professor of finance can be so utterly clueless about modern financial markets.
Let's start with Cochrane's claim that there wasn't a secondary wave of failures after Lehman's bankrtupcy. First of all, that's not even true. Plenty of hedge funds failed as a result of Lehman-related losses. However, since they were generally structured as LLPs, they went into pre-defined liquidation procedures rather than filing for bankruptcy. But that doesn't make those failures any less real. Second, Cochrane, like Taylor, inexplicably ignores the fact that Lehman's biggest counterparties — the other dealers — were virtually all bailed out by their governments.
Next, let's take Cochrane's bizarre attempt to minimize the importance of the obvious knock-on effects from Lehman's bankruptcy — namely, the problems at Lehman's European broker-dealer (LBIE), and the run on the money markets. Contrary to Cochrane's assertion, it wasn't just "repos in the United Kingdom" that were affected by LBIE's failure. In addition to the 140,000 failed trades, over $40bn in prime brokerage client funds and assets were frozen by LBIE's administrator. That's $40bn that was suddenly and unexpectedly unavailable to hedge funds — and when you consider that hedge funds use their prime brokers to lever up, the end result is that LBIE's failure caused hundreds of billions in liquidity to suddenly vanish from the markets. It also caused other hedge funds to pull their money out of their prime brokerage accounts at Morgan Stanley and Goldman (the two biggest prime brokers), since they were now scared that they wouldn't be able to access their funds if either of the prime brokers failed. Investment banks used clients' prime brokerage accounts for funding (which is why prime brokerage accounts are called "free credits"), so when hedge funds started pulling their prime brokerage accounts, that was the equivalent of having counterparties stop lending to them.
And there was absolutely nothing minor about the run on the money markets. One of the biggest money market mutual funds, the Reserve Primary Fund, "broke the buck" because of losses on Lehman commercial paper. This caused a massive run on money market mutual funds, with redemptions totaling over $100bn. So the run on the money markets was directly attributable to Lehman's bankruptcy. As to why the run on the money markets would cause people to stop lending to banks like Citigroup, there are several reasons. The biggest reason the run on the money markets affected Citi's (and other banks') wholesale funding was that to meet the massive redemptions, money funds all drew down their backup lines of credit with banks at the same time. Institutional investors knew this, and started to pull back aggressively from the big banks in the wholesale funding markets. And then there were all the asset firesales by money funds...
(Cochrane's claim that these two problems were "easy to fix" further demonstrates how detached from reality he is. The vast majority of the prime brokerage client assets frozen by LBIE's administrator still haven't been returned yet. Not only was that problem not "easy to fix," but it still hasn't been fixed yet! Also, the money market funds never borrowed from the Fed. I know the structures of the Fed's various financing facilities are a bit complicated, but Cochrane is supposed to be a professor of finance at a prestigious business school, is he not?)
Finally, there's Cochrane's point that "[m]ost of Lehman's operations were up and running in days under new owners." Well, yes, Barclays did buy Lehman's core US units, and Nomura bought some of Lehman's Asian and European units — minus those pesky liabilities, of course! I'm not sure Cochrane knows this, but in a bankruptcy, the debtor's liabilities tend to be kinda-sorta important in determining how large an effect the bankruptcy has on non-debtors.
John Cochrane and John Taylor are both prominent economists, and they will no doubt convince legions of starry-eyed grad students that Lehman's bankruptcy was really only a minor event. John Taylor, at least, will no doubt also convince these grad students that the real problem was the government's handling of the bailout. And 80 years down the road, economists will be saying, "We're still arguing about the causes of the Financial Crisis of 2008."