Sunday, February 14, 2010

Mind-Boggling Nonsense from John Cochrane

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."


Konstantin said...

Thanks for the overview, this is quite an insiteful stuff

Don said...

Thank You!

Don the libertarian Democrat

Adam P said...


unauth said...

"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"

Not if there are blog posts like this, they won't
(from a grad student in another school)

Anonymous said...

LOL. I am supposed to be impressed by a blog with a following that spells "insightful" as "insiteful". Learn to spell. Learn some economics. Then come back and comment.

Anonymous said...

^ The spelling is irrelevant; however, the economics and finance is correct. Cochrane is completely clueless about how markets work.

If I were going to be personal and pissy, I would say that he is (or was) an OK physicist; but, he couldn't make tenure in economics so he moved to finance, married Gene Fama's daughter, and started parroting his father-in-law's unbridled belief in the EMH. Then, even as Fama became less of a proponent of the EMH, Cochrane became a more strident supporter.

But that's all ad hominem. As for facts: Why would a Lehman bankruptcy cause problems at other banks? Because losses cause banks to attempt to deleverage; that may not be successful; and, that failure could in turn affect the second bank's counterparties. That is obvious to anyone who has seen markets work up close. Cochrane, however, seems to prefer dogmatism to markets.

sless said...

Actually, the loss of liquidity that arose because of Lehman Brothers bankruptcy is more extensive than most estimate. see,Manmohan Singh and James Aitken, Deleveraging after Lehman—Evidence from Reduced Rehypothecation, IMF,WP 09/42,at 7("This decline stems from their own counterparty risk, mandate constraints from their clients, and the deleveraging that is taking place. This reduced liquidity of over $2.5 trillion in the United States banking system alone, adds to the cost of funding in the financial system")

Anonymous said...

The fact that you take the least relevant snippet of the article and decide to trash the "clueless and theoretical" academic shows the petty nature of this blog post. Read the full thing and get a clue.

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Anonymous said...

A few months ago, I went down to our very nice public Library (I live in Newton, MA, home to many harvard/mit/bu profs)

looking for a macro textbook; I found Taylors book.

I browsed it, and found a table showing various regulations concerning workplace chemicals, and the cost per life saved, and how many of these onerous gov't regs had very poor cost benefit profiles

Taylor rated the OSHA/EPA rule restricting the use of formaldehyde as the worst example of gov't policy,on the grounds that hundreds of millions of dollars would result in a handful of lives save.
(I'm doing this from memory...sorry if I'm a little off on some numbers)

Turns out, the Formaldehyde rule had nothing to do with number of lives saved, it had to do with reducing non fatal repiratory illness, and when you did a cost benefit, it looked pretty good

so much for Taylor

Richard Gregory said...

I too, found myself staggered by the thought that two very good economists would make such statements without apparently researching the subject. Even ignoring the LLPs that went out, AIG's near failure, the waves of bank mergers afterward, should have been testament to the effects of Lehman. Plus , the fact that no buyer could be found for Lehman should clue you into just how toxic its balance sheet was.....

Peter Deppisch said...

Even professors of economics have a mindset and it is always the mindset that dominates the thinking. They write to prove their that their worldview is the only correct one.
During WW I the British Army Staff planned the battles from London looking at maps. And supposedly after the war when they did travel to the battle areas they exclaimed: My God, we did not know it was like this!
You either spend 10 years of your life on the trenches of the industry you write about or you stay in academia and build models that have very silly assumptions about the rationality of humans!
My favourite quote:
You can lead a horse to water but you can't make him drink unless it is the right kind and approved watering hole!
Yes - it boggles the mind that 80 years after the Great Depression there is no agreement on what caused it and what cured it!

EverywhereOnce said...

Rather than "the least relevant snippet of the article" it actually goes to the heart of his argument. Cochrane's position is that everyone lent to Goldman and Lehman etc. under the assumption that they'd be bailed out and it was the surprise at Lehman's failure that caused a run on the financial system. This is not at all what happened.

Pre-crisis, nobody thought any of the investment banks were too big to fail. Nobody. Fannie and Freddy, on the other hand, had implicit government guarantees. Everyone understood these institutions would be bailed out. As a result, Fannie and Freddy enjoyed credit spreads much narrower (cheaper) than the big banks and far narrower than the investment banks. A simple glance at the kind of returns investors were charging pre-crisis for true government credit risk (treasuries), angencies (Fannie), large banks (Citi), and investment banks (Lehman) tells you that the market judged default risk very different among all of these types of institutions. If, however, the market judged them all "too big to fail" they'd have paid roughly the same credit spreads as Fannie. That they did not, tells us Cochrane has badly misread what happened.

Full Employment Hawk said...

The fundamental problem with economics is that dogma plays much too large a role and genuine science plays much to small a role.

Taylor acted as a scientist in the past and made important contributions to the field, but now has switched to being a complete ideologue. On the other hand, Cochran appears to be an ideologue and nothing else.

John Emerson said...

Most Americans are, as I am, in the same position in relation to economists as we are in relation to doctors. We are pretty much at the mercy of experts whose work we don't understand.

I trust MDs, though I have some interest in alternative medicine in the areas where it conflicts least with standard medicine.

The case is quite the opposite with regard to economists. I don't understand economics any better than I do medicine, but I can't have any trust in the profession as such, given the enormous and extremely consequential disagreements being expressed within the profession.

My response has been to gamble on the economists I agree with most politically, while giving special favor to the most unorthodox (Mirowski, Keen, Bowles, Baker, et al). But that's obviously a shot in the dark.

What this all really means, in my opinion, is that the post-WWII technocratic Federal Reserve fantasy has popped with the housing bubble. It's a perilous situation, since the Koch / Paul goldbugs also mistrust the Fed, for different reasons. But I think that the most deluded are the complacent centrists who trust the status quo.

Peter Principle said...

"Next, let's take Cochrane's bizarre attempt to minimize the importance of the obvious knock-on effects from Lehman's bankruptcy"

I'm tempted to make an insulting comment about "pointy headed Ivy League professors who never had to meet a payroll (or settle a trade)." But that's the kind of thing conservatives say.

Anonymous said...

"The fact that you take the least relevant snippet of the article and decide..." Odd for an academic to put the least relevant snippet at the very start of of his explanation. Or maybe you are just an idiot.

Unknown said...

Remember 'Inside Job'; the point is not that Cochrane and Taylor are idiots, but who is paying them to be useful idiots - you don't really think they believe what they're saying, do you? A little background investigating into the source of their funding, who they work with, who they advise financially will tell you exactly why they make this stuff up - whose bitches are they?

Anonymous said...

People are forgetting the Big Short. Burry was trying to place his CDS shorts in the fall of 2005. Most of the Street didn't know what he was talking about, the mortgages were money good. GS hired auditors to look at the origination and they found fraud in 50%. Early in 2006, non-conforming lending began to tank. Mudd from Fannie went looking for conforming loans, Mozilo told him he had a pile of ALT-A to take off his hands. The word spread on the Street and any loan including internal portfolios were being securitized and dumped. Nobody blew the whistle because someone maybe making money. In early 2007, GS was trying to sweat collateral payments out of AIG even though the rating agencies had not downgraded any of the securities. In other words, the gun was cocked and the Street was waiting for the trigger to be pulled. It is not clear Lehman knew what was going to happen, they specialized in these crank loans. In the meantime, the banks were into commodities with gas predicted to go to $5, scaring the consumers who were rationing trips to the market. Once Lehman went down, no one knew who would remain solvent. Once the value of collateral began dropping, the contagion spread to a much wider selection of mortgages. The consumers had closed their pocket books, retail sales were dropping and in the Spring the lay-offs began.

Serious job displacement started in the 1990's but the FIRE sector absorbed some of those displaced workers but the semi-skilled were in a precarious position. Workers were down-scaling and accumulating debt to stay afloat. We had full employment in 2000 and by 2003 Bush was frantically trying to push through tax cuts to boost employment. For a few years the boost in Real Estate provided jobs. We had built a house of cards with debt.

gaius marius said...

the question is rapidly degenerating to a choice between, "are cochrane and taylor stupid?", or, "are cochrane and taylor acting stupid willfully?" -- and further, "is there a difference?"


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Anonymous said...

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But that's all ad hominem. As for facts: Why would a Lehman bankruptcy cause problems at other banks? Because losses cause banks to attempt to deleverage; that may not be successful; and, that failure could in turn affect the second bank's counterparties. That is obvious to anyone who has seen markets work up close. Cochrane, however, seems to prefer dogmatism to markets. 2013 Cheap Jerseys Wholesale

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