Archive for September, 2013
Five years on, what can we learn from the collapse of Lehman Brothers? The conventional opinion is that we should have saved Lehman Brothers just like we saved the rest of the financial sector in the immediate aftermath of the Lehman collapse. But some critics assert that the decision to save Bear Stearns convinced everybody that Lehman would be saved when push came to shove. When this expectation was not met, chaos ensued.
Market data from March 2008 to September 2008 supports the critics. Lehman’s credit spreads halved between March and June 2008. Even when Lehman’s stock price started falling in May and June, its credit spreads barely reacted. The below graph (courtesy the WSJ) captures just how dramatically Lehman credit spreads fell in the aftermath of the Bear Stearns bailout:
The Bear Stearns bailout convinced everybody that Lehman would be treated no differently as a Wall Street Journal article from June 2008 explains:
The ouster of two top executives at Lehman Brothers Holdings Inc., including the person responsible for keeping the company’s books, sent the bank’s share price tumbling to a new six-year low, but the normally jittery bond market shrugged off the move.
While Lehman’s stock price fell 4.4%, investors were bidding up some of Lehman’s bonds, and the price of protection against default on Lehman debt ultimately declined on the day. It costs an investor $280,000 annually to protect against default on $10 million of Lehman debt for five years – down from $285,000 Wednesday, according to Phoenix Partners Group.
The tempered reaction in the bond markets underscores investors’ conviction the Federal Reserve won’t let a major U.S. securities dealer collapse and that Lehman Brothers may be ripe for a takeover. In March, when Bear Stearns was collapsing, protection on Lehman’s bonds cost more than twice as much as it does now.
Of course allowing Bear Stearns’ creditors to take a loss may just have brought forward the chaos of September 2008 to March 2008. Given that bank creditors had been bailed out in the United States since Continental Illinois this is entirely plausible. Nevertheless, the policy actions of 2008 made things worse. If an evil genius had taken over the world in March 2008 with the sole aim of causing financial chaos, he could not have done any better – bail out Bear Stearns, convince everyone that no failures will be allowed and then renege on this implicit promise six months later.
There are many schools of macroeconomic thought. Most people agree that some form of stimulus is needed during a recession but what should this stimulus look like? Is monetary stimulus sufficient or do we need fiscal stimulus as well? What should this monetary stimulus look like? Do we need quantitative easing? Or is effective monetary stimulus largely about conditional forward guidance as Michael Woodford and Mark Carney seem to think?
Macroeconomic stimulus in practise is however a one-trick pony that has almost no relation to the theoretical debate. In the developed world since the Great Moderation, macroeconomic policy can be boiled down to one simple rule – prop up asset prices. In the Anglo-Saxon world, the rule is even simpler – prop up house prices. Mark Carney may grab all the headlines regarding UK economic policy but the only policies that matters to the UK economy are George Osborne’s attempts to boost the housing market.
There is nothing novel about this. Alan Greenspan was always quite frank about his approach to monetary policy. For all the talk about Taylor rules and how central banking and monetary policy became a rule-based science in the 1980s, the reality of Greenspan-era monetary policy was much simpler and followed only one rule – do not allow asset prices to fall. Abenomics is simply the logical end-stage of Greenspan’s monetary policy doctrine. Greenspan only needed to cut rates when stock markets tanked but the Bank of Japan needs to literally buy equity ETFs and real estate investment trusts(REITs) every week to prop up the markets. The Bank of Japan would love to provide more support to the housing market but unfortunately its purchases are already too large for the REIT market. Maybe the BOJ could buy up the housing stock of the country and rent it back to the people of Japan? Maybe eventually all assets in capitalist “free-market” economies will be owned by the central bank? What could possibly be objectionable about such an economic system?