John Cochrane on the Financial Crisis
University of Chicago Professor John Cochrane explains the causes of the financial panic and how two mistakes turned what might have been a mild recession into a deep recession.
The short form is:
- Failure to bailout Lehman Brothers after bailing out (or at least appearing to) Bear Stearns.
- The chaos surrounding the TARP legislation.
Cochrane points out that the bankruptcy of Lehman was nothing special in an of itself. Many of Lehman’s operations were back up and running within days under new owners. Overall, it was unremarkable save for a few glitches here and there. What was really problematic though was that initially the government had signalled that it would bailout large financial entities under the “too big to fail” belief. Then when Lehman indicated it was in trouble the government not only didn’t act, it claimed it didn’t have the legal authority to act. Basically the belief that the government saw large financial entities were “too big to fail” was in serious doubt and people panicked.
After that the TARP mess just made things worse. As Cochrane puts it,
Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, and President Bush got on television and said, basically, “The financial system is about to collapse. We are in danger of an economic calamity worse than the Great Depression. We need $700 billion, and we won’t tell you what we’re going to do with it. If you need a hint, we justmade it illegal to shortsell bank stocks.”
These speeches should be remembered as a case study in how to start a financial crisis, not how to relieve one. In the Washington context theymay havemade sense, and I understand and sympathize with the awful position that Bernanke and Paulson were in. I suspect that they wanted legal authority to bail out the likes of Lehman and they needed to scare Congress into giving themthemoney, even as stubborn rightwing fiscal conservatives like Barney Frank were saying impolite
things like, “No one in a democracy, unelected, should have $700 billion to spend as he sees fit.” Alas, the speeches scared everyone outside the Beltway too.
And these kinds of things did not start recently. As has been noted before this has happened before. In 1998 the government bailed out Long-Term Capital to some financial fall out. You can read about it here, but the bottom line was that a bail out was arranged because fairly large amounts of money were owed to Bear Stearns, Merrill Lynch, and Lehman Brothers.
Cochrane’s look at mortgage backed securities and how things went so wrong there is interesting as well.
Third, it hides risk and avoids regulations, which may be much of its design. An institution that issues short-term debt to hold mortgages is what we used to call a “bank.” Why call it an spv? Because the regulations assessed lower capital requirements on spvs. This structure allows investors who really do want higher risks and higher yields, but are constrained by regulations that specify types (commercial paper) and ratings of individual securities they must hold rather than focusing on portfolio risk. Thus the regulatory system ends up encouraging artificial obscurity and fragility.
It is often claimed that “free, deregulated markets failed,” bringing about the housing collapse and financial crisis. In fact, the free, relatively deregulated equities market absorbed massive losses this time, as last time, with relatively little turmoil. It was the regulated, supervised part of themarket that failed.
I recommend reading the whole thing.