The accepted narrative is that, after Lehman Brothers filed for bankruptcy in
September 2008, the American financial system teetered on complete collapse. Only
massive federal intervention prevented it from imploding.
This narrative is the premise underlying extensive regulatory reform for American
financial institutions and markets, such as recently passed the House of
But now that, a little more than a year later, all the major financial institutions
have or are in the process of repaying the capital given to them under the Troubled
Asset Relief Program, it's worth kicking the tires a bit on the accepted narrative.
The Lehman bankruptcy supposedly froze credit markets. The commercial paper market
was roiled for awhile when the assets of one money market fund, with exposure to
Lehman, dipped below par. And short-term interbank lending rates did shoot up for
Stanford economist John Taylor has convincingly established that the latter wasn't a
result of the Lehman bankruptcy. Instead he attributes it to all the uncertainty
about the federal government's response to the Lehman bankruptcy, which did set off
a deep stock market decline and panic in Washington.
In any event, there's little evidence of an overall credit crunch in the numbers.
Total business debt outstanding went up in the two quarters following Lehman's
bankruptcy. Even today, it exceeds what it was in the quarter preceding the
The first decision of the federal government following the Lehman bankruptcy was to
bail out AIG. AIG had liquidity problems because it had insured various
collateralized debt obligations that were losing market value. The counterparties
were mostly large financial institutions. The losses to which AIG's illiquidity
exposed them were relatively minor compared to their overall operations.
Nevertheless, the federal government made them whole to keep AIG from going
AIG had pension and commercial paper obligations about which federal regulators
worried. But AIG was not a bank, wasn't a big player in financial markets, and was
subject to protected reserve requirements in its insurance products. Hard to see a
limited AIG bankruptcy as something that would have toppled the entire financial
structure of the United States.
And then there was TARP. The first TARP capital infusions were made in mid-October
2008. At the time, Treasury Secretary Henry Paulson said that the big banks
accepting them were healthy. They were accepting the infusions to make it less of a
stigma for financial institutions that really needed the help. There are indications
that federal officials didn't really believe that was the case, that they believed
that these large institutions were in trouble themselves.
Either way, this is deeply disturbing. Either federal officials forced healthy banks
to take taxpayer money to obscure from investors and depositors the true financial
condition of other banks, or federal officials were lying about their perception of
the true financial condition of these financial institutions.
Several of these large financial institutions had paid back their TARP money by
June, with interest and a premium to buy back the stock options given as collateral.
The last two large financial institutions, Wells Fargo and Citigroup, announced
plans to do so this week.
If our financial system was teetering on collapse, how did the largest financial
institutions in the country get so well so fast? After all, this occurred in the
midst of a severe recession during which demand for financial service products has
Some look at this and say, it proves how effective the government intervention has
been. That's one explanation.
Another is that excessively lax monetary policy and careless federal activity in the
secondary mortgage market (Fannie Mae and Freddie Mac) created a bubble in
collateralized debt obligations. When the bubble burst and the sorting out began,
Washington panicked and overreacted. And the reason financial institutions recovered
so quickly in the midst of a severe recession is that they weren't as sick as
Washington thought to begin with.
The chronology and the facts more comfortably fit the latter explanation than the