Lessons from the Fall of Lehman

As you have undoubtedly noticed, this week marks the one-year anniversary of the fall of Lehman Brothers–the moment at which the financial crisis became a severe economic crisis.

I did an interview on Fox Business on Tuesday to discuss some of the lessons learned. (My wife’s comment  on the interview: “You need to straighten your collar next time.”)

Going in, I had two basic points I wanted to make:

  • First, the fall of Lehman Brothers was the moment that the abstract threat of “systemic risk” became tangible to many policy makers and the public. As we progressed from propping up Bear Stearns to taking over Fannie Mae and Freddie Mac, many observers began to suffer from policy fatigue, and, in some circles, there was concern that the scale of the government actions might be disproportionate to the alleged, but little-seen, risk of a systemic crisis. That changed when Lehman fell, and the dominoes started toppling.
  • Second, we still have our work cut out for us. The major items on our to do list include:

(1) Taking steps to avoid such enormous shocks in the future (e.g., by increasing capital requirements and reducing allowed leverage for financial firms).

(2) Fixing the problem of too-big-to-fail (or, if you prefer, too-interconnected-to-fail). Unfortunately, this problem has worsened, in many ways, since the crisis began. Some gigantic firms have grown even larger. And the necessary interventions to prop up the financial sector have reinforced the idea that the government will prevent these firms from failing in the future.

(3) Disentangling the government from private firms, so that it can again act as a referee, not as a player. That will take time given the enormous investment portfolio that the government has amassed in financial firms and the auto companies. It is heartening, however, that even Citigroup is beginning to ponder how to raise outside capital and reduce the government stake.

4 thoughts on “Lessons from the Fall of Lehman”

  1. I’m in favor of Narrow/Limited Banking. Here’s a post from Peston today that recommends two works that I’ve already read and basically agree with:

    http://www.bbc.co.uk/blogs/thereporters/robertpeston/2009/09/banks_can_learn_from_retailers.html

    What we need is a modern version of the Chicago Plan of 1933. Alternatively, we could follow the ideas of Milton Friedman’s “A Monetary and Fiscal Framework for Economic Stability”.

  2. “That changed when Lehman fell, and the dominoes started toppling.” -Donald Marron

    Hello Dr. Marron:

    Regarding the ripple effects of the commercial paper market and the extent of the domino effect caused by its bankruptcy, I was wondering if you could comment on the view that Dr. Francis Longstaff [1] (UCLA/Anderson School) made on October 1, 2008 [2] (link provided in footnote) in which he called the Lehman bankruptcy “essentially a non-event” because counter-parties were able to renegotiate their Lehman contracts and that the problems in the commercial paper market existed before Lehman failed.

    I am curious to see if Dr. Longstaff’s view still has merit or has more evidence come forth making that view dated.

    Regards,

    Jim T., a student of economics

    ——–
    [1] Francis Longstaff is the
    Allstate Professor of Insurance and Finance at UCLA Anderson School of Management.

    [2] “Tackling the Current Economic Crisis.” Video of panel discussion at UCLA Anderson on Oct 1 2008. Dr. Longstaffs comment begins at 50:38 minutes. http://www.youtube.com/watch?v=21LGHitvcCY

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