Inside Financial Services

THE FDIC’S RESOLVE-LEHMAN SCENARIO REALLY DOES COME FROM FANTASYLAND

Simon Johnson points out that the hypothetical resolution of Lehman Brothers published by the FDIC last week is a load of nonsense:

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Simon Johnson points out that the hypothetical resolution of Lehman Brothers published by the FDIC last week is a load of nonsense:

[T]here are two major problems with this analysis: it assumes away the political constraint, and it ignores the most basic reality of how this kind of business operates.

At the political level, if you wish to engage in alternative or hypothetical history, you cannot ignore the presence of Henry M. Paulson Jr., then secretary of the Treasury.

Mr. Paulson steadfastly refused, even in the aftermath of the near-collapse of Bear Stearns, to take any active or pre-emptive role with regard to strengthening the financial system — let alone intervening to break up or otherwise deal firmly with a potentially vulnerable large firm.

This is of course exactly right. As Lehman teetered, recall, policymakers’ big concern had to do with the moral hazard that would be associated with a government bailout, not any second- and third- order effects that might occur if they let the bank collapse. Regulators had assumed that counterparties and creditors knew there was a problem (which they did), and had everything battened down (which, it turns out, they did not). So the government let Lehman go. The next thing you know, kaboom. Hank Paulson was as surprised by it as everyone else. Even if the FDIC had its new-and-improved resolution authority at the time, Paulson’s main concern still would have been moral hazard-and things would have happened exactly as they did.

The other problem with that idiotic FDIC report is that it assumes everyone stays rational during a time of crisis. That’s, well, crazy. Lehman collapsed because its liquidity providers were so jumpy that no one would fund it anymore, even overnight. If word had gotten out that FDIC people had arrived on the premises for a potential resolution, the bank’s liquidity would have been totally gone before anyone even opened the envelope of the living will. . . .

One Response to “THE FDIC’S RESOLVE-LEHMAN SCENARIO REALLY DOES COME FROM FANTASYLAND”

  1. Pat O'Brien

    When faced with the choice between a moral hazard or a run on the bank. I’ll take the moral hazard every time.

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