Robert Pozen on Lehman Brothers

In his new book he writes:

In my view, the adverse repercussions of Lehman' failure could have been substantially reduced if the federal regulators had made clear that they would protect all holders of Lehman's commercial paper with a maturity of less than 60 days and guaranteed the completion of all trades with Lehman for that period.

As I interpret that recommendation, it is to guarantee the obligations which are vulnerable to run-like behavior, but not to guarantee debt obligations more generally.

Here is my previous post on Pozen's fine book.

Addendum: James Kwak comments.


In principle is this any different than a bankruptcy?

The hope is to avoid standard bankruptcy. But it is no different than FDIC, which is like bankruptcy insurance for banks. The could have guaranteed the short notes from Lehman's other assets, much like the government will claw back the early claimants of a Ponzi scheme.

Point being, the government already does this and could have done it for no loss of liberty. The crime of lending long and borrowing short already happened. There was no virtue in victimizing the investors that could have kept Lehman solvent. That would have coordinated a solution to the first-mover dilemma.


My point is that the government always defines seniority in a bankruptcy process. Bankruptcy by definition is when contracts are broken. The government is asked to pick up the pieces. For a bank, if there is no run, then everyone gets paid. If people provide short-term lending, then there is no run. They don't because short-term is exactly the stuff that has low seniority. They don't do this because there is uncertainty about who is going to get paid. So, there is a run and people are hurt. The government could have eliminated the uncertainty. They should have done it years ago. They have responsibility for the bankruptcy system, perhaps one of their few legit purposes (we don't really want bankers shot in the street). Or, they could have done it johnny-on-the-spot.

Short-term lenders may not be the appropriate people to put the full responsibility of due diligence on, especially in a crisis. Again, the government already defines property rights in a bankruptcy. There is moral hazard with bankruptcy protection. The long-term bondholders and management would be chastened in a debt-for equity swap and would go to the government for a speed protection sparingly, or any number of other infinite possibilities for incentives.

In fact, there really is no moral hazard risk for banks because "we" want them to borrow short and lend long. "We" want them to get back to doing what got them in trouble as quick as possible, because we have not viable alternative for matching capital to borrowers. We just want the dumb lending to stop, but banks don't really determine that, at least not anymore. The moral hazard is built into the system. That's what makes them special. If you want to talk sound money or free banking, that's another debate. That's not a debate anyone with power is having.

What I am suggesting is completely independent of any evaluation of who is a systemic risk (big) and how good their lobbying is and picking the winners (connected). It is something the government can and should have already done. What I'm talking about is laying out guidelines for investment time horizon and seniority and the due diligence responsibilities that will be enforced upon the request for emergency bankruptcy protection.

One of the points missed by a lot of people is that many people deposit money in a "bank" that does not have FDIC insurance. I believe Posner calls is a "21st bank" or maybe it was someone else, but it was "invented" circa 1970 when inflation was outstripping Regulation Q.

The bank of NO FDIC is called a money market fund.

While initially money market funds were quite restricted to prevent them from being like a checking account or even a demand deposit savings account with regulation, which most money fund managers liked, but over time, the fund managers wanted more checking like convenience to get deposits and the regulators were lulled into believing money market funds were as safe as bank checking accounts or in some cases, I'm sure people thought they were safer because they were lightly regulated and the depositors were much more sophisticated and thus not going to put their money in a risky fund.

So, which money market fund suffered a bank run that broke the bank? The very first and longest running retail money market fund: Reserve Primary Fund. And the run on that bank triggered a run on all the other NO FDIC banks, so that is when I'm sure the law was broken.

The ultimate in "moral hazard" was the Treasury using the Exchange Stabilization Fund to provide the "FDIC insurance" after the fact to money market funds, on September 19, 2008.

I have not seen a single commentary that says the government shouldn't have acted on September 19, and just let the fund managers and if necessary the SEC, the courts, and the bankruptcy courts resolve who gets what and when, like has been happening with the several funds associated with Reserve Primary Fund.

I can only assume that almost all the critics have deposits in the "NO FDIC" banks and while they are happy to criticise the FDIC and all the other government interventions, they don't want to condemn the government intervention that saved their money market fund deposits.

And it was Reserve Primary Fund that acted as Lehman's checking/saving deposit manager, as well as others of the investment banks who were near collapse.

It just seems to me the idea that "if only the government didn't offer all that evil moral hazard insurance and explicit and implicit bailout protection, people would make only safe investments by depositing their money in no risk banks" is all a bunch of hooey.

Until I see a lot condemnation of that September 19 Treasury action insuring money market funds which is certainly illegal, I think all the critics are hypocrites.

I agree that Bob Pozen has done a great job with this book -- it's not only an insightful analysis of what happened, but also full of carefully considered recommendations for change. One part of it is excerpted in October's Harvard Business Review (addressing the mark-to-market controversy). Pozen has also been blogging other of his ideas at HBR's web site. Here's the URL:

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