Was letting Lehman collapse a mistake? Some evidence

There is disagreement in the academia whether letting Lehamn Brothers collapse in September 2008 was a policy mistake. Moral hazard fundamentalists, as Larry Summers would call them, believe that nothing was wrong with it, and that Lehman paid for its mistakes. Other authors believe that it was a terrible mistake, as explained by Micheal Burda in ths VOXeu column in October 2008. John Taylor believes that it was not the collapse of Lehman per sè the mistake, but the confused policy reaction by US authorities in the aftermath (you let one bank fail, then you rescue AIG, what's this, schyzophrenia?). There are truisms in every of this position. The problem is, we are facing now a credit crunch, and no policy response has been effective to heal it. But was letting Lehman fail a cause behind the current credit crunch?

A recent IMF working paper provide some casuality between the two events. The authors show that, after September 2008, Investment Banks like Morgan Stanley, Merryl Linch, Goldman Sachs, have seen a sharp drop in the amount of collateral received that can be pledged in their prime brokerage activities. These Investment Banks in facts, act as a prime dealer for the Hedge Funds, in that they are able to provide securities or cash the hedge funds need to borrow to finance their investments. The Banks lend to Hedge Funds and get in exchange some collateral ,which they can more or less re-use (rehypothecation in jargon) to finance their own activities without limits. Feeling pressure from investors, after Lehman's collapse, Hedge Funds have seemingly reduced their collateral exposure to Investment Banks (putting these assets in segregated accounts so that they cannot be rehypotecated) , and Investment Banks are finding it harder to raise liquidity on the market because of the shortage of high quality collateral (and also probably because of higher costs of financing as a consequence of higher counterparty risk). This means, lack of high quality collateral, higher counterparty risk, overall liquidity is drying up and we are in the midst of a credit crunch.

Thus, the policy response of providing liquidity, surely alleviated the symptoms, but did not solve the whole problem. Making the less liquid assets again tradable, as the Brady Bonds were meant to be, would have surely reduced better this disordered delevaraging and avoided the current credit crunch.