Wednesday, May 4, 2011

Lehman and Bear Were Not Considered “Small” Before 2008

I’ve seen several people — most recently Larry Summers at INET’s Bretton Woods Conference — make an argument that, I have to say, I think is utterly daft. The argument is that before 2008, no one would have considered Lehman or Bear Stearns “too important to fail.”

Summers, in his discussion with Martin Wolf, stated that “Lehman, [which] was less than 2% of the US financial system, would not have been ‘too big to fail’ on anybody’s theory.” Avinash Persaud provided an even cleaner version of this argument, writing that “Any list conjured up in 2006 of institutions that were ‘too big to fail’ would not have included Northern Rock, Bradford & Bingley, IKB, Bear Sterns, or even Lehman Brothers.” And the Cato Institute’s Mark Calabria has also made this argument with respect to Bear Stearns.

I’m sorry, but Lehman and Bear Stearns were both widely perceived to be too important to fail before 2008, and anyone who tells you otherwise doesn’t know what they’re talking about. Lehman and Bear were two of the 14 or so major dealer banks that serve as the critical nodes in the global capital markets. Everyone knows who the major dealer banks are, and everyone knew that Lehman and Bear were part of this group. (The fact that Lehman and Bear were two of the smallest major dealers is irrelevant; someone’s always going to be the smallest, and size is hardly the only, or even the most important, factor in determining whether an institution is too important to fail.) In fact, had most market participants been asked to compile, à la Mr. Persaud, a list of TBTF institutions back in 2006, I expect the first thing they would’ve done was add all the major dealers.

It wasn’t just that the majority of market participants knew how massively disruptive it would be for one of the major dealers to have to unwind itself in bankruptcy. It was also that prior to 2008, the failure of one of these massive global dealers was something that was simply inconceivable to a lot of market participants.

I honestly don’t know anyone in the market who legitimately believed that the Fed would let Bear Stearns just chaotically collapse into bankruptcy. (And the same would’ve been true of Lehman had it been the first one to implode.) There’s a reason that when Bear Stearns started to implode in March 2008, everyone in the market kept saying, “The Fed is going to do something, right?” It’s because Bear (and Lehman) had long been considered too important to fail.

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