What Caused the 2008 Collapse?

The policymakers in both Bush and Obama administrations have argued that without the Fed and strong Treasury intervention the U.S. economy would have fallen into a sink hole when Lehman collapsed. In yesterday's Wall Street Journal, John Cochrane and Luis Zingales provided an argument that that I agree with. It was not the collapse of Lehman but was instead the panic shown by Bernanke and Paulson that led to the collapse. Two weeks prior, on Sept. 7, the government took over Fannie Mae and Freddie Mac, wiping out much of their shareholder equity. On Sept. 16, the government bailed out AIG, lending it $85 billion. On Sept. 25, Washington Mutual, the nation's sixth-largest bank, was seized by the FDIC. On Sept. 29, Wachovia, the nation's seventh-largest bank, was sold to avoid a similar fate. All this would have happened without Lehman. http://online.wsj.com/article/SB10001424052970203440104574403144004792338.html





This was not a logical, step by step action to stop systemic problems. It was pure and simple, PANIC. Their panic went against the basic foundation of a market system. It created the feeling that private property rights were unsecure; that could be confiscated at any time. To cement this feeling that private property rights were not secure, the Federal Reserve and the Treasury Department went to Congress to ask for $700 billion for the Troubled Asset Relief Program (TARP).



Cochrane and Zingales provide the graph shown below illustrating the point. On Sept. 22, bank credit-default swap (CDS) spreads were at the same level as on Sept. 12. (CDS spreads are the cost of buying insurance against default.) On Sept. 19, the S&P 500 closed above its Sept. 12 level. The Libor-OIS spread—which captures the perceived riskiness of short-term interbank lending—rose only 18 points the day of Lehman's collapse. But, it shot up more than 60 points from Sept. 23 to Sept. 25, after the TARP testimony. (Libor—the London Interbank Offer Rate—is the rate at which banks can borrow unsecured for three months.)