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Three thoughts on Lehmans’ collapse

1. One feature of the credit crunch is that the worst of the distress has been felt not so much by hedge funds but by Fannie and Freddie, some insurers, and the quoted investment banks; three of Wall Street’s “big five” have now disappeared. 

This is not what the chattering class expected: 2-3 years ago, lots of experts claimed that hedge funds were a big source of systemic risk. They seem to have been wrong (so far!)

Could this vindicate my point that this is a crisis of ownership, not markets? Big sprawling investment banks were unable to overcome principal-agent problems, whereas in hedge funds the division between ownership and control is less sharp, so these have (generally speaking, touch wood) been less vulnerable to disaster. (Not that their returns have been great, but that’s another tale.) 

2. There’s a contrast between the dramatic collapse of Lehmans and the undramatic stock market reaction. Although Lehmans' troubles are a roughly once-in-a-century event, the FTSE 100, as of now, is down a mere 2.7 per cent. This is only a 2.2 standard deviation event (assuming 20% volatility) – the sort of thing that happens 3-4 days a year.

One reason for this muted reaction is that markets believe the Fed and US Treasury will do anything necessary to stop a wider crisis – a belief corroborated by the nationalization of Fannie and Freddie.
This in turn suggests we should regard stock prices not so much as the discounted value of future cash flows, but rather as the probability-weighted price of a bundle of state-contingent securities. The reason for the market’s muted reaction is that traders believe the probability of a catastrophe – thanks to state intervention – hasn’t increased much.

3. What impact does financial distress have upon economic growth? Anatole Kaletsky is moderately optimistic. My instinct is to agree; what we’re seeing is a destruction of “insider assets” (banks’ bets with each other) rather than of the assets that drive economic growth outside the financial sector.

However,  this new paper from Fed economists suggests we might be wrong: financial distress can have big economic effects.