Lehman, Reserve Primary or TARP?

In the popular imagination, the crisis in the global financial markets in the last quarter of 2008 is identified with the collapse of Lehman on September 15, 2008. However, many perceptive analysts believe that it was not the collapse of Lehman itself, but the resulting collapse on September 17 of the Reserve Primary Fund (a large money market mutual fund) that was the real culprit. Finally, some revisionists like John Taylor have argued that the panic started not with the Lehman collapse but with the mishandling of the TARP legislation later in September.

William Sterling has a nice paper analyzing this issue relying on a broad index of financial conditions covering money markets, bond markets and equity markets. Taylor’s use of measures related to Libor was controversial because at the time, people joked that Libor was the rate at which banks did not lend to each other. I like the more comprehensive measure chosen by Sterling.

Based on this index, all three views receive some support, but on balance Sterling rightly concludes that the revisionist case is quite weak. The financial conditions index fell 9.85 points when Lehman collapsed, and fell a further 10.37 points when the Reserve Primary Fund failed. If we regard these two as a single event, the fall in the index over the three days was 20.76 points. But the biggest single day fall was 11.77 points on the day that Congress rejected the first TARP bill. (The index is constructed as a Z-score so that each point change in the index can be regarded as one standard deviation move. Clearly, all three days are extreme tail events).

The most intriguing thing in the paper is the 12.68 point rise in the index on the day before a bailout plan for the money market mutual funds was announced. This is the largest one day change in the index in its entire history. It appears to me that this is indicative of insider trading on a truly massive scale. If this interpretation is correct, this insider trading would make Galleon look like small change.

Posted at 1:48 pm IST on Tue, 10 Nov 2009         permanent link

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