Lehman And The Money Funds

Secretary Paulson's decision to let Lehman fail made sense to me. If Treasury and the Fed bail out creditors to every institution of any prominence, it becomes impossible to credibly suggest that they won't do so again in the future. Lenders would be free support any amount of leverage provided the borrower is large enough, and the government would be writing deposit insurance for them no matter how risky the enterprise. It's a recipe for excess leverage supporting the riskiest possible assets.

But Lehman's collapse contradicted conventional wisdom. Last week I heard Bob Rubin tell Charlie Rose that if you save Bear's creditors, you would probably save Lehman's, which certainly sounded plausible. Since then Treasury's decision has been justified by the argument that the markets had time to prepare for Lehman that they didn't have for Bear. But that's belied by the losses from Lehman paper to Primary Reserve. Maybe they were the only fund with such exposure, and if so, maybe they were just stupid. But I'm also hearing that money fund exposures to AIG were part of that bailout decisions. If a money fund that big thinks the government will support Lehman, then the government's signals aren't getting through with enough clarity.

Note to self: if Treasury Secretary, adjust rhetoric to nudge money fund holdings into general correspondence with internal information on borrower soundness.

Financial crises are too fluid for simple decision rules. But the principles driving those decisions ought to be clear enough that players can make reasonable predictions. The ability of conservative players to accurately find the boundaries of safe decisions is one acid test of that clarity. Maybe the most important -- if the point of all this is to stabilize markets, then shouldn't investors be able to know what they can and can't count on? I question whether the possibility of a Lehman or AIG collapse, without government support, has been communicated by Treasury with enough clarity so that investors as conservative as the money funds would know enough to steer clear. And if Treasury and the Fed aren't communicating the rules of the road, then it is no wonder that the markets are confused, and looking first to their own safety.

Letting Lehman fail might have been a good decision. Letting the government's tolerance of that failure surprise anybody was not. Secretary Paulson has constantly been emphasizing the soundness of the system, for understandable reasons. But perhaps it would have been well to note that the bailout of Bear's creditors was motivated in part by the lack of time to prepare. That would have caused short term problems, as investors moved against the possibility of failures without government support. But it might have laid better ground for a sustainable solution to all this.

Sending these signals is a difficult blend of encouraging realism without inspiring new doubts. Setting these policies is a balance between meeting today's challenge while writing the rules for the next challenge. It isn't easy. But it seems to me that Secretary Paulson is relying chiefly on building up the market's confidence, without underwriting that confidence with a government guarantee. It might be better to do more to encourage market players to move toward positions that are secure without such support from the government.