Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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