Contagion risk

By Eric Crampton 03/10/2012

Why bail out banks and financial companies? Capitalism is about profit and loss; if you bail out the losers, there’s no end to the cost. Well, unless there’s substantial risk that one bank’s falling over wrecks the balance sheets of a pile of other banks, inducing them all to fall over too.

U Southern Carolina’s Jean Helwege presented at Canterbury this past week. She and Gaiyan Zhang painstakingly went back through the balance sheets to examine the real contagion risk of Lehman’s failure. Financial theory tells us that no firm will want to have too much of its balance sheet in any one asset. That’s one of the main points of the Capital-Asset Pricing Model: you diversify away from non-systemic risks. And, regulations on banks and financial services mandate that they not have all of their investments in one place. So it wasn’t all that surprising then that there really weren’t any firms at strong risk of going bankrupt if their Lehman paper stopped being worth anything.

They open with Bernanke’s analogy from a CBS interview:

Interviewer: “Mr. Chairman, there are so many people…who say, ‘To hell with them. They made bad bets. The wages of failure on Wall Street should be failure.”

Bernanke: “Let me give you an analogy. If you have a neighbor who smokes in bed…If suppose he sets fire to his house, and you might say to yourself, you know ‘I’m not going to call the fire department. Let his house burn down. It’s fine with me.’ But then of course,…what if your house is made of wood? And it’s right next door to his house? What if the whole town is made of wood?…What needs to be done to make sure this doesn’t happen in the future? How can we fireproof our houses? That’s where we are now. We have a fire going on.”

Turns out, there were already pretty big fire breaks and sprinkler systems in place; we seem to have paid for expensive water-bombers to put out fires on worthless garbage barges out at sea.

They conclude:

We find that counterparty contagion is significant but limited in magnitude. This owes to the fact that most of the counterparties have rather small exposures to the bankrupt companies. The largest exposures, revealed in the list of the largest unsecured creditors in the bankruptcy petition, often belong to the trustees of publicly traded bonds and since these bonds are widely held, the exposure of a single financial firm is substantially smaller. Outside of the trustees, we find that many of the creditors are financial firms, which supports the description of financial institutions as highly interconnected. However, financial creditors are rarely at risk of failing as a result of another firm’s troubles because these  firms hold diversified portfolios, as is often required by regulation. We find stronger counterparty contagion effects for Lehman Brothers and AIG but even these extreme events did not involve sufficient counterparty contagion to cause numerous cascading bankruptcies in the financial system.

We could laugh at the Americans, but we did have our own particularly ridiculous bailouts here in New Zealand.

In related news, I probably have the only kids on the planet who can be encouraged to eat the less tasty parts of their dinner on the promise of getting to watch this one for the n= (large and increasing)th time:

It is ridiculously cute when a 2.5 year old girl pleads for “Keynes and Hayek!”

Best is when she demands the video with breakfast; no better way to start the day, really. “Eye of the Tiger” for economists.

Posting will remain light while I remain mired in grading hell.