Via Jim Hamilton, Cochrane has a piece up at Cato that I find largely correct in its analysis of the crisis. In particular Cochrane states

Why did Lehman fail– along with Fannie Mae, Freddie Mac, AIG, Wamu, and very nearly Citigroup and Bank of America? Here is where I part company on the usual worries about bubbles, imbalances, silly mortgages, and so on.

The underlying decline in wealth from the housing bust was not that large…. Most estimates put subprime losses around $400 billion. The stock market absorbs losses like that in days. But it turned out that housing risks are spread very differently from stock market risks.

The difference is that mortgages were held in very fragile financial structures.

Perhaps, unusual for an academic economist, I watched the crisis unfold in real time. From the first rumblings in August 2007 until well after the collapse of Lehman I spent the better part of most days combing through the financial news.

Part of my role is to serve as an advisor to the North Carolina government and the key question on my mind from the start was whether or not this was going to affect employment in the Charlotte region. Even before it was clear that this would become an international, or even national crisis, it was clear that it would affect bank profits.

Certainly, at the time it seemed that fragility was the issue. However, I would go further and say it wasn’t just that the government didn’t bail Lehman out, it was that Lehman experienced what looked like a run. Moreover, it seemed at the time that the run was spreading. The money markets were reportedly in turmoil.

There was a rumor that Wachovia was offering 30% APR to roll over 7 day paper and could not find a buyer. From my perspective it seemed as if a liquidity crisis might be enveloping all of the major financial institutions in the United States. So much so, that warned my colleagues and contacts that we were “walking a fine line.”  And, it was not inconceivable that the entire global transactions infrastructure was going to come undone.

Now, its true that if there was a credible government guarantee that none of this would be a problem. However, from the Fed statements surrounding the Bear Stearns issue it was clear that the government was hesitant to engage in direct intervention.

Instead, I at least, felt a general sense that actually bankruptcy and short term creditor losses just “weren’t going to be allowed to happen.” I am not sure exactly what I would have been expecting. Whether that meant a last minute buyer pressured by the Fed, or action by the Treasury or  even something as fanciful as a private consortium of banks swooping in, in an effort to stave off systemic collapse, I can’t say.

The fact that nothing happened, however, was a shock.