The Lehman Lesson

Tuesday, September 16, 2008

THE COLLAPSE of Lehman Brothers, the venerable Wall Street investment bank, and the prospect that it could be followed by insurance giant AIG bring new uncertainties and new dangers to an already shaky global financial system. According to Lehman's freshly filed bankruptcy papers, the company owes a staggering $613 billion to 100,000 creditors all over the world, including bondholders who are owed $155 billion. Now all of these companies and individuals will have to settle for whatever they can get once a court is done supervising the sale of Lehman's assets, which are made up in large part of dodgy mortgages. Thus will Lehman's downfall spread financial loss and psychological pain around the globe, shrinking credit and crimping the capacity of both the U.S. and global economies to grow. Fear of those effects drove the stock market down more than 500 points yesterday.

Nevertheless, the U.S. government was right to let Lehman tank. Potential buyers for the firm wanted the Federal Reserve to grease the transaction by taking Lehman's bad loans onto its balance sheet -- much as it did when a much smaller investment bank, Bear Stearns, ran into trouble in March. Both Fed Chairman Ben S. Bernanke and Treasury Secretary Henry M. Paulson Jr. refused. Perhaps this was because of real differences between the two situations; Bear Stearns's collapse was relatively sudden and potentially shocking to the financial system, whereas Lehman's death has been foretold for months, giving investors more time to adapt and prepare. Or perhaps the nation's economic policymakers, having already bailed out Bear Stearns and mortgage giants Fannie Mae and Freddie Mac, simply chose Lehman to make the point that the government can't rescue everyone. Either way, we think they made the right call. The long list of bailout candidates, headed at the moment by AIG, confirms that policymakers were going to have to send this signal sooner or later. Merrill Lynch, thought to be the next target of the bears, seems to have gotten the message, accepting a merger offer from the better-capitalized Bank of America. Merrill's behavior contrasts starkly with that of Lehman, which tried to survive on its own for months -- until it was too late.

As we have said in previous editorials, federal bailouts can be justified, but only when the benefits to the financial system as a whole outweigh the potential costs -- as measured both in direct taxpayer expense and in "moral hazard," which is an economist's name for the risks companies take on when they think government will shield them from negative consequences. We have to hope that policymakers got that cost-benefit analysis right on Lehman; one lesson of the last year is that no one has a certain template to guide such decisions. Wall Street massively overcommitted to unwise investments. Undoing all of those mistakes will take time and cost billions of dollars -- on top of what investors and consumers have already lost. But the only thing worse than paying those costs would be pretending that they can be avoided.

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