But Lehman has to go. In the “larger interests” of continuing a vibrant, risktaking and efficient worldwide financial system, it is best that the Fed does not bail out Lehman.
I had written about this a few months back, in hindsight, after Bear was bailed out by Fed who arranged for a hurried takeover by JP Morgan. Given that Lehman is still alive, though just, I think it’s time to revisit the arguments that I had made there. Quoting from the earlier post:
However, I think the easiest method of regulating these banks would have been to convince them that they are not too big to fail. Yes, they allowed Bear to almost fail, and its shareholders almost got wiped out. However, my belief is that this episode will be quickly forgotten and people will be back to the same old risky practices once the current crisis is over.
Most wall street banks used to function under the assumption that they are “too big to fail” and that if they make huge losses, the US Taxpayer would somehow bail them out. This led to the oft-repeated unhealthy scenario of “private profits, socialized losses” and encouraged extremely risky behaviour. The Bear bailout has set a bad precedent in this regard, and might lead banks to go back to their bad habits once they are out of the current crisis.
Then, I had written that
What if Bear would have been allowed to fail? People with whom it transacted would have all lost tonnes of money. So how would that have helped? Basically, in future, banks would become more wary of counterparty risk. They would be continuously monitoring each other. If one guy behaved badly, other banks would stop talking to him. Which would push up the level of everyone’s behaviour. I think being boycotted by your friends is a bigger punishment by being caned by the teacher.
The near-failure of Lehman has presented the Fed with an opportunity of setting right the mistakes that it did when it arranged the Bear bailout. They are lucky that there is an investment bank, not too large, which is on the brink of failure, and whose complete failure can change the way wall street functions.
I hope Lehman doesn’t fail. I hope they manage to do something on their own, or arrange some sort of funding, to pick themselves up from this crisis. However, if these efforts fail, they should be allowed to fail, however ungracefully. A bailout can only worsen the way major investment banks function.