Lehman's Fall: The What-Ifs Linger

What would the past year have been like if the government had bailed out Lehman Brothers? There's no easy answer

By Theo Francis and David Henry

Around every memory of Lehman Brothers' bankruptcy filing one year ago hangs the question: What if Lehman had been saved? Wouldn't we all be better off—and a little less stress-worn—than we are today?

It was Lehman's failure that was the immediate cause of the Panic of 2008, now a landmark in financial history. The credit markets had been rattled for months by the deterioration of the housing market and only a week earlier by the steps the federal government took to prop up mortgage financiers Fannie Mae (FNM) and Freddie Mac (FRE). But it was Lehman's bankruptcy that sent the global financial system into outright crisis mode.

When Lehman stopped paying on its commercial paper—the short-term corporate IOUs it used to borrow from money market funds—individuals and corporate treasurers alike rushed to withdraw their cash from money funds all over. The funds, in turn, scrambled for cash and took back what money they could from banks on both sides of the Atlantic, freezing up lending everywhere. In the following weeks, governments around the world had to take unprecedented steps, such as guaranteeing money market funds and pumping hundreds of billions of dollars into shaky banks, before the financial system would begin to thaw.

"We Had to Let It Fail"

Officials in charge at the time, from the Bush Administration and Federal Reserve, argue to this day they had no choice but to let Lehman fail. They say they lacked the legal authority and funds to intervene with the investment bank. Fed Chairman Ben Bernanke told Americans in an unprecedented televised "town hall" appearance in late July that while the Fed had been able to backstop a buyer for Bear Stearns the previous spring, the problems at Lehman were too grave. "[T]here was just a huge, $40 [billion], $50 billion hole that we had no way to fill and no money, no authorization, no way to do it, so we had to let it fail," Bernanke said.

Others argue policymakers could have found a more creative approach, had they wanted to. "In that kind of emergency, they could have found a way," say Douglas Elliott, a former investment banker and now a fellow in economic studies at the Brookings Institution think tank in Washington.

But would doing so have helped? In one limited sense, maybe. If Lehman had not gone bankrupt, its commercial paper would have still been good, there would have been no losses at money market funds and no panic, right? Not necessarily. Many economists, market participants, and policymakers argue that saving Lehman would only have postponed the panic briefly, if at all—and may well ultimately have worsened the crisis.

The Underlying Awareness

The fundamental problem was that there was an underlying awareness that many financial institutions, like Lehman, had used too much money from short-term lenders, such as money market funds, to make long-term loans that were going bad, such as those on real estate. If the short-term lenders hadn't discovered that Lehman might run short of money to repay them, they would have soon faced the reality at another financial institution and rushed to get their money back then. Or so the thinking goes.

Something like a run on the bank might have even started the next day. After all, American International Group (AIG) was also on the verge of failure. And just a day after Lehman's bankruptcy on Sept. 15, 2008, the insurer received $85 billion in government funds and guarantees. Given the company's integral role in the multitrillion-dollar derivatives market, its failure would have triggered many of the same reverberations as Lehman's—perhaps more—and policymakers knew it. "You would have still had a crisis when AIG was bailed out," says John Coffee, a Columbia University law professor specializing in the financial markets.

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