Why Lehman's Failure Is the Best Outcome

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As we went into the weekend, the Federal Reserve, the Treasury Department, and all of the titans of Wall Street gathered at the Reserve Bank of New York offices to figure out how to save Lehman Brothers.

Treasury officials made it clear that the government would not be stepping up to put more taxpayer money at risk, as it did during the fire sale of Bear Stearns to JPMorgan Chase. And by the end of the weekend, the potential bidders all stood aside, with Barclays (NYSE: BCS  ) and Bank of America the last to leave the dance floor.

All of this meant one thing: None of these entities, including fellow investment banks and parts of the federal government, found it in their best interests to save the beleaguered company.

And that's a good sign.

No, really
As painful as it is, as painful as it will be, the fact that both the government and the financial industry let Lehman fail is ultimately a sign of confidence in our financial markets.

Think about it -- all of the players involved knew quite well that the markets would absolutely tank if they didn't make a deal. And it wasn't that capital was unavailable; despite the credit crisis, there's plenty of capital out there to bid -- from the more liquid Wall Street banks, from sovereign wealth funds, or from private equity players like Blackrock (NYSE: BLK  ) or Blackstone (NYSE: BX  ) .

And yet these players found the risk of financial Armageddon more palatable than the price they'd have to pay to take over Lehman. There will be plenty of collateral damage with this bankruptcy -- and they still decided not to act.

The only reasonable conclusion is that the major players think the unwinding of the $600 billion in assets on Lehman's balance sheet won't be as bad as commentators fear.

A short detour through history
If you think now is scary, the summer of 1998 was just as hair-raising for Wall Street firms. The Asian financial crisis and Russian default had the market reeling. At the epicenter of the panic was a secretive hedge fund with more than $100 billion in assets that were at one point leveraged 100-to-1, even before you factored in billions in notional value of derivatives contracts.

The hedge fund was Long Term Capital Management (LTCM), and as it edged closer to failing, the major Wall Street banks put aside their differences to rescue the firm. If LTCM failed, they judged that the risk to the financial system was just that significant.

Lehman, with six times LTCM's assets and many more friends on Wall Street than the reviled LTCM, received no such bear hug. No one stepped up to the plate to buy it. In theory, it posed a bigger risk to the financial system than an upstart hedge fund. In reality, the big banks and the Fed aren't seeing the same level of systemic risk.

And they don't appear to be alone. The S&P 500 is only down about 3% today, despite the trumpeting headlines.

Capitalism at work
At the end of the day, the Fed has done the right thing, and that is to let the free market do its job. A free market is just that -- free. Companies are free to be as aggressive or as conservative as they like. If excessive risk-taking leads to failure, well, the company pays the price.

Not only that, by declining to save Lehman, the Fed has addressed the issue of a moral hazard -- which will be a strong disincentive for risk-taking among Wall Street firms and banks. The complete wipeout of the firm's equity (a part of which executives are awarded through compensation packages) sends a clear message to other managers who might otherwise take risks with the assumption of a government bailout.

By letting Lehman fail, the Fed is helping to prevent another such financial crisis down the line.

Picking up the pieces
While this is ultimately the right outcome for Lehman and for the financial industry as a whole, picking up the pieces and moving forward will not be easy. Both stocks and bonds will feel downward pressure, and already shaky asset markets might seize up entirely. The liquidity crisis will force other banks to mark down their portfolios of dodgy assets even further. Funding costs will rise; profits will drop.

But this is -- and remains -- a liquidity crisis, not a solvency crisis. The United States is not bankrupt, and excess capital is indeed still in the system. Even within the financial industry, Lehman's unwinding is unlikely to seriously dent the fortunes of foreign players like Allied Irish Banks (NYSE: AIB  ) or Banco Santander (NYSE: STD  ) . And while other (remaining) bulge bracket banks such as UBS (NYSE: UBS  ) and Credit Suisse (NYSE: CS  ) have their fair share of problems, they are more diversified, and thus less risky, than Lehman is and was.

Wall Street banks are above all else concerned about saving their own hides. If they see no need to band together to save Lehman, it's a pretty good sign for the future of the market as a whole.

Andrew Sullivan owns none of the securities mentioned in this article. JPMorgan and Bank of America are Motley Fool Income Investor recommendations. Allied Irish Banks is a Global Gains pick, and The Motley Fool owns shares of Allied Irish. The Motley Fool's disclosure policy has no need of a bailout.

Read/Post Comments (7) | Recommend This Article (23)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 16, 2008, at 12:25 AM, paulgresham wrote:

    It's about time America stands firmly behind what she allegedly represents, freedom, free markets and opportunity for all. And good to see someone backtracking to the LTCM debacle that unwound without loss. Surely if these houses cannot survive, then let them die, those are the rules of the game. More than anyone these people know the risks they are taking. Instead of a nanny state bailing them out, these people should be made legally accountable for what they've done. Any commitment to get into these complex positions should obligate these people to also undertake the unwinding of the subsequent failures else face sentencing on par with any similar crime that abuses tax payers money or the health and security of the state.

    It's time to be both tough and to believe in the fair market system.

  • Report this Comment On September 16, 2008, at 9:38 AM, POTPOLITICS wrote:

    Hi Fool

    Look I don't want to pretend like I have deep knowledge of economics or that I'm secretly glad all this corrections of wealth are occurring.I don't pity the fool that thought only of themselves and now want people to feel sorry for them.It's a buyers market and Once Obama's here many of these white collar types will be wearing pinstripes in the joint.You can't abuse the system and expect to escape the rath of your own doing.Me I own nothing and owe no one nothing and money to me is irrelevant and yes I'm a rich man. Now who's the FOOL;)

  • Report this Comment On September 16, 2008, at 11:30 PM, jssusi wrote:

    I don't know what the base of this article title, but today was a good relieve to read that Barclays finally has a gut, partially, to save Lehman. Free economy does not mean punishing the failed companies, it does not mean helping all including the loosers. Bailing out does not mean forgiving the mistakes or being a nanny to greedy executives if it is done right. A global company that has lasted for 158 years, that served as a main engine for country's growth, can not and will not be able to fix itself under a distress economic condition. It's more complex than a mere mismanagement in risk. And if it is, the Fed has had a role in regulating the industry. Moral hazard is true when helping out the corrupt and fraud executives, such as in enron case. True, US is not bankrupt but the people will be, who's gonna absorb that 600 billion debts at the end of the day? We are !!

  • Report this Comment On September 17, 2008, at 1:01 PM, huggybunny wrote:

    Man, AIB is getting creamed

  • Report this Comment On September 19, 2008, at 10:10 PM, Mandragoran75 wrote:

    Even the so-called bailouts of the other companies are not all that much different from this. Lehman had to actually file for bankruptured, but how is that a lot different from losing 90% to about 100% of the stock value? If I lost 90% of my money I would think that was a sufficiently negative message and try not to go there again:-)

    BTW, we keep hearing about a credit crunch, but a friend of mine who is a business broker says that there is still money available from local banks for the kind of deals that he works on. Indeed, if you talk to those local banks they will tell you they wish more people knew that they have money; it is frustrating that people assume there is no money, so they don’t look for business opportunities or apply for loans. I wonder how much of that is going on at higher levels, too, where the transactions would be in the billions instead of millions or less; your comments in this article would appear to indicate that the crunch is more perception than reality.

    [The liquidity crisis will force other banks to mark down their portfolios of dodgy assets even further. ]

    We keep hearing that there are so many loans, and all individual borrowers are different, that nobody knows how much the loans are worth. I suspect, from what I know of the mortgage business, that by now people could have put a reasonably accurate value on those huge portfolios of loans if they tried. Haven’t Lehman and others just failed to fool enough of the people enough of the time? The software people have a term, “vaporware” meaning that you advertise the next version of the whatever, as if you had it for sale now, but really knowing that it will be a long time before it becomes available, if ever; seems that Lehman has failed to sell their vaporware loan portfolios, but that does not mean those loans have no value. Now, as you say, people may realize that they need to work on establishing the real value of whatever they have.

  • Report this Comment On September 20, 2008, at 6:09 AM, Ricodemus wrote:

    A boorish Aussie financial commentator David Hunt who likes to drop names even if they' re the wrong ones or those of companies from which he has departed said this as a contributor (for Adeco) on the Fox Business Channel: that Bush's head is a vacuum, that McCain will die in office and that Hank Paulson, as an executive of Goldman Sachs (according to his CV!), refused to bail out Lehman because it was a competitor and AIG was not. I much prefer your reasoned, insightful version and suggest you please send Mr Hunt a subscription.

  • Report this Comment On October 14, 2008, at 3:18 PM, aamcadams wrote:

    AIB is still getting recomended? This t_rd has lost almost 80% of its price in the last 6-8 months! I'm mean c'mon from 38 to 9 bucks??? I seriously hope this is an annomily for "the fool" dot bomb. I'm begining to think this is a broken company, rather than a broken stock. After the Brit Bank bailouts I figured this might get a little 'bump', boy was I wrong, down another 3 bucks over the last 48 hours. I wonder what these "Governments" know that we don't??? The "profanity filter" needs to get a life, while I'm on a rant! LOL

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