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.