The Wall Street Journal’s 4,800-word on the weekend of Lehman’s demise will be discussed and disected endlessly. But one thing seems clear to us: the bailout of Bear Stearns had in fact introduced massive moral hazard into the markets, allowing investment banking executives and their boards to believe that they wouldn’t be allowed to fail. Letting Lehman go into bankruptcy, a move that is now widely criticised, seems to have been the catalyst that made the banking community get real about the potential of failure.
Look at a few of the facts:
- Initially, at least, John Thain, the head of Merrill Lynch, was certain he didn’t need to sell Merrill Lynch. He resisted the idea when it was proposed, according to the Journal, and merely sought to sell a 10% stake to raise more capital. He had no idea, it seems, that his institution was completely upside down and couldn’t continue on its own.
- Lehman Brothers board members were stunned that the Federal Reserve and the Treasury were not going to bail them out. The bail out of Bear Stearns had convinced them that a bankruptcy was not a realistic possibility.
- The various potential buyers of Lehman were so certain they could get a government backstop for Lehman’s assets, they never really considered a free market purchase.
What this seems to demonstrate is that the market had become badly dysfunctional after the Federal Reserve’s backstop of JP Morgan’s puchase of Bear Stearns, reliant to a dangerous extent on a confidence that a government safety net was in place. Investors, board members, would-be buyers and executives had all come to rely on this idea. Market discipline had been shattered.
Years from now the lesson of Lehman will likely be viewed as exactly the opposite of the conventional wisdom today. The destruction of Lehman, the calamitous credit market results, the loss to creditors and counter-parties all helped rebuild a discipline in the markets.
Unfortunatey, the subsequent bailouts may have already undone the good letting Lehman go did. Let’s hope it wasn’t all for naught.