How it all might have been different
It would have changed the course of history, certainly, but maybe not for the better.
The collapse of Lehman is considered the domino that led to the tumbling of so many others: Merrill Lynch's hasty sale to Bank of America; the bailout of the American International Group; the breaking of the buck in the US money market; the near collapse of Goldman Sachs and Morgan Stanley; and the decision by the government to pursue the $US700 billion Troubled Asset Relief Program to bail out the entire banking industry.
The decision not to rescue Lehman has been called a mistake and worse. Christine Lagarde, the French finance minister at the time, called it "horrendous".
No one suggested Lehman deserved to be saved. But the argument has been made that the crisis might have been less severe if it had been saved, because Lehman's failure created remarkable uncertainty in the market as investors became confused about the role of the government and whether it was picking winners and losers. The US government had bailed out Bear Stearns and then nationalised Fannie Mae and Freddie Mac, but left Lehman for dead only to turn around and save AIG.
Henry Paulson, the US Treasury secretary at the time, has suggested that the government didn't have a choice because it lacked the tools to take over Lehman without a willing buyer.
Paulson may be right. But that didn't stop the government from finding ways to bail out AIG and then pursuing strong-arm tactics - like pressing Bank of America to complete its deal for Merrill without disclosing the severity of Merrill's problems to shareholders - that would have been considered unconscionable had the country not been in the midst of a crisis.
Had Washington stepped in, what would have happened next?
That's where the guessing game begins. But there are some educated assumptions that can be made. The blowback against a bailout of Lehman would have been fierce. It is often forgotten, but the prevailing wisdom the day after Lehman fell was that its collapse was a good thing. The New York Times wrote in an editorial: "It is oddly reassuring that the Treasury Department and Federal Reserve let Lehman Brothers fail." (The Wall Street Journal came out on the same side.)
It is also worth noting that most of Wall Street was convinced that the failure of Lehman would not pose a systemic risk.
In the fairy-tale version of bailing out Lehman, the next domino, AIG, would have fallen even harder. If the politics of bailing out Lehman were bad, AIG would have been worse. And the systemic risk that a failure of AIG posed was orders of magnitude greater than Lehman's collapse.
Had the Fed stepped in to save AIG at that point anyway, it then becomes unlikely that the Treasury would have been able to muster congressional support to pass the Troubled Asset Relief Program. At the least, the size and scope of it would have been curbed. And remember, Congress originally rejected the program before it reversed itself days later after the markets appeared to be gripped in a death spiral.
As Rahm Emanuel said in 2008: "You never want a serious crisis to go to waste. It's an opportunity to do things you think you could not do before."
The failure of Lehman may have allowed the US government to do more to prop up the economy than it otherwise could.
Ed Lazear, chief economic adviser to President George W. Bush, told a group of students at the University of Chicago Booth School of Business that thinking about the crisis as a series of dominoes may be the wrong analogy.
"Under the domino theory of contagion, one domino falls and knocks over the other dominoes, and they all topple, and you've got a mess on your hands," he said. "That's pretty much what we were thinking in saving Bear Stearns. That looked like the way to go. Unfortunately, the model was not dominoes, it was popcorn.
"When you make popcorn, you heat it up in a pan and, as the kernels get hot, they pop. Taking the first kernel to pop out of the pan doesn't do anything. The other kernels are still getting hot, the heat is on, and they're going to pop no matter what," he said.
Frequently Asked Questions about this Article…
The Lehman Brothers collapse in 2008 is seen as a key tipping point that amplified market stress. According to the article, its failure helped trigger a chain of events — the hurried sale of Merrill Lynch to Bank of America, the bailout of AIG, the breaking of the buck in US money markets, and the near-collapse of other firms such as Goldman Sachs and Morgan Stanley — all of which created major uncertainty for investors about market stability and government intervention.
It's uncertain. The article explains that while rescuing Lehman might have changed the course of events, it may not have made things better. A bailout would likely have provoked fierce political backlash, could have worsened the AIG situation, and might have affected congressional willingness to approve wide-ranging programs like the $700 billion TARP. Ultimately any answer is speculative and depends on how policymakers and markets would have reacted.
At the time, Treasury Secretary Henry Paulson argued the government lacked the legal tools to take over Lehman without a willing buyer. The article also notes inconsistency in policy: the government had previously aided firms like Bear Stearns and later saved AIG, but left Lehman to fail — a choice that generated intense debate and disagreement about government roles in crises.
Lehman's failure left investors confused about whether the government would pick winners and losers, the article says. That confusion heightened uncertainty across markets, reduced confidence in short-term funding markets (including the breaking of the buck in money market funds), and made it harder for investors to gauge policy responses during the crisis.
The article describes TARP as the roughly $700 billion program the US government pursued to stabilise the banking industry after the Lehman collapse and ensuing turmoil. It also notes Congress initially rejected the program before reversing course days later when markets appeared to be in a freefall, illustrating how Lehman-era shocks helped shape large policy interventions.
The piece contrasts two ways to think about contagion. The 'domino' view suggests one failure knocks others down sequentially, while the 'popcorn' model — favoured by Ed Lazear in the article — suggests many institutions were independently vulnerable and would fail as conditions heated up. For investors, that means a single rescue might not stop broader problems if underlying pressures are widespread.
The article argues that if Washington had bailed out Lehman, the political fallout could have made an AIG rescue even more difficult. AIG's potential failure posed a far larger systemic risk than Lehman, so the timing and form of interventions mattered — rescuing one firm might not have reduced the overall risk and could even have complicated efforts to stabilise the system.
Based on the article, investors should recognise that policy decisions and uncertainty about government intervention can significantly affect markets. Crises can prompt large, fast policy responses (as seen with TARP), political reactions can limit or shape those responses, and contagion may be widespread rather than sequential — all reasons for investors to consider systemic risk, diversification and the potential for abrupt market moves during stress.
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