How it all might have been different

Let's play a game. It is called "What if ... ?" As we observe the five-year anniversary of the financial crisis - Lehman Brothers filed for bankruptcy five years ago this weekend - the most intriguing hypothetical question about those fateful days is what would have happened had the US government bailed out Lehman.

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.