Lehman: This time, feds let a big bank fall

America's financial crisis has entered a difficult new phase as policymakers try to contain the fallout from the collapse of the fourth largest US investment bank.

The challenge is partly in the ripple effects of Lehman Brothers going into bankruptcy. But it's also much more. Lehman's fall, a battle for survival at insurance giant AIG, and a rushed merger between Merrill Lynch and Bank of America are just the latest signs that a real-estate investment bust continues to suck large financial firms into its undertow despite a year of government intervention and crisis management.

A central question for policymakers becomes, how can the problems be quarantined and resolved at least cost to taxpayers?

In a weekend of tense negotiations involving Wall Street's top bankers, the US Treasury Federal Reserve drew a firm line: Not every moment of panic will be met with an influx of federal dollars.

After the rescues of Bear Stearns, Fannie Mae, and Freddie Mac, the decision may have been necessary to dissuade banks of the notion that government is a willing partner for every large firm in crisis. The move also allows the Treasury and Fed to keep some powder dry for future needs.

"You're not dealing with the best solutions anymore," says Brian Bethune, an economist at the forecasting firm Global Insight in Lexington, Mass. "You're dealing with what's pragmatic, what's going to work, what's going to get us over the hump."

While the Fed avoided putting its own balance sheet, or taxpayers, at further risk over the weekend, that still leaves large problems unresolved.

One big problem is that some of the largest financial institutions became over-exposed to real estate investments, only to watch alongside American homeowners as the housing boom turned bust.

The further home prices decline and the more the economy weakens, the more financial firms could be engulfed, Mr. Behthune says. To navigate that risk, he says, the Federal Reserve may need to cut its short-term interest rate substantially and soon, after holding it at 2 percent since April.

For now, the crisis-watch mentality surrounds a handful of large financial firms. Lehman led the list heading into last weekend. After a restructuring plan failed to soothe anxious investors, the firm had hoped to find a buyer for all or part of its business by Monday. But its bad real estate assets posed too big a hurdle for potential buyers. The Wall Street icon filed for bankruptcy protection, putting it on the path to liquidation.

AIG, a leading insurance firm, asked the Fed for an emergency loan over the weekend, according to news reports. The firm is mired in losses tied to mortgage-investment guarantees.

Washington Mutual, one the nation's biggest mortgage lenders, has also been pummeled by investors in the past week.

Only two major investment banks remain as stand-alone US names: Goldman Sachs and Morgan Stanley.

Merrill Lynch, despite its long emphasis on serving retail brokerage clients nationwide, fell victim to its own load of hard-to-value real estate investments. It was not on the brink of bankruptcy, but a plunging share price pushed it toward a rapid $50 billion deal Sunday to be acquired by Bank of America.

"I think Merrill was very much the next domino," says Hyun Song Shin, an economist at Princeton University. "They would have been in the sights [of bearish investors] this morning."

The merger will pair Bank of America's huge depositor base with Merrill's investment brokerage. But in the short term, it also saddles the bank with Merrill's sour real estate portfolio.

Mr. Shin says policymakers, including Treasury Secretary Henry Paulson and Timothy Geithner, president of the Federal Reserve Bank of New York, calculated that financial markets could weather the storm following a Lehman collapse.

"The Lehman problems have been so well [known], the hope was that the web of interlinked obligations and claims was not as serious" as when Bear Stearns collapsed, he says. "Time will tell whether this was the correct move."

Even in the rescue of investment bank Bear Stearns and mortgage giants Fannie and Freddie, the Fed and Treasury imposed a measure of market discipline – showing aversion to any bailout for private-company shareholders.

But the interventions did bail out the financial system. "Now it becomes a matter of who don't you help," finance expert Joseph Mason said in an interview just after the Fannie/Freddie takeover. "Who doesn't get help other than the hurricane victims?"

Lehman Brothers, apparently, is the reply.

Mr. Mason warns that bank failures could leave the Treasury with $100 billion or more costs beyond its current deposit insurance fund. The cost to keep Fannie and Freddie healthy could be as high.

Minimizing taxpayer costs may be a matter of choosing among bad options. Judging by history, a point will come when so-called vultures swoop in to buy distressed assets, forming a bottom in real estate. But many financial firms are highly leveraged, investing with borrowed money. That creates a risk that firms including hedge funds, now rushing to "delever" and rebuild a safety cushion of capital, will create a glut of assets on sale.

Some finance experts say the Treasury may ultimately need to set up a fund to buy bad assets, or liquidate failed institutions, as the Resolution Trust Corp. did in the wake of the 1980s savings-and-loan crisis. Recovery in financial stocks "is likely to be when the government forms an entity specifically designed to facilitate the consolidation of the financial sector," Richard Bernstein, chief strategist at Merrill Lynch, wrote recently.