Unfortunately, letting Lehman go down was probably the right decision.
Hold the glee about obnoxious bankers feeling some pain for a change. The Fed and Treasury have been, over the past year, trying to prevent contagion that could result in a major counterparty collapse. This would cause a lot more suffering on Main Street than Wall Street.
Moral hazard, not only in lending, but also in work-out decisions, has become a problem among large finance companies because of this. Witness what AIG is doing right now. Sooner or later the government had to let somebody go all the way down. Lehman was the obvious target, because it was precariously balanced, and big enough to be an example but not so big that it would pose a very high risk of creating a full meltdown. Here’s how I put it in a post back in March on the day after the Bear rescue:
Bear is the counterparty to many credit contracts (hence its problems). The risk of letting such an institution fail is that otherwise healthy institutions go down with it. Because of the central role of leverage in the financial sector, and the central role of the financial sector in funding every other sector of the economy, this would be a disaster. Of course, it creates a moral hazard, but on balance is almost certainly worth doing. That said, my guess is that we’re likely to see some other household name that is not too big to fail go down before this is all over – the government will need to demonstrate that it is willing to do this. Not for nothing, but I wouldn’t be investing a lot of my retirement account with Lehman right now.
Paulson and Bernanke need to be able to look bankers (and now, apparently, insurance executives) in the eye and say “You’re right, Fannie was too big to fail …but you’re not”. They are playing a dangerous game for high stakes.