The government's dance with Lehman after having bailed out Bear Stearns reminded me of a game we used to play as kids. One kid would stand in front of another and fall backwards. The idea was that the kid in back would catch his falling friend. The Fed and Treasury are like the kid in back. Unfortunately, it's now completely unclear whether and when they'll catch an investment bank as it falls.
I don't mean to suggest the government should have bailed Lehman out. I don't think they should have. But they've managed to create a situation where it's almost completely uncertain whether the government will or won't step in. This is one problem.
But there's a second problem as well: the government is focusing too much on the wrong issue.
The underlying issue that complicates everything else is the continuing uncertainty about asset values. No one knows what Lehman's assets are worth, especially the assets related to real estate. This is why Lehman's competitors weren't willing to step in unless the government provided some kind of guaranty. When the government walked, so did they.
One reason for the uncertainty about asset values, I suspect, is the government's failure to do more to address the subprime crisis. Last month's Fannie Mae legislation promises a government guaranty of mortgages that are restructured, but leaves the decision up to the lender whether or not to restructure. Almost no one thinks that enough mortgages will be restructured to make a real dent in the mortgage crisis. It seems clear that a more aggressive approach is needed, such as enactment of the proposed bankruptcy reform that would allow borrowers to write down their mortgages in bankruptcy (as discussed in earlier posts, such as this one).
If there were a serious effort to fix the mortgage mess, and real estate prices reached more of an equilibrium as a result, the government's presence would be a lot less essential when a bank like Lehman ran into trouble. Assets would be easier to value, and a troubled but viable bank might be able to find non-governmental financing, even without the government's help. In the meantime, we're stuck with a world where the Fed and Treasury make case by case decisions whether or not to catch a bank as it falls, and no one steps in if they don't.