How the Lehman Bailout Increased Moral Hazard

David Schelicher emails with a provocative question, in the wake of my IM exchange with John Carney yesterday: what if letting Lehman fail actually increased the amount of moral hazard involved in lending to banks? "Moral hazard is based on predicted future government decisions," he notes, adding:

A lack of a Lehman bailout only reduces moral hazard if investors think it is a preview of future actions. But the failure to bail out Lehman has been blamed throughout the world press and by world leaders (see, e.g., Lagarde in France) as the cause of the world-wide credit crisis. The cost of the Lehman failure made clear to world leaders the cost of allowing a major broker-dealer bank to go under. Because it is widely considered a mistake (whether or not it actually was one), the Lehman non-bailout makes a bailout for the next major financial institution more likely. Hence, moral hazard was increased, not decreased by the decision not to bailout Lehman.

I think he’s right: Hank Paulson has pretty much explicitly said that he won’t let any more banks go under (ie default) on his watch, and the WSJ is reporting today that the moral-hazard trade is now being extended to insurers as well.

If Treasury had bailed out Lehman, there would always have been the chance that it wouldn’t bail out the next bank to get into difficulties — just as the bailout of Bear Stearns didn’t mean that Lehman was safe. But after Treasury let Lehman fail, no further failures could be allowed, and indeed one of the main functions of the TARP bill was to make government bailouts much easier.

People like Carney, then, who care deeply about moral hazard, should probably wish that Lehman had been bailed out, rather than be happy that it wasn’t.

Update: In the comments, SteveOh says something very interesting:

I do get the feeling that the Fed has had the banks in their back pocket ever since.

If it were not for the Lehman failure, do you think Merrill would have merged with BoA, or that GS and MS would have become bank holding companies, or that JPM would have accepted their capital injection?

I’m quite sure this isn’t the reason that Lehman was allowed to fail — there’s zero indication that anyone at Treasury or the Fed has been able to look that far ahead. But it is a consequence of letting Lehman fail. In the case of Bear Stearns, Jamie Dimon was to a very large extent calling the shots, and policymakers were doing his bidding. Now, thanks largely to Lehman, the tables have been turned.