No-bailout stance sends vital message

Believe it or not, some good things started to happen when Treasury Secretary Henry Paulson just said no to Wall Street's latest desperate request.

It didn't feel that way yesterday. Stock markets around the world took their worst beating in years, and teetering Lehman Brothers Holdings Inc. was forced into a mad dash to US Bankruptcy Court after Paulson refused to bail out the giant brokerage with the government's checkbook. Investors worried that the latest financial emergency would reverberate across the economy and contribute to a recession.

But Paulson's hard line on Lehman sent an important message. Wall Street's troubled traders and investors can't count on the government to save them. Private firms and their money will have to risk failure, a stark reality that has already prompted action with the sale of Merrill Lynch & Co.

Paulson's decision faces an even bigger test right away. Bankers yesterday searched urgently for as much as $75 billion in private financing for insurance giant American International Group Inc., another company choking in the grip of fearful credit markets. Success for AIG will help make Paulson's point that the market should solve most of its own problems.

The enduring impact of anything that smelled like a government bailout of Lehman - after exposing taxpayers to fallout from disasters at Bear Stearns Cos., Fannie Mae, and Freddie Mac - probably would have been far worse. Aggressive federal intervention is not an unlimited solution, and this is a good time to draw a line in the sand, or at least attempt to do so.

Whether intended or not, the government's hard line with financial giants over the weekend doomed the most seriously injured company among them but led to a merger that preserved another with less acute problems. Think of it as the financial version of battlefield surgery.

Bank of America was one of two serious bidders for Lehman Brothers, but balked when the federal government would not step up and guarantee assets it would acquire. Instead, the bank turned around and agreed to spend $50 billion for Merrill Lynch, a struggling but not yet desperate financial giant. Paulson's hard line had the effect of redirecting private capital to protect Merrill at the expense of Lehman, which was the wiser choice.

The Lehman crisis was a good place for government officials to force private business to deal more aggressively with its own problems. The financial services industry, which sneers at any government encroachment while it's making money, had come to take a helping hand for granted in its time of need. Other industries, particularly auto manufacturers, began to form a line of their own in Washington to lobby for financial support.

In most cases, the answer should be no. That's an easier message to deliver once you've slammed the door in someone else's face.

But Paulson's resolute decision about Lehman Brothers (he says he never once considered any kind of government bailout) comes with real risks. Figuring out exactly what they are and who they threaten most is the tricky part.

"You have to wonder who is going to suffer as Lehman goes down," says Nariman Behravesh, chief economist at Global Insight. "It could be commercial banks or pension funds, you name it. The interconnectedness of the financial system means it can have major ramifications for the average American. The financial markets have gotten so arcane people think maybe it doesn't affect them but it does."

Companies like Lehman, known as broker-dealers, borrow and lend money to dozens of other parties as a routine part of business. They borrow heavily to own relatively straightforward investments like mortgage-backed securities, but also execute millions of transactions in more complex corners of the market like that for credit default swaps, a kind of insurance investment to protect against the failure of yet other securities.

Connecting all those dots is virtually impossible. But that's only half the problem.

The other half, perhaps the more important part, is a fundamental question of confidence - whether investments are worth their price, and whether they're safe. Paulson and Federal Reserve chairman Ben Bernanke have acted aggressively through the crisis, but neither speaks with the kind of authority to soothe financial and economic leaders around the world.

"At some level, there's a vacuum of leadership here, someone who is a figure who is talking to the world economy" says Nancy Koehn, a Harvard Business School professor and business historian.

Those problems will keep the federal government aggressively involved in capital markets and the economy, even while it tries to hold the line on anything that looks like a bailout. One example: Most analysts expect the Federal Reserve to cut interest rates soon.

Meanwhile, the Fed continues to offer Wall Street banks access to the kind of loans of last resort it has always made available to commercial banks. That offer was first extended up and down Wall Street when Bear Stearns failed, though it hasn't been used by any investment bank since July. Now the Fed has expanded the kinds of collateral it will accept, including pledges of stock in return for loans.

There are certainly more financial shocks to endure, and government action will have to be part of the response. Perhaps something resembling a bailout will become inevitable, despite the tough talk of the moment. It's too hard to predict when an emotion like confidence is the critical issue.

But this is a good time to see whether giant investors and traders who created so much of the problem can do more to fix it on their own.

Steven Syre is a Globe columnist. He can be reached at syre@globe.com.