Page last updated at 12:54 GMT, Monday, 15 September 2008 13:54 UK
Lehman Bros files for bankruptcy

By Anthony Reuben
Business reporter, BBC News

The likely disappearance of two of Wall Street's biggest names - Lehman Brothers and Merrill Lynch - looks like a big change in US government policy.

Lehman Brothers headquarters
Lehman Brother has filed for Chapter 11 bankruptcy protection

In March, when fellow investment bank Bear Stearns had to seek emergency funding, it was acquired by JP Morgan, but the takeover was backed by the US central bank, the Federal Reserve, which sweetened the deal with a $30bn (17bn) loan.

Only a week ago, the US government took over the giant mortgage finance providers Fannie Mae and Freddie Mac, which between them guarantee about $5.3 trillion (3 trillion) of mortgages.

But over the weekend, when other banks were considering taking over Lehman Brothers, no incentives appear to have been offered by the government.

"The US Treasury has decided it was time for shock therapy, and taken an extremely gutsy gamble by letting Lehman fail, against widespread expectations that a solution would be brokered over the weekend," says Marco Annuziata, global chief economist at Unicredit.

"If it works, it should boost considerably the hopes that the global financial system can work itself out of the year-long crisis, but the risk is enormous."

'Very healthy'

Peter Douglas from the hedge fund consultancy GFIA agrees that there could be long-term benefits from the government's decision.

This policy came under such a lot of criticism in the US that it was not able to repeat it for Lehman Brothers
Jon Danielsson, London School of Economics

"The US and the Federal Reserve in particular, appear to be drawing a line under public funding," he says.

"Longer term this is very healthy as it accelerates the clearing process, and therefore the rehabilitation of the financial system."

But it is important to appreciate the differences between some of the institutions that have received government money, according to Jon Danielsson from London School of Economics.

"Bear Stearns was a change in policy for the US government because it had not fully appreciated the problem of how interconnected the banks are," he says.

He adds that government policy before that had been to help High Street banks but not investment banks, but that it considered the damage that would have been done by Bear Stearns failing was so great that its takeover had to be supported.

"This policy came under such a lot of criticism in the US that it was not able to repeat it for Lehman Brothers," says Mr Danielsson.

Members of Congress were among those who objected to the Bear Stearns bail-out, saying that by limiting the damage caused by failure, the government was encouraging banks to take greater risks in the future.

"Last week, after the bail-out of Fannie Mae and Freddie Mac, you could see traders rushing to the market to take more risks," says Paola Subacchi, research director in international economics at Chatham House.

Former Federal Reserve chairman Alan Greenspan has predicted that more financial firms will fail.

"We shouldn't try to protect every single institution. The ordinary course of financial change has winners and losers," he told the US network ABC.

Previous crisis

While there was no direct help for Lehman Brothers, the Federal Reserve did announce other help for the banking system, including broadening the range of collateral that financial institutions can put up to obtain central bank loans.

The government may be hoping that the banks themselves find a way out of the crisis, and indeed on Sunday 10 of the world's biggest lenders agreed to establish a $70bn emergency fund, which any one of them may tap up to a third of should they face any liquidity problems.

"If you look at previous crises such as the secondary banking crisis in 1973-75, that's the kind of solution you need rather than governments endlessly throwing money at the problem," says Terry Smith, chief executive of the brokerage Tullet Prebon.

It is in this atmosphere that AIG, formerly the world's biggest insurer, is - according to the Wall Street Journal and New York Times - approaching the Federal Reserve for a $40bn bridging loan.

"If they didn't give the money to Lehman they are not going to give the money to an insurance company," predicts Jon Danielsson.

Election issue

The amount of extra debt already taken on by the government to fund stimulus packages and bail-outs will also be a factor in the decision.

"Who is buying all this debt? How long will investors be prepared to buy into dollar-denominated debt?" asks Paola Subacchi at Chatham House.

She also predicts that bail-outs could become an election issue.

"The candidates have no idea how to get out of this mess and until recently did not seem to care."

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