Moral Hazard: The Hidden Cost of Every Safety Net

You wake at 4:47 a.m. on Sunday, September 14, 2008. Your phone has been ringing since midnight.

You are a senior official at the U.S. Treasury Department. In roughly eighteen hours, Lehman Brothers, the fourth-largest investment bank in the United States, will open its books to the world and be unable to meet its obligations. The firm holds $639 billion in assets on paper. It also carries $613 billion in debt. The gap between those two numbers, once markets price Lehman's mortgage-backed securities honestly, is a chasm.

Hank Paulson, the Treasury Secretary, is already on calls with the heads of every major Wall Street firm. The Federal Reserve has dispatched teams to Lehman's offices at 745 Seventh Avenue. Tim Geithner, then president of the New York Fed, has been awake since Friday. Everyone is looking for a private buyer. Barclays is interested but pulls back after the British financial regulator refuses to approve a deal over the weekend without a shareholder vote. Bank of America has already pivoted to acquire Merrill Lynch instead.

There is no buyer. The phone on your desk is the last line.

The question in front of you is blunt: does the federal government step in with public funds to prevent Lehman's collapse, the way it did six months earlier when it orchestrated the rescue of Bear Stearns? Or does it stand aside?

The case for acting is overwhelming in one direction. Lehman is not an isolated firm. It is a node in a web of counterparty relationships stretching across every major bank, money market fund, and pension system on the planet. When Bear Stearns wobbled in March 2008, the Fed arranged a $29 billion guarantee to smooth its sale to JPMorgan Chase. Markets stabilized. The logic of doing the same for Lehman feels almost mechanical: the alternative is a financial cardiac arrest.

You have a single Sunday to decide. The markets open Monday morning in Tokyo at 9:00 a.m. local time, which is Sunday evening in Washington. Whatever you choose, you choose it now.