The theory seems to be that Lehman's failure caused a domino affect whereby other liquidity strained institutions also failed because of Lehman. What's become more clear a year later is that some financial firms were insolvent and some only had liquidity problems. While the line between the two became blurred during the heyday of the crisis, the distinction is important. The insolvent firms would've failed regardless of whether Lehman was bailed out. AIG would not have survived. Citi would've gone down. Bank of America, because of its horrible Merrill purchase would've failed as well. The government-assisted sale of Bear Stearns to JP Morgan and the preemptive seizures of Fannie and Freddie, which were all meant to stabilize the market and keep liquidity flowing, did not keep Lehman from failing. The insolvent institutions were doomed; it was only a matter of time. Lehman's failure only sped up the process.
While it is nearly impossible to calculate how much the domino effect of Lehman's failure actually cost the economy, it is indisputable that Lehman's secured creditors received less than 10 cents on the dollar. The firm had an $100 billion hole in its balance sheet, and possibly more. A bailout of Lehman would've only cost our government an additional $100 billion dollars that was simply unrecoverable. So frankly, I'm glad Paulson drew a line in the sand and I wish he'd have kept it there instead of reverting to more bailouts.
The most important thing that happened when Lehman failed was that it reintroduced the idea of risk into investing. Markets from stocks, to emerging markets, to money market funds were slapped across the face with a giant RISK! Credit markets move in cycles and often in the good times, investors forget that they are actually taking risk with their money when they invest and then remember when they lose money in the down cycles. During this last boom, it was as if risk no longer mattered, and investors just made up numbers and plowed headlong into every stupid investment peddled to them. The Fed's decision to take $26 billion in Bear's crappy assets onto its balance sheet and assist the sale to JP Morgan in the early days of the credit crisis introduced the idea that the government would never let a systemically important institution fail. This is precisely why the market ripped for two months following that move. Yippee! The government is going to support every institution that's in trouble, so investing is risk free again. No worries. But as defaults began to rise and losses started piling up, risk reared its ugly head again.
Sadly, the government's intervention through the introduction of a variety of new mechanisms, liquidity injections and direct capital support, has removed the idea of risk taking from investing again. Now everyone is just focused on how much money they can make by taking advantage of the government's largesse. The government has taken away a key function of the market, which is the obligation to make the determination between those institutions that would've survived the crisis and those who should've failed due to too much risk-taking. For example, JP Morgan and Goldman Sachs likely would've survived. They may have been forced to raise very expensive capital from alternative sources, but they probably would've scraped by. By offering government guarantees for their debt and cheap financing for their collateral through the Fed, the government took money from investors and handed it directly to JP and GS. Without these guarantees, we wouldn't be having any discussions about bonuses, because the banks would be hoarding capital to stay alive. While the short-term benefits have been great for the market, the long-term effects are murky, and frankly scare me. If you introduce the idea of risk-free investing for everyone, banks are just going to throw money at stupid investments again expecting a bailout later. Heads I win, tails the taxpayer loses.
The government had six months after Bear caved to come up with a solution for letting financial institutions fail without cratering the market. They failed to do so. It's been a year since Lehman failed and we still don't have a viable plan on the table. This sends a signal to the market that the government is going to support our financial institutions indefinitely. Make no mistake, we will pay for this later.