Lehman: This time, feds let a big bank fall

America's financial crisis has entered a difficult new phase as policymakers try to contain the fallout from the collapse of the fourth largest US investment bank.

The challenge is partly in the ripple effects of Lehman Brothers going into bankruptcy. But it's also much more. Lehman's fall, a battle for survival at insurance giant AIG, and a rushed merger between Merrill Lynch and Bank of America are just the latest signs that a real-estate investment bust continues to suck large financial firms into its undertow despite a year of government intervention and crisis management.

A central question for policymakers becomes, how can the problems be quarantined and resolved at least cost to taxpayers?

In a weekend of tense negotiations involving Wall Street's top bankers, the US Treasury Federal Reserve drew a firm line: Not every moment of panic will be met with an influx of federal dollars.

After the rescues of Bear Stearns, Fannie Mae, and Freddie Mac, the decision may have been necessary to dissuade banks of the notion that government is a willing partner for every large firm in crisis. The move also allows the Treasury and Fed to keep some powder dry for future needs.

"You're not dealing with the best solutions anymore," says Brian Bethune, an economist at the forecasting firm Global Insight in Lexington, Mass. "You're dealing with what's pragmatic, what's going to work, what's going to get us over the hump."

While the Fed avoided putting its own balance sheet, or taxpayers, at further risk over the weekend, that still leaves large problems unresolved.

One big problem is that some of the largest financial institutions became over-exposed to real estate investments, only to watch alongside American homeowners as the housing boom turned bust.

The further home prices decline and the more the economy weakens, the more financial firms could be engulfed, Mr. Behthune says. To navigate that risk, he says, the Federal Reserve may need to cut its short-term interest rate substantially and soon, after holding it at 2 percent since April.

For now, the crisis-watch mentality surrounds a handful of large financial firms. Lehman led the list heading into last weekend. After a restructuring plan failed to soothe anxious investors, the firm had hoped to find a buyer for all or part of its business by Monday. But its bad real estate assets posed too big a hurdle for potential buyers. The Wall Street icon filed for bankruptcy protection, putting it on the path to liquidation.

AIG, a leading insurance firm, asked the Fed for an emergency loan over the weekend, according to news reports. The firm is mired in losses tied to mortgage-investment guarantees.

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