Lehman Failure Seen as Straw that Broke Credit Market, AIG

As finance chiefs gathered in Washington D.C. this weekend to work out what went wrong with the world economy, the refusal of the U.S. Treasury to rescue investment bank Lehman Brothers was being blamed as the straw that broke the economy’s back.

“For the equilibrium of the world financial system, this was a genuine error,” French Economy Minister Christine Lagarde said on Wednesday, one day before departing to attend the Group of Seven meeting in Washington.

“When we let one go, the risk is that others at that moment don’t know who their counterparty is anymore and find themselves exposed. Once we let one domino fall, the rest risk collapsing,” Legarde said.

U.S. Treasury Secretary Henry Paulson defended his decision and said there was no other choice.

“I think that, looking back, we’ve taken the right moves,” he told a news conference on Wednesday.

“There was no buyer for Lehman Brothers. There was no buyer, there was no whole to fill. And as I think we’ve said, repeatedly, we did not have the wind-down authorities that we needed for…non-banking financial institutions. So I’ll leave it at that.”

Lehman filed for bankruptcy on Sept. 15. By September 16, Libor rates that measure how much banks charge to lend to each other had more than doubled to 6.44 percent.

Later that day a big money market mutual fund called the Reserve Primary Fund was forced to inform shareholders it had ‘broken the buck’, or seen its net asset value fall beneath $1 a share, after it wrote off $785 million invested in Lehman Brothers debt and commercial paper.

This accelerated a stampede of clients demanding their money back from money market funds, forcing them in turn to sell assets like commercial paper, and by Friday the U.S. Treasury had to start guaranteeing the $3.4 trillion in such funds.

“The Lehman bankruptcy pushed AIG over the cliff,” said Christopher Low, chief economist at FTN Financial in New York, referring to the $85 billion lifeline thrown to the world’s largest insurer, America International Group by the Federal Reserve on Sept. 16.

“It dramatically reduced the capitalization of European banks who had exposure at Lehman. It broke the money market funds, which caused the fight of retail capital out of the market,” said Low.

An auction of credit default swaps backed by Lehman on Friday this week may further clarify losses.

According to analysts at IFR, a service of Thomson Reuters, this may involve contracts nominally worth as much as $400 billion and could be prompting banks to hoard cash, and further drive up Libor rates.

International Monetary Fund chief economist Olivier Blanchard said that Treasury Secretary Henry Paulson had rolled the dice with Lehman.

“It was a bet. It was lost. What happened as a result is all kinds of financial institutions realized that their claims were not as secure as they thought,” he told Reuters in an interview on Wednesday.

“Whether without it (the fall of Lehman) we would have avoided where we are today, I do not know. Some other event might have triggered the same thing a week later.”

(Additional reporting by Emily Kaiser in Washington and Tamora Vidaillet in Paris)