On the whole, I would say my misgivings about Lehman’s failure have been borne out in the market. And, indeed there were fire-sale prices across the board in all asset classes. Spreads did NOT come in after the Lehman failure. They rose.

Certainly, one can quibble about which markets were actually most affected by the action, but my basic belief had been that the domino transmission would occur because of a loss in market confidence for weaker institutions. Was AIG destined to fail? Perhaps. WaMu. Same answer. Did they fail because of Lehman’s failure? I would say that they were weak institutions who lost the faith of the market, partially as a result of the Lehman failure.

My conclusion here is this: Lehman was probably bankrupt, as were AIG and WaMu. However, the U.S. regulators had not and still have not set up an adequate framework in which to deal with a failure of this size.

Failure is a part of capitalism and banks should be allowed to fail regardless of size. Letting Lehman fail was not a mistake. Letting it fail without a contingency plan for that failure was the mistake. And the turmoil and confusion after Lehman’s failure was an enabler of other failures down the line, deepening and worsening the recession.

Interesting post, but I’m not convinced. Your basic argument is (was) that letting Lehman fail would lead to fire-sales in three classes of assets: CMBS, CDS, RMBS. These fire-sale would have a domino effect, taking down the financial system.

RMBS did not experience fire-sales. Spreads came in. This suggests that letting firms fail with a Fed backstop in place may be a more efficient way of dealing with a troubled bank.

CMBS spreads spiked. However, there was also a marked (some might say predictable) deterioration in the CRE market, and one could argue that CMBS spreads are rational. Should we prevent rational pricing? That seems to be the current government view.

Lastly, CDS spreads also spiked and led to AIG’s trouble, and it then “had” to be bailed out. True enough. However, now that we know more about just how reckless AIG’s Financial Products Group was, is that spread spike a surprise? Was it caused by the Lehman domino falling, or by the untentable nature of AIG’s CDS book? In the absense of a Lehman failure, do you think that book would have held together better?

I suppose what I’m saying boils down to this: correlation is not causality. Or better yet, there’s a difference between a catalyst (lehman) and a cause (leverage). If you agree with the catalyst analogy, then the government would have to work mighty hard to neutralize all the catalysts out there.