Lehman a test of government will on bailouts

By David Lawder - Analysis

WASHINGTON (Reuters) - Takeover talks for Lehman Brothers are a key test of the government's willingness to bail out large financial institutions -- less than a week after the seizure of home finance giants Fannie Mae and Freddie Mac.

Treasury Secretary Henry Paulson and Federal Reserve officials, working to broker a deal to sell Lehman Brothers to a stronger financial institution, have made it clear that any buyer of Lehman will not get the same kind financial support granted to JPMorgan Chase & Co. in March in the rescue of Bear Stearns.

"It's time to draw a line. If the government assists Lehman, there's going to be another one coming for a bailout," said William Poole, former president of the Federal Reserve Bank of St. Louis. "The more often you do it, the harder it becomes to say it's just a special exception."

"If the market is so fragile, so close to the edge, then bailing out Lehman is not going to solve the problem," Poole said. "Letting Lehman go down, if it comes to that, that would clear the air," he said, if such an event "doesn't trigger an enormous crisis. And that would be my expectation."

Paulson in early July called for a stronger regulatory process that can allow big investment banks to fail in an "orderly way" without threatening the stability of the financial system. He said he wanted to avoid the perception that an institution is "too interconnected to fail or too big to fail."

But the Treasury's involvement in quickly finding a buyer for Lehman shows that Paulson is a long way from achieving that goal, and such failures will require a guiding hand from the top of the Fed and Treasury, at least from a deal brokering standpoint.

Alice Rivlin, a Brookings Institution fellow and former Federal Reserve vice chairman, likened the Lehman talks to former Treasury Secretary Robert Rubin's recruitment of banks in 1998 to provide loans in a privately funded bailout of hedge fund Long Term Capital Management.

"What they'll try to do is get the people together and say 'don't let this organization fail, which could be very disruptive,'" she said, adding that a sale or multiple asset sales at very low prices is the most likely result.

Although Lehman has $45.8 billion of mortgage and asset-backed securities clouding its books, it also owns valuable crown jewel businesses, including asset manager Neuberger Berman and private equity and wealth management units, as well as a strong fixed-income trading desk.

The bank viewed as the most likely suitor, Bank of America, would vault to a top-tier investment banking position with an acquisition of Lehman.

But as the Lehman talks looked set to drag on through the weekend, investors worried about the exposure of a much larger financial firm, insurance giant American International Group, to mortgage-related losses. AIG shares fell 31 percent on Friday.

A firm "no" on a government bailout "would send a very strong message" to financial institutions that they have to raise capital on their own, said Gerald O'Driscoll, senior fellow at the libertarian Cato Institute in Washington.

"The Fed has to stop being a lender of first resort," he said. Anybody who's left dealing with Lehman knew the risks and should have protected themselves."

(Editing by Leslie Adler)