When historians write the definitive account of the Great Recession in coming decades, one of the major questions they will tackle is why the government decided to allow Lehman Brothers go bankrupt and AIG (NYSE: AIG) to survive thanks with a $182 billion bailout. The answer is simple: fear.

In 2008, the collapse of the once venerable Lehman was stunning in its swiftness and brutality. Merrill Lynch & Co. was the next domino to fall, declaring bankruptcy after the federal government couldn’t find it a merger partner. Bank of America Corp. eventually stepped up and acquired the investment bank, succumbing to what its then-CEO Kenneth Lewis described as arm-twisting by Treasury Secretary Henry Paulson. He has denied doing anything improper.

Fear gripped the market as investors wondered where the next axe would fall. Would it be Goldman Sachs (NYSE:  GS), Citigroup lnc. (NYSE:  C) or JPMorgan? (NYSE:  JPM)? Paulson forced the banks to take federal aid whether they wanted to or not.  That turned out to be the right move since most of Uncle Sam’s generosity was paid back ahead of schedule with interest.  Then the question arose about AIG.

The world’s largest insurer had its fingers in so many fiscal pies that it was hard to ignore.  Indeed, as the Congressional Oversight Panel revealed earlier this year, some $52 billion used to satisfy insurance contracts on securities called credit default swaps.  A total of $108 billion went to these counterparties which included Wall Street firms, European banks and municipal governments such as Goldman Sachs, UBS (NYSE: UBS) and Deutsche Bank (NYSE: DB).  Panel Chair Elizabeth Warren demanded answers.  A June report from the Panel concluded that the bailout created a “poisonous” effect because as Fox News noted “now the markets believe the government will commit taxpayer money to prevent the collapse of big financial institutions and to repay their trading partners.”

Questions remain whether the money was wasted.  At the time of the bailout, investor Jim Rogers argued on CNBC that AIG should have been allowed to go bankrupt.  Rogers bucked the conventional wisdom which claimed that the insurance giant’s collapse would have had calamitous consequences for the financial system.   History so far shows that Rogers was right.

The Congressional Budget Office believes that taxpayers will lose about $36 billion on the AIG deal.  To be fair, Uncle Sam may see some money returned if the AIA IPO is successful.  This raises even more troubling questions about moral hazards.

Why is the government allowing some stupid business decisions — such as AIG’s — to succeed while allowing Lehman Brothers to suffer the consequences of its equally bad moves?   The notion of too big too fail helps Wall Street immensely but this also leads to the less well-known phenomena affecting most Americans of being  too small too succeed.

The lessons of AIG boil down to this: economic help does not trickle from the haves to the have-nots unless there is a compelling reason to do so.  By rewarding bad decisions, the government will make sure nothing changes.

–Jonathan Berr

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