By allowing Lehman Brothers to fall, the authorities demonstrated their reluctance to save financial institutions with public money. Banks – even big, famous ones – would be allowed to fail if it were felt the system could handle it.
But AIG was too important to go under. Default on its $441bn exposure to credit default swaps and other derivatives would have been a global financial catastrophe. Cancelling the insurance it underwrote would cause another wave of writedowns, further reduce lending and spread the crisis deeper and further.
As with Freddie Mac and Fannie Mae, the nationalisation of AIG has caused problems for future policymakers, but future systemic moral hazard is of secondary importance when the system itself is at risk.
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