Could Lehman's Failure Cause a Systemic Meltdown?

What are the risks of a systemic crash if Lehman Brothers is allowed to fail? As Sudeep Reddy says, Lehman is just as big and interconnected as Bear Stearns was:

Mr. Bernanke, testifying before Congress in July, outlined his three reasons for stepping in with Bear Stearns: One was the size of the firm and its implications for broader financial markets. Another was that financial infrastructure was not strong enough to protect against a failure in derivatives markets. The third was "extremely fragile" financial conditions.
Supporting the case for Fed action with Lehman: Most of those issues aren't resolved today.

Yet the situation with Lehman is clearly not a re-run of Bear. Why not? That's harder to answer. The main reason is that the Lehman unravelling has taken so long that everybody pretty much expects it to fail, at this point -- and in the markets, if something is expected (a/k/a priced in), there's generally little likelihood much chaos when it actually happens.

On the other hand, I suspect that although a bank failure might be priced in to the LEH share price, the same expectations have yet to percolate fully through the rest of the financial system. It's easy for a stock market investor to anticipate a Lehman collapse: you just sell the shares. But what if you're a widget manufacturer in Iowa whose treasurer has been doing a lot of business with Lehman's derivative desk? Those positions are much harder to unwind. If you're expecting a big payment next month on the interest-rate swap which Lehman wrote for you, what are you meant to do?

I would hope and expect that the New York Fed will somehow manage to backstop most of Lehman's obligations to its counterparties, but given that nobody knows anything, it's impossible to say for sure. There should be some way to keep the pure trading book functioning smoothly even if people who lent money directly to Lehman are forced to take a haircut. But it would be much easier for a big commercial bank to take over the entire Lehman Brothers operation -- Bank of America seems to be the most likely contender, according to the WSJ.

Remember that when BofA took over Countrywide, it was careful not to guarantee Countrywide's debt. It might be able to do something similar with Lehman: buy the bank, absorb its employees and traders, but then allow the subsidiary to default if it turns out to be insolvent.

That might be a desirable outcome from the point of view of the New York Fed, but I can't see Ken Lewis being particularly keen on taking the reputation risk associated with such a move: no banker wants to default on his obligations, ever. It'll be interesting to see whether Tim Geithner comes up with a clever way of twisting his arm.