It looks like the United States’ no bailout policy lasted all of two days

AIG’s bondholders got a huge break. That is an observation, not a criticism. The credit markets were not reacting well to Lehman’s bankruptcy filing.

$85 billion is a lot of money. The terms of the loan are onerous. 850 bp over LIBOR (a penalty rate) plus equity warrants. The US government now effectively owns a significant chunk of the US financial system, and provides liquidity to an even bigger chunk of it. To state the obvious, the crisis has entered a new phase.

Rogoff and Reinhart’s paper on the cost of systemic banking crisis looked good when it first came out. It looks even better now.

An anonymous Federal reserve official was quoted recently in the Wall Street Journal saying:

“We’ve re-established ’moral hazard,’” said a person involved in the talks, referring to the notion that the government should eschew bailouts, since financial firms might take more risks if they’re insulated from the consequences. “Is that a good thing or a bad thing? We’re about to find out.”

Felix is right; the person involved in the talks didn’t quite get the concept of moral hazard. The US government removed ’moral hazard“ -- the availability of insurance that protects investors from losses on risky assets -- from a portion of the credit market. I am still not sure if it was a good or a bad thing. But it sure seems to have revealed that a significant portion of the US financial system wasn’t strong enough to stand on its own, without a government backstop.