I have been pondering this question. The story of the banking disasters
that have unfolded over the last two years is essentially a tale of terrible chain reactions and a slow-motion collapse of faith. First faith in credit ratings collapsed (in the summer of 2007), then in shadow banks, then in real banks. The next logical step is that we will see faith in governments collapse, too, but let's pray we don't get to that stage. Even without that, the problem right now is that nobody has any idea what anything is worth anymore, what they can trust, or what the next twist in this saga is. We are in a world of unknown unknowns, to paraphrase Rumsfeld's infamous quip, at least in the minds of many investors.
We have got here because time and time again the policymaking world and banking community have ducked away from addressing the issues and trying to establish real values. Remember Ben Bernanke saying that the subprime losses would be no more than $100 billion (May 2007)? All those Wall Street bankers saying that the problem was contained (fall 2007)? The repeated efforts that were made to prevent true price discovery for all those collateralized debt oblications? If assets are not traded and none of the flashy models work, then no one has any idea what anything is worth. Credit is not just about numbers but about human psychology. In a vacuum, faith crumbles.
So, alongside all the other really obvious "what ifs" that I am sure that others will point out in relation to Lehman Bros., et al, here is a less obvious one: If bankers had pressed ahead with their threat to conduct a public auction of the CDOs sitting on the books of the Bear Stearns hedge funds back in the summer of 2007 (remember that?), things might not have been so bad today. The huge irony sitting inside 21st-century finance is that while bankers presented their innovations (such as CDOs) as a step to create better markets, they hated the idea of letting these trade in a way that would create true market "prices." If they had been forced to engage in price discovery earlier, though, it would have been clear to everyone the degree to which the models had malfunctioned, and the banks would have been forced to write down their books at an earlier stage. It might have even prompted some coordinated action by the governments and banks at an earlier stage, before the problems truly spiraled out of control and investors lost faith in anything and everything that governments and bankers ever said.
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