Why did the government save AIG after letting Lehman Brothers fail?

Bill Thomas, the former congressman who is the vice chairman of the Financial Crisis Inquiry Committee, put the question to Fed chief Ben Bernanke Thursday. Bernanke responded by justifying policymakers’ choices two years ago, while admitting that new financial rules should change the calculation the next time around.

Bernanke said the Fed rescued AIG  because officials believed the firm’s problems were isolated in its financial products business, which wrote hundreds of billions of dollars in derivatives bets without holding enough capital to pay out when the bets lost. Policymakers believed AIG’s insurance business remained a going concern, which meant AIG had sufficient collateral to borrow from the Fed at low risk to taxpayers.

By contrast, Bernanke said, Lehman’s status as a going concern was “melting away” as trading partners pulled back from the firm amid questions about its capital position and access to cash. The Fed couldn’t have lent to Lehman without risking a large loss, he said.

One issue Bernanke didn’t explicitly address was the domino effect on AIG’s trading partners had the insurer been allowed to fail. Critics of the AIG bailout and the Fed’s reluctance to disclose the effects of its actions contend the AIG rescue was actually a backdoor rescue of trading partners, notably some big foreign banks and Goldman Sachs .

Bernanke did say he believed an AIG failure would be “catastrophic,” and that the heavy use of derivatives made the AIG problem potentially more explosive.

An AIG failure, thanks to the firm’s size and its vast web of trading partners, “would have triggered an intensification of the general run on international banking institutions,” Bernanke said.

In an interesting twist, Bernanke was also asked how the Fed might handle the crises at Bear Stearns, Lehman Brothers and AIG had the financial reform law passed this summer been in effect in 2008.

The Dodd Frank Act gives regulators something Bernanke and other policymakers have been asking for since the crisis began, the ability to wind down big nonbank financial firms without resorting to a bankruptcy filing. Bernanke said ensuring that troubled big firms don’t get bailed out is the key to ending the financial system’s destructive too big to fail mentality.

“There has to be a credible way to let firms, in fact to require that they fail,” Bernanke said.

Accordingly, he said, the crises at Bear, Lehman and AIG under the new regime would likely result in the firms’ resolution – the process of winding down their operations and liquidating them over time.

That means AIG, next time around, would go through the wringer too.

“I don’t see what the alternative would have been,” he said, “unless we could have stopped the run through some cheery words of some kind.”