Nov. 13 (Bloomberg) -- Maybe the Federal Reserve and the Treasury Department learned a lesson from letting Lehman Brothers Holdings Inc. collapse.

The alternative to a costly rescue could be worse: a long and painful recession.

If taking risks with taxpayers' money is part of a sweeping effort to prevent failures of large institutions that could threaten the entire system, so be it. Some institutions really are too big to be allowed to fail, a point driven home by the Lehman bankruptcy two months ago.

In the wake of that event, the world's financial system seized up, stock prices collapsed and frightened consumers slashed their spending. If there were any doubts about whether we were in a recession, that combination put them to rest.

American International Group Inc., the world's biggest insurer, unfortunately falls into the too-big-to-fail category. On Sept. 16, the Fed loaned AIG $85 billion in exchange for warrants to buy common stock that would give the government 79.9 percent of the company. The Fed extended another $38 billion in credit on Oct. 9.

That wasn't enough. On Nov. 9 the loans were restructured, interest rates were reduced and the Treasury chipped in $40 billion to purchase preferred stock in AIG. The same day, the company reported a $24.5 billion loss for the third quarter.

Unwarranted assistance for a failing company from Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson? Some critics sure thought so.

Good Gone Bad

Peter Morici, a University of Maryland business professor, called the help ``throwing good money after bad'' and said, ``Secretary Paulson appears more intent on helping his pals on Wall Street than protecting taxpayer interests.''

No, Paulson is risking taxpayer money in order to protect the whole country's interest, by preserving a functioning financial system. That's what the whole $700 billion Troubled Asset Relief Program, or TARP, is all about.

``We used TARP funds to purchase preferred stock in AIG, as part of a broader restructuring of their balance sheet, in coordination with the Federal Reserve,'' Treasury Interim Assistant Secretary for Financial Stability Neel Kashkari said in a Nov. 10 speech. ``This action was necessary to maintain the stability of our financial system.''

Would an AIG bankruptcy have the same sort of devastating impact on the system that the Lehman Brothers failure did? No one can be sure, though there's a real risk it would.

The risk is heightened because financial markets still are under duress. Goldman Sachs Group Inc. economists said on Nov. 10 that ``money market stresses are now about half as intense as in mid-October'' when they were the highest since at least 1984.

Extraordinary Step

``That said, money markets are still under considerably more strain than is normal, even during a recession,'' the economists told their clients.

An example of that stress led the Fed on Nov. 10 to take another extraordinary step in extending credit.

In October, credit-card companies, including American Express Co., were unable for the first time in 15 years to sell bonds backed by customer payments. To gain access to the Fed's credit facilities, American Express applied to become a commercial bank.

The Fed approved the application, waiving the normal 30-day waiting period because of ``the unusual and exigent circumstances affecting the financial markets,'' a Fed statement said.

More Help

The additional help for AIG also included a major new wrinkle in Fed assistance.

AIG has provided insurance on billions of dollars worth of collateralized-debt obligations. As the value of the CDOs has dropped, AIG has been forced to put up cash as collateral with the CDO owners, which is one reason the company had to borrow so much from the Fed.

To ease that cash squeeze, the Fed is creating a special purpose vehicle to purchase and hold some of the CDOs. It will be jointly funded, with AIG putting up $5 billion and the Fed $30 billion.

Until now, the Fed has sought to provide assistance primarily by extending loans backed by collateral rather than purchasing assets outright. The only exception was the $29 billion the Fed contributed to finance assets held by Bear Stearns & Co. when it was taken over by JPMorgan Chase & Co. in March. Those assets were placed in another special purpose vehicle.

The Fed, confronted with one weakness in the financial structure after another, has no choice but to cobble together solutions that prevent them from taking down the system. If taxpayers ultimately lose money as a result of these actions, it's to prevent the far greater losses from an economic meltdown.

(John M. Berry is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: John M. Berry in Washington at jberry5@bloomberg.net

Last Updated: November 13, 2008 00:01 EST