Left Flank

Leaving aside the deregulation rant, it's odd to hear Krugman calling for turmoil.

The real answer to the current problem would, of course, have been to take preventive action before we reached this point. Even leaving aside the obvious need to regulate the shadow banking system - if institutions need to be rescued like banks, they should be regulated like banks - why were we so unprepared for this latest shock? When Bear went under, many people talked about the need for a mechanism for «orderly liquidation» of failing investment banks. Well, that was six months ago. Where's the mechanism?

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Lawrence H. White disposes of the deregulation rant.

On campus this afternoon I overheard the following remark by a non-economist, trying to explain to another non-economist the Lehman failure and today's stock market decline: «It's a combination of deregulation and greed. Boy, if you deregulate enough, the greed will follow.»

If I had butted in, I would have made two points. (1) If an unusually large number of airplanes crash during a given week, do you blame gravity? No. Greed, like gravity, is a constant. It can't explain why the number of crashes is higher than usual. (2) What deregulation have we had in the last decade? Please tell me. On the contrary, we've had a strengthening of the Community Reinvestment Act, which has encouraged banks to make mortgage loans to borrowers who previously would have been rejected as non-creditworthy. And we've had the imposition of Basel II capital requirements, which have encouraged banks to game the accounting system through quasi-off-balance-sheet vehicles, unhelpfully reducing balance sheet transparency.

And, Megan McArdle takes aim at Senator Barack Obama's jugular.

This was not some criminal activity that the Bush administration should have been investigating more thoroughly; it was a thorough, massive, systemic mispricing of the risk attendant on lending to people with bad credit. (These are, mind you, the same people that five years ago the Democrats wanted to help enjoy the many booms of homeownership.) Lehman, Bear, Merrill and so forth did not sneakily lend these people money in the hope of putting one over on the American taxpayer while ruining their shareholders and getting the senior executives fired. They got it wrong. Badly wrong. So did everyone else.

What, specifically, should the Bush administration have done, Senator? Don't tell me they should have beefed up SEC enforcement, since this is not a criminal problem (aside from minor lies by Bear execs after the damage was already done). Perhaps he should not have reappointed Greenspan, or appointed Ben Bernanke? Both moves were widely hailed at the time. Moreover, to believe that a Democrat could have done better is to assert that a Democratic president would have found a Fed chair who would pay less attention to unemployment, or a bank regulator who would have tried harder to prevent low-income people from buying homes. Where is this noble creature? And why didn't Barack Obama push for him at the time?

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Now, this might be too optimistic!

Last March, Mr. Paulson convinced Fed Chair Ben Bernanke to cross a line when we bailed out Bear Stearns. Maybe that will cost $30 b. The Fannie Mae and Freddie Mac bailouts are difficult to cost out, but it will be at least $200 b. or $300 b. and maybe more. Last weekend, Mr. Paulson drew the line at putting taxpayer money into Lehman Brothers or AIG. Finally, there is some shared sacrifice. Now lets be willing to cut federal spending and to raise federal taxes enough in the next few years to keep from passing these burdens on to our children.

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Don't overreact, Lehman Brothers and Merrill Lynch are not that big a deal!

1) Why is the U.S. government taking a hands-off approach with Lehman when it was quick to bail out Bear?
2) What will the aftermath of Lehman's collapse look like, and what will it mean for global markets?

The answer to the first question, experts say, relates mostly to nitty-gritty market mechanics. The Financial Times reported last week that Bear Stearns, despite being a smaller firm, in fact posed a greater risk to financial stability than did Lehman. The reasons for this included Bear's deep involvement in the credit default swap market, its prime brokerage business, and its role in the financial clearing system.

A more basic factor also comes into play, and helps answer question #2 as well as question #1. Since Bear's collapse, a variety of reforms have been made that alter how the Treasury and the Federal Reserve operate. The FT's Peter Thal Larsen noted in a video analysis before Lehman's collapse that the six months following Bear Stearns allowed global markets to factor in the idea of a large bank collapsing, so the impact of losing Lehman is potentially less devastating than the shock of Bear's rapid demise. Even so, the news of Lehman's bankruptcy shook global markets on September 15, sending equities worldwide falling sharply (WSJ), particularly in the financial sector. The collapse also spotlights the high level of insecurity among other major U.S. financial institutions. Washington Mutual has been hobbled of late (Forbes) by loan defaults, and on September 15 the insurance giant AIG required emergency government authorization to loan itself $20 billion (NYT) in order to stabilize its operations. Above and beyond lingering concerns over liquidity and mortgage-backed debt, the collapse of Lehman could create new problems for financial firms. Analysts say unwinding all the financial contracts tied to the bank in an orderly manner will be no small task.

A six months learning curve?

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Donald L. Luskin says it's so, and Don Boudreaux agrees.

This would suggest that anyone who says we're in a recession, or heading into one -- especially the worst one since the Great Depression -- is making up his own private definition of «recession.» And probably for his own political purposes.

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Take your pick of perspectives on today's financial meltdown eliminating two investment houses and an insurer, AIG: doom, opportunity, and optimism. Here's my choice:

MARGARET WARNER: Professor Rogoff, do you think it will be until 2010? Alan Greenspan said yesterday he thought -- he hoped the housing market would stabilize sometime in 2009. And that's what Paulson said today, too.

KENNETH ROGOFF: Well, I'd put a little bit of optimism after today in that they're at least admitting there's a problem. Until now, the government policy has been to lower interest rates, try to bail out a firm here and there, and think that somehow this is going to go away.

But the problem is our financial sector is bloated. There have been years of epic profits. They've become too big. They need to shrink. And the government can't support them all.

And by finally really acknowledging that this weekend, I mean, I think it's looking towards some healing. And I think we're certainly going to have a deeper recession as a result of this, but maybe we might come out a little faster.

On the other hand, I certainly don't think we'll be in good shape still by the middle of next year.

DIANE SWONK: Underscoring that, I just wanted to add, Japan never acknowledged its problems, and that's why they had over a decade, almost 15 years of problems. This is somewhat -- as hard as it is, at least realizing your problems is one step to solving them.

KENNETH ROGOFF: Absolutely.

The Economist adds gloom for measure, not its usual manner.

Even if markets can be stabilised this week, the pain is far from over—and could yet spread. Worldwide credit-related losses by financial institutions now top $500 billion, of which only $350 billion of equity has been replenished. This $150 billion gap, leveraged 14.5 times (the average gearing for the industry), translates to a $2 trillion reduction in liquidity. Hence the severe shortage of credit and predictions of worse to come.

Indeed, most analysts think that the deleveraging still has far to go. Some question how much has taken place. Bianco Research notes that while the credit positions of the 20 largest banks have fallen by $300 billion, to $1.3 trillion, since the Fed started its special lending facilities, the same amount has been financed by the Fed itself through these windows. In other words, instead of deleveraging, the banks have just shifted a chunk of their risk to the central bank. As spectacular as this weekend was, more drama is on the way.

It's going to be a long few years.

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