September 2008 Archives

...is by David Altig.  (Though some of his commenters have dissenting views.)

Five days ago, I wrote:

So I am fairly confident that a "workable" solution will be reached before the markets open on Monday.  I do not look for an "optimal" solution.  If an optimal solution exists, it is undoubtedly too complicated to be "workable".  But I believe that a number of ideas on the table have the potential to avert a complete meltdown.  I think that when all the parties (including both McCain and Obama) meet behind closed doors and really come to grips with the magnitude of the problem and the fact that a workable solution exists, we'll get one.

I sure hope I'm right.

I was wrong.  At least for now.  There's always the possibility that something will happen later this week.  I don't know what the likelihood is.  Obviously the party whips don't know either--and they're the ones who should. 

At the moment, the way I am organizing my thoughts about the situation is in the form of questions and answers.  So here are the questions I've been asking myself, and my best attempts at some answers.

Q:  Did we need this bill?
A:  I would be careful not to say that we needed this bill.  That is, neither this bill nor any bill was or is a necessary condition for preventing financial Armageddon.  Certainly there were some other options out there other than this bill that I may have preferred.  But after the bill failed, the Federal Reserve announced additional lending measures.  This represents another stop-gap measure that hopefully will help us limp through tomorrow.  The Fed could (with the assistance of special treasury issues) continue to do this for some time.  But of course this is not what we like to see either.  It would be nice to get a legislative solution.  However, if Congress is too dysfunctional to do it, then so be it.  There are other ways.

Q:  What is the biggest mistake that Congress and others are making?
A:  Actually, I see two misconceptions being perpetrated out there.  One is the framing of this issue as Wall Street versus Main Street.  That is, that the government is taking from Joe Six-Pack to give to big bankers.  On the other side of the aisle, there are those who oppose this or any "bailout" out of an unwavering commitment to free market principles.  That is, the bailout is just socialism by another name and should be rejected outright.

Both views have an element of truth, but both views also miss the point.  I think most of my readers understand the connection between Wall Street and Main Street.  However, it is becoming clearer that many people have never made that connection.  And let's be clear, it's not about the stock market!  The fact that the stock market dropped over 700 points is a symptom--not the disease.  The reason to do the deal is not to prop up the stock market--though that certainly gets (and deserves) a lot of attention.  But the drop in the stock market is just an indicator of the drying up of liquidity.  If you doubt this, just read John Jansen's excellent blog (Across the Curve).  If this continues for much longer, it WILL cause firms to have difficulty meeting payroll, paying for inventory, and financing expansion.  At that point, Main Street is affected.  That is what happened in the Great Depression in a very big way.  We may be able to stave off a Great Depression, but there is the potential for a very severe recession.

Those who say the bailout is socialism may say that a severe recession may be the price we have to pay and is not an excuse for such an intervention.  I understand this argument, and it is not entirely without merit.  If the situation, as I understand it to be, was less dire, I might even agree.  But Ben Bernanke is a student of the Great Depression.  If he's worried, then I am too.  My own study of history tells me that this is the closest we have come to such a scenario since the Great Depression.  So I am willing to put aside the "bailout is socialism" argument and argue that a strong government response is warranted.

Let's take a look at some very smart words from Robert Shiller, an economist that I respect a great deal:

So is the government's bailout a major departure? Hardly. Today's federal involvement offers bailouts as a strictly temporary measure to prevent a system-wide financial calamity. This is entirely in keeping with our basic principles -- as long as the bailout promotes, rather than hinders, financial democracy.

Which, so far, it seems to. Congressional critics may be right to demand more help for homeowners and more accountability for Wall Street blunders, but the core idea of the plan is sound: to protect the financial infrastructure. Remember, Fannie Mae used to be a government entity, and by taking it over, the federal government is merely returning to the status quo ante. The measures to take toxic debts off the hands of financial and insurance firms are intended only to deal with a crisis, not to transform our financial system. The proposals do not represent any landmark change in the American way of prosperity. Everyone should take a deep breath. Changing our thinking about finance does not mean abolishing capitalism, but it does raise questions about what the changes mean.

Indeed.  Whatever "bailout" happens, if any, it will not be a permanent intrusion of socialism into the financial markets.  In fact, this represents a tremendous opportunity to modernize the financial system.  By "modernize", I don't mean the kind of derivatives that got us into trouble, but rather a sensible set of regulations that acknowledge the moral hazard problem and prevent institutions from doubling-down on a bad bet.  Read the rest of Shiller's column for more specifics.  I agree with his assessment.

This is a profoundly unique moment in our financial history.  The Fed and the Treasury will do what they can with or without Congress--they have made that clear.  Hopefully that will allow us to limp along.  But I am really starting to worry about the possibility of a stagnant economy for many months if the normal lending channels are not unclogged very soon.

Just add this to the pile...  From the Bureau of Economic Analysis

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 2.8 percent in the second quarter of 2008, (that is, from the first quarter to the second quarter), according to final estimates released by the Bureau of Economic Analysis. In the first quarter, real GDP increased 0.9 percent.

The GDP estimates released today are based on more complete source data than were available for the preliminary estimates issued last month. In the preliminary estimates, the increase in real GDP was 3.3 percent.

... comes from Menzie Chinn:

So if we end up delaying until households and small firms individually experience the credit crunch directly for the sake of ideology, well, we'll know where to locate the responsibility.

So says a "smart friend" of Greg Mankiw.

For the last few days, I've been listening/reading rather than talking/writing.  Reflecting on what I have read and heard, there is one thing that stands out.

Everybody's got their own idea of how they would fix the financial markets.

Some are actually pretty good and might even work better than what we'll probably get.  Others sound good but probably wouldn't work in practice.  Others are downright nonsense.

But the purpose of this post is not to list and categorize all of the proposals floating through the blogosphere.  Nor will I offer a complete proposal of my own.  Rather, I just want to offer a few general observations.

I'm generally in favor of getting this toxic paper off of the balance sheets of the banks in the interest of unclogging the system and restoring a sense of normalcy in the markets.  I am genuinely concerned about what could happen if the banks continue to hold this paper for a long period of time.  The crisis of confidence and the inability to lend would lead to a stagnation not unlike Japan in the 1990s.

So if we agree to take this paper off the books of the banks, the next step is to agree on a way of valuing that paper.  Given that the market for this paper is not functioning very well, price discovery is a challenge.  The government would be making the market, and being the only buyer of any consequence, you'd think that they would be able to buy the paper at a pretty good discount.

But...

If the government buys the paper at fire sale prices, you still have the solvency problem and many financial firms could go under.  While many folks may not lose a lot of sleep over this, there still is the matter of making sure that the market participants are on sufficient footing to move forward in the aftermath.  With lots of insolvent firms out there, credit will still be constrained.

Since fire sale prices will not cure the insolvency problem and since paying more than market prices means taxpayers are more likely to lose, there is a reason to look for another way.  It would not be out of line to require troubled institutions to give up some equity in return for the above market price on the assets.  That way, the shareholders will bear some of the cost--as they should.

It is also not out of line to demand management changes and a reduction of the "golden parachutes".  I am not against multi-million dollar salaries for CEOs whose leadership is valued by the market.  But I do believe that some of the cases we have seen recently are evidence of a collective action problem in which the shareholders have been unable to exert the optimal level of control over compensation issues.  In the long run, that's a problem that deserves more study.  In the short run, in the case of insolvent firms dumping their toxic paper, a more direct approach may be in order.

I'm not against having the firms being "bailed out" suffer a little pain in the process.  But for the sake of the system, that pain cannot be so severe that it threatens the ability of the firms to function in the future.  If you're looking for my bottom line, there it is.

There will have to be regulatory changes going forward.  However, it is impractical, and I believe folly, to require those changes as a condition to passing this "bailout" package as some in Congress would like.

The world markets are watching.  At the moment, the world markets are extending their forbearance to us as they wait to see how we are going to handle the solvency crisis that now looms large even as the liquidity crisis enters its end game.  They have been very patient with their forbearance.  But if inaction means a significant risk of catastrophic failure of these institutions, then the world's patience will wear thin.  And that's a scary thought.

So I am fairly confident that a "workable" solution will be reached before the markets open on Monday.  I do not look for an "optimal" solution.  If an optimal solution exists, it is undoubtedly too complicated to be "workable".  But I believe that a number of ideas on the table have the potential to avert a complete meltdown.  I think that when all the parties (including both McCain and Obama) meet behind closed doors and really come to grips with the magnitude of the problem and the fact that a workable solution exists, we'll get one.

I sure hope I'm right.

By the way, today's award for the best job of explaining the consequences of inaction and the issues inherent in the different approaches to a solution goes to Peter Orszag of the CBO for his testimony to the House Budget Committee.  His complete statement is on the CBO Director's blog.  Excellent explanation.

From the NY Times:

Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government.

That strategy held banks responsible and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.

Worth a look.

Here's the NY Times article explaining it.  Calculated Risk explains why it's not quite like the RTC.  Actually, the buying of distressed mortgages from banks that don't want them sounds more like the original Fannie Mae.  There is an important difference from Fannie Mae in that this does not appear to be permanent.  Its temporary nature is one point of similarity with the RTC.  I think we'll just have to wait and see what it looks like when it's all said and done.

I haven't had time to think about it enough to have an opinion.  I'll probably wait until the details are out.  I do have some questions though.  One thing I don't have a feel for is how much of a discount will be taken when the government purchases these assets and what they'll be worth when the government sells them.  Just how quickly will the plan restore these balance sheets to something approaching normal?  For all the attention the other interventions have received, this one has the potential to really be The Big One.

Doesn't the fact that overseas markets are surging in response to this make you the least bit nervous about how this will be interpreted?

What will become of the $70 billion private liquidity fund?  Will it even be tapped now that The Big One is on the horizon?

My working hypothesis is that the connectedness of the markets made this simply impossible to unravel piece-by-piece.

It's been a while since I've said this, but my sentiment right now is approximated most closely by Paul Krugman's latest column.  Go.  Read.  Understand.

This just hit CNBC's website:

Morgan Stanley CEO John Mack held various conversations with potential merger partners Wednesday afternoon including top executives at Citigroup and Wachovia Bank. However, Mack continues to work to keep Morgan Stanley an independent company CNBC has learned.

Executives at Morgan are currently crunching numbers to determine how much of an additional minority stake they need to sell to settle market fears about the company.

Mack's plan is to sell a piece of Morgan Stanley to a Chinese bank. Mack has been dealing with Chinese government officials all day Wednesday to line up money from China.

It's shaping up to be another interesting day tomorrow.

This one comes from Lawrence White at Division of Labour.  It's a Forbes article on the Shadow Financial Regulatory Committee (which is sponsored by the American Enterprise Institute).

Washington, D.C. -

An independent panel of academics Monday cautioned Washington against rushing into an innovation-stifling regulation of investment banking, but urged that structures be put in place to ensure the industry itself bears the cost of any future federal bailouts.

The Shadow Financial Regulatory Committee also took a stand against new restrictions on short-selling and recommended that the government liquidate Fannie Mae and Freddie Mac once the market for mortgage financing has stabilized. The federal government took over the two quasi-private mortgage giants earlier this month.

...

The committee noted approvingly that the Federal Reserve Bank of New York has been pushing industry players to create a central clearinghouse for credit default swaps and other derivatives. In a clearinghouse model, Calomiris said, investment banks would share the costs of a member's default, thus creating an incentive to enforce capital standards and to demand more transparency from other participants.

The committee also recommended that the federal government levy a special assessment on investment banks to pay for any future industry bailouts, thus giving the bankers an incentive to support federal intervention only when a failure would present a true risk to the financial system.

The model for this, the committee noted, was established when Congress passed the Federal Deposit Insurance Corporation Improvement Act of 1991.

...

The $70 billion liquidity fund that 10 financial institutions, including Citigroup, Credit Suisse and Deutsche Bank, agreed to set up over the weekend was an acknowledgment by these institutions that it's appropriate for them to share losses to contain systemic risk, the committee noted.

In his post, White adds:

If the Fed and Treasury are now giving a de facto guarantees to the creditors of investment banks (as in the Bear Stearns intervention), why not require the Fed or Treasury to recoup the cost through an assessment on all investment banks? That would insulate ordinary taxpayers, and it would give healthy investment banks an incentive to oppose unnecessary bailouts. Ditto for guarantees to the creditors of insurance companies (as in the AIG nationalization).

It is a bad idea to extend federal guarantees to the creditors of investment banks and insurance companies. First-best is to let those industries organize their own cross-supports (on the model of pre-Fed bank clearinghouses) if they think it worthwhile. But extending federal guarantees to an industry at a zero price, subsidized by ordinary taxpayers, is the worst idea of all.

I could certainly get behind such a proposal going forward.  The liquidity fund setup over the weekend is definitely a step in the right direction.  To the extent that the Fed and Treasury used moral suasion to make it happen, they deserve some credit.  Providing government guarantees to insurance companies is not something that I like to see either, but I'm willing to give the benefit of the doubt to the front line troops in the heat of battle.  I would agree that for the next firm in this position, the Fed and Treasury need to lean on them really hard to use the private liquidity fund.  I mean really hard.

Another good comparison that may be more familiar to people would be the way that we fund unemployment insurance.  Unemployment insurance is funded by a tax on employers that is experience rated.  That is, firms that have more layoffs are taxed more heavily.  Likewise, the government could set up an assessment (i.e. tax) on investment banks, perhaps even make it dependent on an audit of their financial position and transparency.  I think that idea deserves some attention.

There is a way forward.  And it is definitely appropriate to start thinking creatively about ways to prevent the moral hazard which could lead to another crisis.  The door is broken and the cows are out of the barn.  Our first priority is rounding up the cows, but it doesn't hurt to put a few smart minds to work on the problem of fixing the door--it may even keep in some of the cows that have not yet escaped.

Here's an interesting comment from the WSJ MarketBeat blog:

"With this move the Fed and Treasury have blinked in the face of market pressure once again," writes Drew Matus, economist at Merrill Lynch. "They continue to react to situations rather than getting in front of them and now they have created uncertainty about what firms qualify for bailouts and which do not."

Let's think about this.  If there was an easy way to tell which firms pose the most potential for systemic risk and if the Fed started to "get out in front" of those situations, what do you think the result would be?

Yeah.  Not pretty.

A little uncertainty is a good thing here.

The other important thing to remember in all this is that the size of the AIG "bailout" may be much less than the $85 billion that has people worked up.  This is really just an extension of the Fed's credit facilities that have always been available to commercial banks and have recently been extended to investment banks.  AIG would not qualify for such help from the lender of last resort, but the harm to the system from its failure would be at least as great as the harm from failures of a traditional bank.  Therefore the Fed used its emergency power to extend that credit to them.  AIG will essentially reorganize as if it were going through bankruptcy but without the agony to the system that a bankruptcy would cause.  There's a very real probability that the Fed could come out ahead on this deal.

Tyler Cowen explains why no one else was willing to do it, and Felix Salmon also agrees with me on the possible upside.

The next big problem in the short term is getting the money market through all of this.  No sighs of relief until they are, at least temporarily, out of the woods.

Here's the statement from the Fed:

The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers.

The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.  

The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy. 

The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility. 

The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries.  These assets include the stock of substantially all of the regulated subsidiaries.  The loan is expected to be repaid from the proceeds of the sale of the firm's assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.

The Wall Street Journal gives a very thorough rundown of all the details.

Opinions are surely going to be divided on whether this is a good thing or not.  John Jansen sees the Fed as "careening down a very slippery slope".  I have a feeling that most commentators will be against it even though their specific reasons will differ.

Mark Thoma thinks it is a good idea.  And while I would have rather seen them tap the private equity market, something had to be done.  Recall that AIG has been turning down private assistance for the last couple days because they didn't want to give up control of the company.  With the Fed deal, they will surely give up some control, but exactly what the company will look like going forward remains to be seen.

Is it a bailout?  Is it a takeover?  To me it looks more like bankruptcy by another name.  Effectively it gives AIG some time to sell a lot of its assets--more than just the junk--and reorganize itself.  In the meantime, its creditors will be made whole.  Equity holders may properly bear some of the cost as the government has veto power over dividends.  At the end of the 24 month period...hopefully...the company, in whatever form it takes, can resume something approaching normalcy.  Assuming, of course, that it has any reputation left.  Perhaps sometime during or after that 24 months a suitable buyer can be found.  These are questions that no one can answer now.

Make no mistake, this is not something that the Fed should enter into lightly, and I am quite confident that they took this step only when it became apparent that it was the last option.  But this might have been one of those turning points where a decisive action had to be made.  Anyone who has not read chapter 7 of Friedman and Schwartz needs to do so right now.  Every time I tell a macroeconomics class about the mistakes the Fed made in the Great Depression, I end by talking about the many things we have learned since then about how not to let it happen again.  Few people know those lessons better than Mr. Bernanke.  Dithering in the face of these problems only makes them worse.  Better to have swift decisive action and move toward a resolution.

To those who say that this fails to properly punish those who took excessive risk, I agree in part but can only say that protecting the innocent (or perhaps less guilty) is more important right now than punishing the truly guilty.  To those who would say that this is an affront to the free market system, I would simply say that without confidence in market institutions the system doesn't work.  The system's ability to restore that confidence has been compromised by the foolish actions of many people.  Some will get their comeuppance.  Some will not.  It's not a perfect world.  We'll try to reform the system so as to do better next time.  Right now let's focus on doing it better than last time.

In a nice commentary, Calculated Risk appears cautiously optimistic.

There will be more grim news, perhaps for another year or more. And there is definitely some possibility of a systemic financial collapse (see Professor Roubini's excellent discussion of the downside risks). But unlike observers that believe this only marks the end of the beginning, I believe there is a chance that these events mark the beginning of the end of the crisis.

As I said yesterday, I think the end game has begun.  Clearly the push to mark down the values of these assets is in full swing.  The AIG deal could be a catalyst for an orderly sale of these assets, a rebalancing of portfolios, and a fair market valuation of assets on the books of other firms.  In the process, we might find other AIGs, but more than likely any of the truly enormous problems will be discovered first, and that process may not take too long.  Several months, perhaps--but not several years.  Indeed, we are fortunate that these problems are being discovered and dealt with rather than festering for a decade or more.

I've been in class all day, so I haven't had a chance to write about the days events.  Actually, there's not that much more to say other than that I really admire the fact that the Fed held the line on interest rates today.  As I said yesterday, the crisis is one of quantity, not of price.  The new lending facilities are much more important and useful than a 25 basis point cut in the funds rate.  So my confidence has been buoyed by this news.

Here's the link to the Fed's press release.

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Ms. Cumming voted as the alternate for Timothy F. Geithner.

My quick take is that it is very noncommittal about whether any rate cuts are forthcoming.  The inflation pressure still figures prominently in the press release, though they do expect inflation to ease.  This is an announcement that leaves all avenues open--and that is a very good thing.

In my intermediate macro class today, I lectured against a backdrop of the live (well, actually slightly delayed) tick-by-tick chart of the fed funds futures on the CBOT.  I was teaching macroeconomics as it happened.  You don't get to do that very often.

Seems like the big questions on everyone's mind are whether there will be some kind of development with AIG tomorrow, which firms are most exposed to Lehman, and whether the Fed will cut interest rates.  It goes without saying that everyone is also wondering about whether and how much the Dow may fall.  As I write, the futures market is down, but not drastically, suggesting that the day may start on a down note.

I can't say much about the first two.  But let's think about the Fed for a minute.  When I wrote in the afternoon, it looked like the market was only pricing in a small probability of a rate cut.  Late night coverage on CNBC suggests that the probability has increased substantially now.

The Wall Street Journal acknowledges the uncertainty:

Federal Reserve officials aren't inclined to veer from plans to hold short-term interest rates steady at Tuesday's meeting, even though financial markets are putting strong odds on a quick rate cut.

The Fed's thinking could change, particularly if there is another sharp deterioration in markets and the financial sector Tuesday. And even if officials decide to stay on hold, they could signal in their end-of-meeting statement a greater willingness to consider rate cuts if the economy or markets worsen.

A rate cut would be a confidence booster, to be sure.  Ordinarily, one might expect a rate cut in this case would prevent the financial market problems from spreading to Main Street.  I'm not sure that 25 basis points (or even 50) would really have much of an effect in that regard.  Plus, if the Fed were to cut 50 b.p. tomorrow (as some are expecting), it leave only another 1.50% to go before hitting the zero lower bound.  Given that this could go on for a while, it is imperative that they hold back some ammunition just in case things get much worse.

But most importantly, I don't see how 25 points (or even 50) does anything substantial to ease the credit crisis that the expansion of the quantity of credit through the various lending facilities can't do.

In the end, they may decide that a 25 or 50 point move is necessary to inspire confidence.  I would like to think that in the last year the market has wised up in that regard and can understand that this problem will not be solved by a rate cut any time a financial firm runs into trouble.

These are momentous times, the likes of which we will be talking about for years to come.

Repeat after me.  Always think twice before importing a new species into an ecosystem.  Even if you think you're keeping it in a closed environment--there's always a chance it will escape.

Ignore that warning and stuff like this happens.

FYI, the location in the story is about a half-hour drive from me.

Fact:  Cell phone use on airplanes is prohibited because of concerns about interference with the avionics.

Fact:  Airlines are beginning to allow broadband Internet access through a special connection that will not interfere with the avionics.  Yet, the airlines have blocked access to Skype and other VoIP software.  (Joe Sharkey explains in this NY Times essay).

Claim:  They're worried about people talking too loudly in the cabin.  As Sharkey explains:

Airlines should allow voice calls, at least for business travelers, one woman posting on Computerworld.com said, adding that she thought businesspeople could be counted on to use the service in a "respectful, quiet manner."

But that optimism isn't shared by others who assert that, as a blogger elsewhere put it, "these Type-A business people are the worst in bellowing on their cellphones." Another comment on Computerworld.com supported the in-flight blocking of Skype and similar programs "until phone users learn to speak in a normal conversational tone instead of shouting."

Fact:  Those in-seat phones that charge outrageous rates are still there, but their future is in question now that Verizon sold the service to LiveTV.

Drawing the appropriate conclusion is left as an exercise for the reader.

I watched the press conference with the John Thain and Kenneth Lewis (CEOs of Merrill Lynch and Bank of America, respectively) as well as the CNBC interview with Lewis.  Mr. Lewis looked like the cat that ate the canary.  He certainly gives the impression that this is the deal of a lifetime.  Who knows?  He may be right.

At this point, I have begun to make a few inferences.  We'll see how accurate they turn out to be.

1. Based on CNBC's reporting, it sounds like Merrill Lynch really cleaned up their act (and their books) in the last few months.  They make it sound like Merrill might have even been able to survive this crisis without being sold.  That's encouraging.  Perhaps some of the other firms that are in less dire condition may be able to heal themselves, even if it takes some time for it to all work out.
2. Either Lehman's position in the market must have been significantly different than that of Bear Stearns a few months ago, or the market is better equipped to deal with a failure of that magnitude.  Both could be true as well.  There was no cataclysmic market meltdown this morning.  Contrast that with the speculation on what might have happened this spring if Bear Stearns had declared bankruptcy.  This is also encouraging.
3. Remember when people criticized the Fed for taking part in the rescue of Bear Stearns?  Remember when people said that it would create moral hazard and make it difficult for the Fed to say no next time?  Well, apparently the Fed is stronger than a lot of people gave them credit for.  While I don't think Mr. Bernanke expected it to play out exactly this way (who would have?), I do applaud him for taking the action with Bear Stearns to prevent the first incident from being such a shock to the system.  A lot of people wanted a sacrificial lamb.  Mr. Bernanke may have been correct in thinking that a better candidate than Bear Stearns would come along.
4. AIG's potential collapse sounds like it would have a greater impact than Lehman's.  I think the Fed is right to hold the line.  The announcement from the governor of New York will help.  The growing pool of private equity might help too.  And of course someone might ride to their rescue as well.
5. Expect another year of write-downs, bankruptcies, and mergers.  But I think that the end game has begun.  By that, I do not mean that the danger is over or that things will get eaiser.  When I say that the end game has begun, I mean that the deals will start happening at a quicker pace in the next 12 months than in the last 12 months and that each one will bring a bit of relief, however slight.  The financial markets will probably not be over this until 2010, and even then they won't be at pre-crisis strength.

So then there is the matter of the FOMC meeting tomorrow.  September futures on the Chicago Board of Trade jumped a little bit this morning on all of the news, but have pulled back a bit.  Traders are pricing in a significant probability of at least a 25 basis point cut.  However, it is far from a sure thing.  I'm hoping they don't.  I don't think they want to.  The expansion of the various lending facilities should do more to ease the strain than a 25 basis point cut anyway.  Plus there is the obvious fact that they would like to save some ammunition in case it is needed later if things don't play out as well as they might.

Let's see how things go tomorrow.

It certainly says something when firms that survived the Great Depression are falling victim to the aftermath of the last decade's credit binge.

And so the venerable Lehman Brothers passes from the scene at the age of 158.  When the sun rises in the morning, we will see how Wall Street deals with this development.  Of course, many people were expecting this, and undoubtedly made contingency plans.  By Friday, it seemed that a Sunday night announcement was almost a sure thing.  After all, we went through this once before with Bear Stearns.  Yet, even though this was possibility for the past few weeks and months, it is now reality.

It is interesting that Bank of America, which as of Friday many people were expecting to buy Lehman, took a pass on that deal and is instead buying the troubled (and storied) Merrill Lynch.  How's that for misdirection? 

But that's not all.  Showing once again that bad things do indeed come in threes, the insurance giant AIG is also in need of assistance.

With these three companies in such dire straits, the Federal Reserve did what it could... quoting in part:

The Federal Reserve Board on Sunday announced several initiatives to provide additional support to financial markets, including enhancements to its existing liquidity facilities. 

"In close collaboration with the Treasury and the Securities and Exchange Commission, we have been in ongoing discussions with market participants, including through the weekend, to identify potential market vulnerabilities in the wake of an unwinding of a major financial institution and to consider appropriate official sector and private sector responses," said Federal Reserve Board Chairman Ben S. Bernanke. "The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets."

"We have been and remain in close contact with other U.S. and international regulators, supervisory authorities, and central banks to monitor and share information on conditions in financial markets and firms around the world," Chairman Bernanke said.

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.

The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

By expanding the types of collateral accepted, the Fed addressing the need for liquidity by immediately expanding the quantity available.  At this point, that is what is needed (as opposed to any action on interest rates).

Justin Fox has a pretty good summary:

We'll learn much more about the exact chain of events over the coming days and weeks and months, but the basics go something like this: New York Fed boss Tim Geithner (and his pals from Washington) tried to figure out some way to avert the failure of Lehman Brothers without offering any kind of federal guarantee. But nobody wanted to buy Lehman without help from Uncle Sam, so it looks like Lehman will go under. Which meant Merrill Lynch would take over Lehman's spot as Most Obviously Troubled Investment Bank. So Merrill sold out to Bank of America at $29 a share ($44 billion total). Which is an awful lot less than the $97 a share Merrill was selling for a year-and-a-half ago, but also a lot more than nothing.

So on Monday we'll get to see what the failure of an investment bank with $600 billion in assets looks like. And more important, we'll get to see if the obviously deeply flawed American financial system will be able to retain the confidence of the foreign lenders and investors who keep it going.

One crucial thing to remember in all of this is that none of the experts on Wall Street have any real idea of what they're dealing with. What has worked for the past quarter century or so has stopped working. And nobody knows what American financial institutions are going to look like going forward. Probably a lot more like the universal banks of Continental Europe. But anybody who says they know for sure is lying.

Want to read a little history about the last time something like this happened?  Here's what the NY Times had to say about Drexel Burnham Lambert in 1990.  It reads a lot like today's news, right down to the weekend meetings.  Just replace "junk bonds" with "subprime mortgages".

There are some differences, of course.  The biggest difference is that there are still so many firms in similar condition that there is no guarantee that this crisis is over.  I think that Fox is right in saying that "anyone who says they know [what American financial institutions will look like after this] for sure is lying."  But I am confident that the system will get through this very troubling time.

As this Wall Street Journal piece by Justin Lahart points out, there needs to be quick and decisive action to prevent something like what happened in Japan during the 1990s.  The sooner everybody confronts that reality, the quicker we can get back to business.  It is good to get the "unwinding" process started as soon as possible.  Make sure that the smaller firms don't become collateral damage from counterparty risk, and let the consolidation result in the inevitable (but probably only short-to-medium run) shrinkage of the sector.

Every time one of these trouble firms is finally taken aside and shown the handwriting on the wall, we take one more step toward the day when someone gets to write one pretty massive after-action report.  And of course, now that the extent of the damage to these three firms has been revealed, the rush is on to find who is next.  Until the answer to that question is "no one", there will be more rough days ahead.  I don't think we're there yet.

John Jansen has some excellent commentary and I'm sure will be adding more in the morning.  He is quite worried about how all of this will end.

Government has not been able to hold bank the forces which have taken down financial giant after financial giant. Capitalism demands pain. Good risk is rewarded and imprudent risk is punished. We were engaged in an orgy of imprudent risk taking for nearly a decade and now a heavy price will be paid for the violation of so many simple and common sense precepts of trading.

Very true.  On a related topic, Tyler Cowen opines in the NY Times:

There is a misconception that President Bush's years in office have been characterized by a hands-off approach to regulation. In large part, this myth stems from the rhetoric of the president and his appointees, who have emphasized the costly burdens that regulation places on business.

But the reality has been very different: continuing heavy regulation, with a growing loss of accountability and effectiveness. That's dysfunctional governance, not laissez-faire.

Blame enough to go around, to be sure.  Like I said, it's going to be some after-action report.

Mark Thoma has a good collection of links for your morning reading as well.

Buckle up.  It could be an interesting day.

UPDATE:  Here's one more comment on the AIG situation.  First the Wall Street Journal:

During a weekend scramble to shore up its finances, AIG turned down a capital infusion from a group of private-equity firms led by J.C. Flowers & Co. because an option tied to the offer would have effectively given them control of the company, an 89-year-old giant that does business in nearly every corner of the world.

Which prompted Yves Smith of Naked Capitalism to say:

That is not going to endear them to the Fed, turning down a deal, particularly when Merrill did the right thing and sold itself to avert a possible systemic event. This is brassy and risks overplaying their hand. If I were the powers that be, I'd tell them to stuff it and take the deal.

Indeed.  I think the Fed is really trying to limit the taxpayers' exposure on this one.  If AIG turns down a deal, it gives others license to do so.  I don't like where that leads.

Our thoughts go out to the Texas gulf coast region this weekend as Hurricane Ike bears down.  Predictably, talk of price gouging has resurfaced.  See Market Power, EclectEcon, and Cafe Hayek.  I'll refrain from rehashing what I've said before (see here, here, and here if you're interested).  I haven't changed my views that much.  Basically it comes down to this:

(1)  The price system is useful for allocating goods in disaster areas.
(2)  The fact that I believe (1) is true does not mean that I think that people selling bottled water for $5/bottle is a socially optimal outcome.
(3) Big box retailers are able to move mass quantities at a relatively low cost and so can resupply affected areas more efficiently than what frequent commenter spencer calls "guys in pickup trucks".  They should be entitled to mark up the goods to recover their costs, but for a variety of reasons they may choose to mark up less than that or not at all.
(4) That (3) is true should be celebrated, but it should be pointed out that (3) does not invalidate (1).

Like I said, for the subtleties read my original posts, but that says it in a nutshell.

But now I would like to tap into another interesting aspect of this problem--the role of information.

For some time, I have been of the opinion that the real problem that underlies the price gouging phenomenon is the lack of information.  As a result of the lack of information, arbitrage becomes a risky activity and prices can vary widely across the affected area.  This is not an example of efficient markets at work, but it is also not clear that anti-gouging laws are the right way to address the problem.

Phil's post at Market Power comes closest to acknowledging this.  In response to a commenter asking where to report gas stations that are price gouging, Phil responds:

To competitors who are not.  They'll be happy to hear it. You might also try reporting  it to texasgasprices.com so that customers can be informed.  That will do more good than reporting it to some government agency.

And while I agree with Phil in spirit, I have my doubts that such reporting will do a lot of good in the heat of battle, when contraflow traffic is bumper-to-bumper on the interstate, the rain is starting to fall, and not everyone has Internet access in their car.

It may require a more low-tech solution like a radio broadcast or message boards.  But even those may not be realistic in the extreme situations that can result during an evacuation.  Can you imagine how things might change if radio broadcasts in a disaster area devoted a few minutes out of every hour to report on where the lowest prices are?  Being far from hurricane zones, I don't know--do stations do this already?  If so what is the response?

Part of the problem during the evacuations is undoubtedly the fact that people do not know what the price is at the next gas station they will encounter when they see the gas station in front of them has raised their prices.  With better information, less panic buying would ensue and there would in turn be less reason for stations to raise their prices so dramatically.

Turning to the aftermath, when people need water, cleaning supplies, chainsaws, generators, and the like, I think a solution is possible.  As I have alluded to before, the big-box stores do a good job of getting the supplies to the affected areas.  They may raise their prices on some items, not on others, and may even donate some items.  This is good.  Now consider how these stores contribute to the information available.  Everyone knows the names of these stores.  Most people live near them.  Word gets around fast that the trucks have arrived and supplies are available at a reasonable cost.  Information is the key.

Price gouging laws are not the best way to handle the situation because they don't address the real problem.  Some people will gouge anyway, hoping that they won't get caught--and invariably many will not get caught.  Some people may be erroneously charged with gouging and end up incurring the cost of defending themselves before the law.  All the while, the real reason for the dispersion in prices--the lack of information--persists.

Markets, whether at the stock exchange or the corner gas station, work because of the process of price discovery.  When price discovery is compromised, bad things happen.  Politicians have just chosen the wrong way to go about correcting the problem.  Getting better information to consumers about prices is the way to reduce the incentive to gouge.

While private entities may be able to provide this information, there may be a role for government to play as well.  That is, if we can get them off the fixation that price gouging laws are the way to go.  After all, going after criminals plays better with the voters than setting up an information system.  Passing laws makes it look like you're doing something.  And if the only tool you have is a hammer, every problem looks like a nail.

Clip art by T. C. Design

I so want to sit down and knock out a post on Fannie and Freddie, but I've been slammed this week.  Maybe tomorrow, and if not then, certainly this weekend.

My feed reader delivered this headline from the Wall Street Journal:  "North Korea Says Leader Not Ill."

Of course not.  He's "Il."  (Barrump-bump!)

But don't call him Mr. Il.  He is Mr. Kim.  Korean surnames come first followed by their given name.  According to answerbag.com, he shares this most popular surname with 22 percent of Koreans.

The headline on the link is different from what was delivered to my feed reader.  Perhaps someone noticed the odd way that it sounded.

From the BLS,

The unemployment rate rose from 5.7 to 6.1 percent in August, and non-farm payroll employment continued to trend down (-84,000), the Bureau of Labor Statistics of the U.S. Department of Labor reported today. In August, employment fell in manufacturing and employment services, while mining and health care continued to add jobs. Average hourly earnings rose by 7 cents, or 0.4 percent, over the month.

Series Id:           LNS14000000
Seasonal Adjusted
Series title:        (Seas) Unemployment Rate
Labor force status:  Unemployment rate
Type of data:        Percent
Age:                 16 years and over

One of the burning questions in my mind right now is when the NBER Business Cycle Dating Committee will declare that the recession began (and when they will make the announcement (see Brad DeLong's comment).

But this is an odd one, in part for the reasons stated by David Altig.  Altig stops short of calling this a recession, but contrasts the strong GDP data and the weak employment data as he pities the Business Cycle Dating Committee for the tough job they have ahead.

How do you square 3.3% GDP growth with a 0.4% increase in the unemployment rate?

As I pointed out earlier, the GDP growth is largely due to the falling dollar.  It's great if you're an exporter, but it does nothing to ease the pain in the housing sector.    And as the WSJ Real Time Economics blog pointed out, Gross Domestic Income paints a somewhat less rosy picture.  The unemployment rate, usually a lagging indicator, is looking more coincident, but that may be because the weakness in the economy is being masked somewhat.

There is little doubt in my mind that we are in a period that should be called a recession.  I could guess at when the starting date would be, but it would be just that--a guess.  I could make a case for sometime in the spring or summer.  And while I admit to being troubled by thinking of a recession in the shadow of 3.3% GDP growth, I am struck by some very strong differences between this recession (if it is one) and the last two.  The usual definitions aren't fitting well.

There's going to be a lot to talk about this fall.  I'm working on the local economic outlook and giving a presentation on it a week from tomorrow.  Lucky me.

Via Wired, here's an interesting idea--open source textbooks.

I think this could work.  I would consider contributing to such a project.