Explaining the Market Meltdown

As we witness the self-destruction of portions of our financial institutions, many of us have been ask ourselves: what the hell is going on?

University of Chicago economists, Doug Diamond and Anil Kashyap, have a Q&A at the Freakonomics blog to answer some questions. One important question is why the Fed chose to bail out Bear Stearns but not Lehman Brother:

When Bear was rescued, the Fed created a new lending facility to help provide bridge financing to other investment banks. The new lending arrangement was proposed precisely because there were concerns that Lehman and other banks were at risk for a Bear-like run. Since March, the Fed had also studied what to do if this were to happen again; it concluded that if it modified its lending facility slightly, it could withstand a bankruptcy; it made these changes to the lending facility on Sunday night.

Once the Fed had made these changes and determined that it and the others in the market had an understanding of the indirect or "collateral damage" effects of a bankruptcy, it could rely on the protections of the bankruptcy code to stop the run on Lehman, and to sell its operating assets separately from its toxic mortgage-backed assets.

Against this backdrop, if the government had rescued Lehman, it would have repudiated the claim that the Bear rescue was extraordinary; it would have also conceded that in the six months since Bear failed, neither the new facility that it set up nor the other steps to make markets more robust were reliable. Essentially, the Fed and the Treasury would have been admitting that they had lied or were incompetent in stabilizing the financial system -- or both.

Read the whole thing.

I still think the Fed has some 'splaining to do about bailing out AIG because the last time I checked AIG wasn't a bank and therefore not under the Fed's purview. (And if the US government gives into this nonsense and bails out the automakers, I kid you not I am moving to Dubai.)

As an aside, here is a testament to how skittish the markets have gotten and how much people are seeking low-risk investments (Hat-tip: Megan McArdle):

At one point today, the yield on the three-month Treasury bill (^IRX) hit 0.01%!!

One Freakin Bip!!

This means that the risk-free rate is now in direct competition with the underside of your mattress.

I would note that if the government continues to print money to bail out more firms, those T-bills aren't going to be safe investments. There are limits to the credit of the US government too. No wonder people are fleeing to gold.