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.

Tags

More like this

I've found a good post that does a very good job of laying out some of the long range and immediate factors that lead to our current economic woes. David Paul lays out how credit default swaps (CDS's) lead to the collapse of AIG (italics mine): ...AIG's collapse came as a result of the following…
(This is sort of a round-up of comment on the economics news. I don't have much to say about it yet.) It would appear that the economy has just gone from bad to really bad, although if you wanted to be technical it was probably bad already. Prices just hadn't fallen to reflect the true magnitude…
With the insanity that's been going on in the financial world lately, a bunch of people have asked me to post a followup to my earlier posts on the whole mortgage disaster, to try to explain what's going on lately. As I keep saying when people ask me things like this, I'm not an economist. I don'…
In the past, I've referred to Peter Pan Conservatives--those who think that winning wars is largely about will (and not logistics, supply, or local political conditions). Well, Treasury Secretary Geithner is now practicing Peter Pan economics: ...top officials in the Obama administration and at…

Would it help to take longer perspective? Who was exposed to Lehamn? Read: what sovereign fund (if any) invested in Lehman. If there was some significant exposure of that kind, may be it was created by somebody whose eyes we once looked into seeing absent virtues? Such betrayed feelings often fill us with desire for revenge.......

By Roman Pohorecki (not verified) on 05 Oct 2008 #permalink