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It's a tumultuous time everywhere. As Hurricane Ike battered the Gulf Coast and made its way up into the Midwest, a different kind of tempest was raging on Wall Street. Lehman Brothers, one of the oldest and most venerable investment banking and securities trading firms, was forced to declare bankruptcy when it was unable to find a suitor to help bolster its equity position. Merrill Lynch, another very old and venerable Wall Street firm, flew for shelter into a shotgun merger with Bank of America (but at least it was orderly enough to provide relatively favorable terms to Merrill shareholders). Lehman and Merrill are just the latest casualties in a long list of companies that have fallen victim to the mortgage meltdown. These include Countrywide (also acquired by Bank of America), Bear Stearns, IndyMac Bank, FNMA, and FHLMC. Add to that list a couple of municipal bond insurers, the auction-rate securities market, the asset-backed commercial paper market, and a bunch of hedge funds, and you can see that this contagion has been severe and widespread. Rumors continue to fly as to whether AIG or Washington Mutual may be next.
This weekend's news comes just one week after the prior weekend's announcement that the U.S. Treasury would take unprecedented steps to support the housing giants FNMA and FHLMC. What is strikingly different is the difference in the level and nature of the government's involvement. With FNMA and FHLMC, you have institutions that were chartered by Congress with a mix of public and private objectives. The government is intervening directly to support them with equity investments, as well as special financing facilities and market purchases of the firms' securities. It is understandable that the government felt a moral obligation to keep these two entities strong. There is also the practical and political consideration that right now they are the lynchpin of the only fully-functioning part of the mortgage market, the Agency securitization business.
This weekend, the situation was different. Treasury Secretary Paulson, as well as the Federal Reserve, were completely opposed to putting forward new government money to bail out Lehman. We now know that Lehman Brothers was not "too big to fail" from the Treasury's perspective. There had come to be an awareness that the Federal Government is painfully overextended with its multiple commitments to the financial system: the FNMA/FHLMC bailout, guarantees to JP Morgan for part of the Bear Stearns bailout, longstanding FDIC insurance for banks, and multiple newly-created lending facilities for banks, brokers, and GSEs. The automobile companies have begun clamoring for a government bailout of their own. Hey, pretty soon it will be the oil companies, then your local grocer, and eventually the neighbor kid's lemonade stand that will be looking for a bailout! Paulson decided that "enough is enough." The government is already overcommitted and can't do more without damaging its own creditworthiness, fomenting more excessive risk-taking in the economy, and pushing up the cost of borrowing for everyone.
The inflation numbers look pretty ugly, but they have been heavily overshadowed by the crises in the financial system. The Producer Price Index was released last week, with year-over-year prices rising by 9.6% (mostly due to rising energy prices) and the core rate (excluding food and energy) up 3.6%. During the coming week, we will see the release of the Consumer Price Index, with an expectation of a total year-over-year rise of 5.5% and a core rate of 2.6%. The Federal Open Markets Committee will meet this week to plot out the course of monetary policy over the next six weeks. Even though the inflation picture might justify a rise in short term interest rates, in the midst of the current chaos it wouldn't make sense and wouldn't be politically palatable to carry out that strategy. In fact the Fed may be inclined to go the other way, with the Fed Funds futures market signaling that rates might be cut as early as this week. With oil prices dropping by one-third over the past two months, we should start to see some moderation in inflation even in the absence of Federal Reserve intervention. So there is some good news amid the noise and the chaos.
The other good news is that, in spite of all of the turmoil among the titans of finance on Wall Street, the financial system is still open for business every day to provide core services for the average American. He or she is still able to get a mortgage (with a good credit history and a reasonable down payment on a moderately priced home), can still obtain car insurance and life insurance, trade stocks securely through a broker, and sleep soundly at night knowing that the family checking account is safe at the local bank.