Financial Meltdowns: How Big a Blow to the Economy?

[ProSense]

Financial Meltdowns: How Big a Blow to the Economy?

By Justin Fox Monday, Sep. 15, 2008

There's been talk of a potential failure of Lehman Brothers for months, and the investment bank already had a near-death experience in 1998. Merrill Lynch has been labeled takeover bait for two decades. Insurers do go under from time to time.

But throw together the collapse of Lehman — the biggest-ever U.S. bankruptcy — the lightning takeover of Merrill Lynch by Bank of America, concerns that giant insurer AIG is now on the brink as well, and a financial crisis that has been rolling along for more than a year now, and you get a day that will be enshrined in the history books. Whether it will go down as an economy-shattering debacle or a near miss is something we'll only figure out over the coming days and weeks. The initial reaction of U.S. stock markets — down sharply but far from disastrously at the open on Monday — is that it's the latter. But who knows?

The chain of events over the weekend went something like this: Efforts to find a buyer for struggling Lehman Brothers collapsed in the face of government resistance to any kind of bailout and the refusal of all potential purchasers (UK-based Barclays was reportedly the one that came closest to making an offer) to sign a deal without government backing. With Lehman headed for bankruptcy, Merrill Lynch was the next- most-vulnerable-looking Wall Street firm, so its CEO, John Thain, quickly inked a $29 a share sale to Bank of America that values Merrill at $50 billion. Meanwhile, AIG asked the Federal Reserve for a $40 billion loan to tide it over — a loan it seems unlikely to get.

The root cause of all this trouble is pretty simple. Banks and Wall Street firms made trillions of dollars in loans they shouldn't have — chiefly subprime home mortgage loans. Now they're having to write off the losses, and some of them no longer have enough capital (money available to cover losses) to get by. Complicating matters for both outsiders and Wall Streeters is the alphabet soup of derivative securities (CDOs and CDSs in particular) that now trade in far greater volumes than stocks. It's the interaction of derivatives markets, debt markets and the housing market that has proved almost impossible to get a grip on.

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Sept. 15 (Bloomberg) -- U.S. stocks tumbled, pushing the Standard & Poor's 500 Index to the steepest drop since the September 2001 terrorist attacks, as Lehman Brothers Holdings Inc.'s bankruptcy and declining commodities increased speculation that credit-market losses and the economic slowdown will worsen.

Lehman plunged 94 percent and American International Group Inc. sank 61 percent after more than $25 billion in losses from subprime-related investments in the last four quarters made with mostly borrowed money. Economic concerns pushed down oil, prompting a drop in energy stocks, and sent General Electric Co. to an 8 percent retreat. Stocks erased more than $600 billion in value as financial shares in the S&P 500 decreased the most since at least 1989, according to data compiled by Bloomberg.

``Fear is in charge,'' said Henry Herrmann, president and chief executive officer of Waddell & Reed Financial Inc. in Overland Park, Kansas, which manages $70 billion. ``This blows another hole in the banking system's ability to extend credit.''

The S&P 500 declined 58.17 points, or 4.7 percent, to 1,193.53, the lowest level since October 2005. The Dow Jones Industrial Average tumbled 504.48, or 4.4 percent, to 10,917.51. The drop followed a slump across Europe and Asia. The dollar weakened the most against the yen since 1999 and two-year Treasury notes surged the most in seven years.

More than 23 stocks slipped for each that rose on the New York Stock Exchange on concern financial shares will continue their slump. The S&P 500 has decreased 24 percent since an October record as bank losses from the first nationwide decline in U.S. home values since the Great Depression reached $514.6 billion.

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US in 'once-in-a-century' financial crisis : Greenspan

Let's not forget Phil Gramm

[ProSense]

1. "The collapse of Lehman dwarfs WorldCom Inc.'s insolvency in 2002"

His comments came as stocks tumbled, pushing the Standard & Poor's 500 Index down 4.7 percent, its steepest drop since the September 2001 terrorist attacks, as investors worried about a deepening of a yearlong credit rout that has led to $514 billion of writedowns and losses worldwide. The Dow Jones Industrial Average dropped 504.48, or 4.4 percent, to 10,917.51.

``We are working through a difficult time in our financial markets right now,'' Paulson said. ``The American people can remain confident in the soundness and resilience of our financial system. Our banking system is a safe and sound one.''

U.S. policy makers are grappling with limiting the impact of the financial market crisis on the U.S. economy. A Fed report today showed industrial production in the U.S. fell by the most in almost three years, indicating the economic slowdown will deepen amid the housing recession and rising unemployment.

Paulson said that housing is at ``the root'' of the economy's problems and that there is ``a reasonable chance'' that the bulk of those problems will be over in months.
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Lehman was forced into bankruptcy after Bank of America and Barclays Plc walked away from takeover talks yesterday. Bank of America, the biggest U.S. consumer bank, then agreed to pay about $50 billion for Merrill Lynch & Co. The collapse of Lehman dwarfs WorldCom Inc.'s insolvency in 2002 and Drexel Burnham Lambert's failure in 1990.

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