politicalOBSERVER

Bernanke remarks at the Economic Club of New York on the day that “Stocks Post Biggest Drop Since 1987 Crash as Retail Sales Fall, Commodities Sink and Investors Worry About Hedge Funds”

A motivation of this blog is capturing a small fragment of history as it is expressed on the World Wide Web. The Credit Crisis has been a main focus for the last 14 months due to its impact on capitalist society, especially in relationship to Globalization. Ben Bernanke’s speech yesterday is an excellent consolidation of events and actions by the Fed, the Administration, and Congress. First, let’s look at economic news from the Wall Street Journal on the day of the speech to sketch the economic climate. I will bold items in the article for skimming.

From the Wall Street Journal “Economic Fears Reignite Market Slump”:

Fears of a deep recession sparked the worst drop in the Dow Jones Industrial Average in 21 years, as retail sales tumbled, demand for commodities sank and bank earnings fell.

The latest data suggest the U.S. economy is poised to fall into its deepest recession since the early 1980s. That news, coupled with renewed signs of trouble in the all-important markets for credit, reignited the sell-off in stock markets, all but wiping out the huge gains that shares had made in Monday’s rally.

The Dow dropped 733.08 points, or 7.9%, to 8577.91 as recession fears and continuing doubts about the world financial system’s prospects shook investors. Wednesday’s decline marked the Dow’s largest percentage drop since October 1987 and the second-biggest point drop ever. The index is down 21% this month and almost 40% from its record close a year ago.

Other indexes plunged, too, including the Standard & Poor’s 500 stock index, which fell 9.03%. Overall, investors lost about $1.1 trillion in U.S. stock-market value on Wednesday, the second day in history that they have lost more than $1 trillion in one day.

In Asia Thursday morning, markets were down sharply, including Tokyo’s Nikkei Stock Average, off 9.7% in early trading.

In another sign of economic weakness, demand for the most important raw materials continued to slide, with oil and copper prices falling sharply.

With the big drop in stocks, many investors fled into safe-haven instruments like the two-year Treasury bond, which rose in price, sending its yield down to 1.6%, while the 10-year bond price rose slightly to yield 4%.

The stock market was unnerved late in the day by new fears of instability in the financial system, this time in the hedge-fund industry. Traders heard talk that hedge fund Citadel Investment Group, whose funds are down between 26% and 30% for the year, was facing margin calls. The rumors fed an already anxious market, where investors have grown worried that some big, highly debt-dependent hedge funds could fail, causing more market declines…

Mr. Bernanke subtly left open the possibility of interest-rate cuts in the weeks or months ahead, noting inflation pressures have receded as a result of falling commodities prices.

But it’s far from clear how much effect further rate cuts would have. Investors have been demanding huge premiums — known on Wall Street as spreads — over benchmark interest rates to make loans to businesses and households. As long as these spreads remain large, the benefits of rate cuts are diminished. A big priority for now remains calming the fear that has swept through financial markets.

Evidence is mounting that the U.S. is likely to experience a far worse downturn than the 2001 or 1990-91 recessions. Job losses started at the beginning of this year but started deepening last month, even before the worst of the credit crisis struck. The degree of the declines is sapping consumer incomes after a decade showing few earnings gains for most Americans…

The Commerce Department said its broad gauge of retail sales dropped 1.2% last month, a much sharper decline than in July and August. The figures followed weak September sales reports last week by major retailers, and confirmed that the economy was softening before this month’s market turmoil, suggesting deeper declines in the coming months. Consumer spending, which accounts for more than 70% of the U.S. economy, is likely to record declines in the third and fourth quarters of this year.

Retail sales slipped in almost every sector. Auto sales fell 3.8%, while furniture, electronics, clothing and food stores also declined.

The troubles are weighing heavily on the global economy. Weak prospects around the world are pushing commodity prices sharply lower, a sign that strong demand — which led to huge price surges earlier this year — has abated with the economic turmoil. Crude-oil prices tumbled $4.09, or 5.2%, to $74.54 a barrel, its lowest settlement price this year.

Meanwhile, the continuing turmoil in credit markets is likely to hit the banking sector hard in the coming months. J.P. Morgan Chase & Co. and Wells Fargo & Co., two of the nation’s strongest banks, on Wednesday said their consumer operations are likely to worsen for months amid weaker performance of mortgages, credit cards and auto loans. J.P. Morgan, which is one of the nation’s largest credit-card issuers, said charge-offs — reflecting loans considered to be uncollectible — represented 5% of its card portfolio compared with 3.64% in the third quarter of 2007. That’s expected to grow to 6% in the beginning of next year and 7% by the end of 2009, the bank said.

The Federal Reserve’s latest “beige book” report, a summary of regional economic conditions, showed weakness across the nation into early October. Consumer spending declined, manufacturing activity dropped and several regions reported lower capital spending or reductions in capital spending plans “due to the high level of uncertainty about the economic outlook or concerns over the availability of credit.” Among the few bright spots were agriculture and other natural resources, though drops in commodity prices since the reports were compiled could hurt those sectors.

Job losses, which started at the beginning of this year, are expected to worsen as businesses feel the credit pinch. The effects of the worsening economy were on display at retail outlets around the country.

After years of conspicuous consumption, many middle- and upper-income Americans are morphing into cautious shoppers. The change in mood could have a dramatic effect on consumer spending on everything from cars and travel to electronics, fashion and jewelry, especially heading toward the holiday season. That’s a radical change from the 2001 economic slowdown when many people shopped to feel better.

In Chicago, Fanchon Simons, an avid 60-year-old shopper, says she couldn’t bring herself to buy a $360 blouse that she tried on at a designer-clothing boutique last week. Ms. Simons says she hasn’t bought much for herself in the past couple weeks — and not because she can’t afford it. Buying “is not that important to me right now because of the climate,” she says. “Maybe it’s a way to be in sympathy with the rest of the people…or maybe it’s that I don’t really need anything.”

High-end consumers aren’t the only ones pinching pennies or turning to window-shopping. Synetha Chambers, a 31-year-old single parent from Cedar Hill, Texas, who makes $25 an hour as a service representative for AT&T, says she has pared her grocery list to the necessities — milk is a must, but she no longer buys soda and chips. “And I will be honest with you, Christmas is no longer a necessity in my household,” Ms. Chambers says.

In recent weeks, a slew of forecasters have predicted that holiday spending this year is likely to be at the lowest level in nearly two decades. The National Retail Federation plans to release a survey Thursday reporting that U.S. consumers plan to spend an average of $832.36 on holiday-related shopping, up 1.9% from a year earlier. It is the lowest increase in planned consumer spending since the survey began in 2002. The survey was conducted Sept. 30 to Oct. 7.

Here is a pod cast from the PBS Online NewsHour with a perspective on the days events.

Now lets look at Bernanke’s Remarks which is a concise history and well articulated. The full speech is below the break by Federal Reserve Chairman Ben S. Bernanke before the Economic Club of New York, delivered on October 15, 2008. First, here is the edited and annotated transcript for skimming.

Bernanke Remarks on the Crisis and Stabilization

On what caused the Credit Crisis:

As in all past crises, at the root of the problem is a loss of confidence by investors and the public in the strength of key financial institutions and markets. The crisis will end when comprehensive responses by political and financial leaders restore that trust, bringing investors back into the market and allowing the normal business of extending credit to households and firms to resume…

This financial crisis has been with us for more than a year. It was sparked by the end of the U.S. housing boom, which revealed the weaknesses and excesses that had occurred in subprime mortgage lending. However, as subsequent events have demonstrated, the problem was much broader than subprime lending. Large inflows of capital into the United States and other countries stimulated a reaching for yield, an underpricing of risk, excessive leverage, and the development of complex and opaque financial instruments that seemed to work well during the credit boom but have been shown to be fragile under stress. The unwinding of these developments, including a sharp deleveraging and a headlong retreat from credit risk, led to highly strained conditions in financial markets and a tightening of credit that has hamstrung economic growth.

What the Fed did as an initial response in 2007 and the Spring of 2008:

• First, following classic tenets of central banking, the Fed has provided large amounts of liquidity to the financial system to cushion the effects of tight conditions in short-term funding markets.

• Second, to reduce the downside risks to growth emanating from the tightening of credit, the Fed, in a series of moves that began last September, has significantly lowered its target for the federal funds rate. Indeed, last week, in an unprecedented joint action with five other major central banks and in response to the adverse implications of the deepening crisis for the economic outlook, the Federal Reserve again eased the stance of monetary policy.

Yet, the credit crisis continued:

Notwithstanding our efforts and those of other policymakers, the financial crisis intensified over the summer as mortgage-related assets deteriorated further, economic growth slowed, and uncertainty about the financial and economic outlook increased. As investors and creditors lost confidence in the ability of certain firms to meet their obligations, their access to capital markets as well as to short-term funding markets became increasingly impaired, and their stock prices fell sharply.

Perspective on normal policy and justification for the strong intervention which began in September 2008:

The Federal Reserve believes that, whenever possible, the difficulties experienced by firms in financial distress should be addressed through private-sector arrangements–for example, by raising new equity capital, as many firms have done; by negotiations leading to a merger or acquisition; or by an orderly wind-down. Government assistance should be provided with the greatest reluctance and only when the stability of the financial system, and thus the health of the broader economy, is at risk. In those cases when financial stability is broadly threatened, however, intervention to protect the public interest is not only justified but must be undertaken forcefully and without hesitation.

Comments illuminating the Fed’s perspective on Freddie Mac, Fannie Mae, Lehman Brothers and AIG:

Fannie Mae and Freddie Mac present cases in point. To avoid unacceptably large dislocations in the mortgage markets, the financial sector, and the economy as a whole, the Federal Housing Finance Agency put Fannie and Freddie into conservatorship, and the Treasury, drawing on authorities recently granted by the Congress, made financial support available.

The difficulties at Lehman and AIG raised different issues. Like the GSEs, both companies were large, complex, and deeply embedded in our financial system. In both cases, the Treasury and the Federal Reserve sought private-sector solutions, but none was forthcoming. A public-sector solution for Lehman proved infeasible, as the firm could not post sufficient collateral to provide reasonable assurance that a loan from the Federal Reserve would be repaid, and the Treasury did not have the authority to absorb billions of dollars of expected losses to facilitate Lehman’s acquisition by another firm. Consequently, little could be done except to attempt to ameliorate the effects of Lehman’s failure on the financial system.

In the case of AIG, the Federal Reserve and the Treasury judged that a disorderly failure would have severely threatened global financial stability and the performance of the U.S. economy. We also judged that emergency Federal Reserve credit to AIG would be adequately secured by AIG’s assets. To protect U.S. taxpayers and to mitigate the possibility that lending to AIG would encourage inappropriate risk-taking by financial firms in the future, the Federal Reserve ensured that the terms of the credit extended to AIG imposed significant costs and constraints on the firm’s owners, managers, and creditors.

The Financial Crisis spreads to the real economy, threatening catastrophic consequences unless the government intervened even more deeply. Commercial Paper in this instance = direct link from financial market crisis to the real economy:

AIG’s difficulties and Lehman’s failure, along with growing concerns about the U.S. economy and other economies, contributed to extraordinarily turbulent conditions in global financial markets in recent weeks. Equity prices fell sharply. Withdrawals from prime money market mutual funds led them to reduce their holdings of commercial paper–an important source of financing for the nation’s nonfinancial businesses as well as for many financial firms. The cost of short-term credit, where such credit has been available, jumped for virtually all firms, and liquidity dried up in many markets. By restricting flows of credit to households, businesses, and state and local governments, the turmoil in financial markets and the funding pressures on financial firms pose a significant threat to economic growth.

Treasury and the Fed are compelled in September and October of 2008 to take deeper action:

• To address illiquidity and impaired functioning in commercial paper markets:
- The Treasury implemented a temporary guarantee program for balances held in money market mutual funds to help stem the outflows from these funds.
- The Federal Reserve put in place a temporary lending facility that provides financing for banks to purchase high-quality asset-backed commercial paper from money market funds, thus reducing their need to sell the commercial paper into already distressed markets.
- Moreover, we soon will implement a new, temporary Commercial Paper Funding Facility that will provide a backstop to commercial paper markets by purchasing highly rated commercial paper directly from issuers at a term of three months when those markets are illiquid.

• To address ongoing problems in interbank funding markets, the Federal Reserve has significantly increased the quantity of term funds it auctions to banks and accommodated heightened demands for temporary funding from banks and primary dealers.

• Also, to try to mitigate dollar funding pressures worldwide, we have greatly expanded reciprocal currency arrangements (so-called swap agreements) with other central banks.

• Indeed, this week we agreed to extend unlimited dollar funding to the European Central Bank, the Bank of England, the Bank of Japan, and the Swiss National Bank. These agreements enable foreign central banks to provide dollars to financial institutions in their jurisdictions, which helps improve the functioning of dollar funding markets globally and relieve pressures on U.S. funding markets.

It bears noting that these arrangements carry no risk to the U.S. taxpayer, as our loans are to the foreign central banks themselves, who take responsibility for the extension of dollar credit within their jurisdictions.

These steps are helping the bank system:

The expansion of Federal Reserve lending is helping financial firms cope with reduced access to their usual sources of funding and thus is supporting their lending to nonfinancial firms and households.

“Nonetheless, the intensification of the financial crisis over the past month or so made clear that a more powerful, comprehensive approach involving the fiscal authorities was needed to address these problems more effectively”:

• The Emergency Economic Stabilization Act (the Administration, with the support of the Federal Reserve, asked the Congress for a new program aimed at stabilizing our financial markets): provides important new tools for addressing the distress in financial markets and thus mitigating the risks to the economy. The act allows Treasury to buy troubled assets, to provide guarantees, and to inject capital to strengthen the balance sheets of financial institutions. The act also raises the limit on deposit insurance from $100,000 to $250,000 per account, effectively immediately.

• The Troubled Asset Relief Program (TARP) authorized by the Emergency Economic Stabilization Act will allow the Treasury, under the supervision of an oversight board that (Bernanke) will head, to undertake two highly complementary activities.

- First, the Treasury will use the TARP funds to help recapitalize our banking system by purchasing non-voting equity in financial institutions. Details of this program were announced yesterday. Initially, the Treasury will dedicate $250 billion toward purchases of preferred shares in banks and thrifts of all sizes. The program is voluntary and designed both to encourage participation by healthy institutions and to make it attractive for private capital to come in along with public capital. We look to strong institutions to participate in this capital program, because today even strong institutions are reluctant to expand their balance sheets to extend credit; with fresh capital, that constraint will be eased. The terms offered under the TARP include the acquisition by the Treasury of warrants to ensure that taxpayers receive a share of the upside as the financial system recovers. Moreover, as required by the legislation, institutions that receive capital will have to meet certain standards regarding executive compensation practices.

- Second, the Treasury will use some of the resources provided under the bill to purchase troubled assets from banks and other financial institutions, in most cases using market-based mechanisms. Mortgage-related assets, including mortgage-backed securities and whole loans, will be the focus of the program, although the law permits flexibility in the types of assets purchased as needed to promote financial stability. Removing these assets from private balance sheets should increase and liquidity and promote price discovery in the markets for these assets, thereby reducing investor uncertainty about the current value and prospects of financial institutions. Unclogging the markets for mortgage-related assets should put banks and other institutions in a better position to raise capital from the private sector and increase the willingness of counterparties to engage. With time, the provision of equity capital to the banking system and the purchase of troubled assets will help credit flow more freely, thus supporting economic growth.

These measures are moves towards a more stable Financial System in the future.

Yet, there is still “the immediate problem of lack of trust and confidence.” The Administration, Congress and the Fed have taken the above measures, yet that does not mean a return of credit to markets. Looking at LIPOR and the TED, the banks are hoarding capital to keep their books solvent in the future instead of taking on the risk of lending to opaque institutions whose books may or may not be toxic:

Accordingly, also announced yesterday was a plan by the Federal Deposit Insurance Corporation (FDIC) to provide a broad range of guarantees of the liabilities of FDIC-insured depository institutions, including their associated holding companies. The guarantee covers all newly issued senior unsecured debt, including commercial paper and interbank funding, and it will also cover all funds held in non-interest-bearing transactions accounts, such as payroll accounts. This broad guarantee will be effective immediately, and fees for coverage will be waived for 30 days. After the 30-day grace period, banks may continue to participate in the guarantee program by paying reasonable fees.

Articulating what the Tax Payer has invested in and what their risk is to the Tax Payer now that the Federal Government has deeply intervened into the Financial Markets:

…(T)he taxpayers’ interests were very much in our minds and those of the Congress when these programs were designed.
• The costs of the FDIC guarantee are expected to be covered by fees and assessments on the banking system, not by the taxpayer.
• In the case of the TARP program, the funds allocated are not simple expenditures, but rather acquisitions of assets or equity positions, which the Treasury will be able to sell or redeem down the road.
• Indeed, it is possible that taxpayers could turn a profit from the program, although, given the great uncertainties, no assurances can be provided.
• Moreover, the program is subject to extensive controls and to oversight by several bodies.
• The larger point, though, is that the economic benefit of these programs to taxpayers will not be determined primarily by the financial return to TARP funds, but rather by the impact of the program on the financial markets and the economy. If the TARP, together with the other measures that have been taken, is successful in promoting financial stability and, consequently, in supporting stronger economic growth and job creation, it will have proved itself a very good investment indeed, to everyone’s benefit.

“Stabilization of the financial markets is a critical first step, but even if they stabilize as we hope they will, broader economic recovery will not happen right away.” These measures alone do not correct the trajectory of the economy towards growth.

Conditions restraining the economy:

• Economic activity had been decelerating even before the recent intensification of the crisis.
• The housing market continues to be a primary source of weakness in the real economy as well as in the financial markets
• We have seen marked slowdowns in consumer spending, business investment, and the labor market. • Credit markets will take some time to unfreeze.
• With the economies of our trading partners slowing, our export sales, which have been a source of strength, very probably will slow as well.

The restraining influences are currently being off set somewhat:

• by the favorable effects of lower prices for oil and other commodities on household purchasing power

The big factor according to Bernanke effecting the economy

Ultimately, the trajectory of economic activity beyond the next few quarters will depend greatly on the extent to which financial and credit markets return to more normal functioning.

So far Bernanke has been commenting on the first of his two tier initiatives–supporting economic growth. His second initiative is to control inflation:

• Inflation has been elevated recently, reflecting the steep increases in the prices of oil, other commodities, and imports that occurred earlier this year, as well as some pass-through by firms of their higher costs of production.

• However, expected inflation, as measured by consumer surveys and inflation-indexed Treasury securities, has held steady or eased

• Prices of imports now appear to be decelerating.

• These developments, together with the recent declines in prices of oil and other commodities as well as the likelihood that economic activity will fall short of potential for a time, should lead to rates of inflation more consistent with price stability.

Globalisation measures. “This past weekend, the finance ministers and central bank governors of the Group of Seven industrialized countries met in Washington.”

• We committed to work together to stabilize financial markets and restore the flow of credit to support global economic growth.
• We agreed to use all available tools to prevent failures that pose systemic risk.
• We affirmed we will ensure our deposit insurance programs instill confidence in the safety of savings.
• We agreed to ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources.
• We further agreed that we would take all necessary steps to unfreeze interbank and money markets, and that we will act to restart the secondary markets for mortgages and other securitized assets.
• Finally, we recognized that we should take these actions in ways that protect taxpayers and avoid potentially damaging effects on other countries.

I believe that these are the right principles for action, and I see the steps announced by our government yesterday as fully consistent with them.

What Bernanke said in closing:

I have laid out for you today an extraordinary series of actions taken by policymakers throughout our government and around the globe. Americans can be confident that every resource is being brought to bear to address the current crisis: historical understanding, technical expertise, economic analysis, financial insight, and political leadership. I am not suggesting the way forward will be easy, but I strongly believe that we now have the tools we need to respond with the necessary force to these challenges. Although much work remains and more difficulties surely lie ahead, I remain confident that the American economy, with its great intrinsic vitality and aided by the measures now available, will emerge from this period with renewed vigor.

The full speech is below the break
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$2.8 Billion Loss at Citigroup on More Write-Downs

New York Times
October 17, 2008
By ERIC DASH

Citigroup reported a $2.8 billion loss in the third quarter, the fourth consecutive period that the global banking giant has been swamped by write-downs on investments and steeper losses on consumer loans.

The bank took more than $13.2 billion in charges in the third quarter, bringing the total amount of write-offs and credit losses since the credit crisis began last year to more than $64 billion.

And as more signs of a global slowdown surface, the bank continues to come under pressure. Although the write-downs in its investment bank declined for the third quarter, losses in Citigroup’s global consumer businesses rose sharply. Credit costs increased 84 percent, to $9.1 billion, driven by charge-offs and reserve increases in the bank’s credit card, consumer finance and banking operations.
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THE RECKONING
New York Times
October 9, 2008
By PETER S. GOODMAN

“Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.” — Alan Greenspan, former Federal Reserve chairman, 2004

George Soros, the prominent financier, avoids using the financial contracts known as derivatives “because we don’t really understand how they work.” Felix G. Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential “hydrogen bombs.”

And Warren E. Buffett presciently observed five years ago that derivatives were “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

One prominent financial figure, however, has long thought otherwise. And his views held the greatest sway in debates about the regulation and use of derivatives — exotic contracts that promised to protect investors from losses, thereby stimulating riskier practices that led to the financial crisis. For more than a decade, Alan Greenspan has fiercely objected whenever derivatives have come under scrutiny in Congress or on Wall Street.

“What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so,” Mr. Greenspan told the Senate Banking Committee in 2003. “We think it would be a mistake” to more deeply regulate the contracts, he added.
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Asia’s revenge

Financial Times
By Martin Wolf
Published: October 8 2008 19:54 | Last updated: October 8 2008 23:48

“Things that can’t go on forever, don’t.” – Herbert Stein, former chairman of the US presidential Council of Economic Advisers

What confronts the world can be seen as the latest in a succession of financial crises that have struck periodically over the last 30 years. The current financial turmoil in the US and Europe affects economies that account for at least half of world output, making this upheaval more significant than all the others. Yet it is also depressingly similar, both in its origins and its results, to earlier shocks.

To trace the parallels – and help in understanding how the present pressing problems can be addressed – one needs to look back to the late 1970s. Petrodollars, the foreign exchange earned by oil exporting countries amid sharp jumps in the crude price, were recycled via western banks to less wealthy emerging economies, principally in Latin America.

This resulted in the first of the big crises of modern times, when Mexico’s 1982 announcement of its inability to service its debt brought the money-centre banks of New York and London to their knees.

Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University identify the similarities in a paper published earlier this year.* They focus on previous crises in high-income countries. But they also note characteristics that are shared with financial crises that have occurred in emerging economies.

This time, most emerging economies have been running huge current account surpluses. So a “large chunk of money has effectively been recycled to a developing economy that exists within the United States’ own borders”, they point out. “Over a trillion dollars was channelled into the subprime mortgage market, which is comprised of the poorest and least creditworthy borrowers within the US. The final claimaint is different, but in many ways the mechanism is the same.”

The links between the financial fragility in the US and previous emerging market crises mean that the current banking and economic traumas should not be seen as just the product of risky monetary policy, lax regulation and irresponsible finance, important though these were. They have roots in the way the global economy has worked in the era of financial deregulation. Any country that receives a huge and sustained inflow of foreign lending runs the risk of a subsequent financial crisis, because external and domestic financial fragility will grow. Precisely such a crisis is now happening to the US and a number of other high-income countries including the UK.

These latest crises are also related to those that preceded them – particularly the Asian crisis of 1997-98. Only after this shock did emerging economies become massive capital exporters. This pattern was reinforced by China’s choice of an export-oriented development path, partly influenced by fear of what had happened to its neighbours during the Asian crisis. It was further entrenched by the recent jumps in the oil price and the consequent explosion in the current account surpluses of oil exporting countries.
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I’ve been real busy at work yet this cartoon with these paragraphs had to go up pronto. However, the end of the essay does not have to be true if we add in a Green Revolution which would wind that wrecking ball down.

From the Financial Times:

The market for ideas – like the market for shares – always overshoots. Ideas become fashionable and get pushed to their logical conclusion and beyond, as their backers succumb to “irrational exuberance”. Then comes the crash.

What we are experiencing now is the bust that has followed the 30-year bull run in conservative ideas that began with the Thatcher-Reagan revolution of 1979-80.

You can get a sense of how quickly the intellectual atmosphere has changed by picking up a copy of Alan Greenspan’s The Age of Turbulence, which was published last year. Mr Greenspan, head of the Federal Reserve from 1987 until 2006, heaped praise on the magic of financial markets and decried the foolishness of those who called for more regulation: “Why do we wish to inhibit the pollinating bees of Wall Street?” he asked rhetorically. Why indeed?

Mr Greenspan was considered such a guru that last year Senator John McCain suggested putting him in charge of a committee on tax reform, adding: “If he’s alive or dead it doesn’t matter. If he’s dead, just prop him up and put some dark glasses on him.” But Mr Greenspan’s reputation is now on the slide and Mr McCain has reinvented himself as a champion of regulation – and is denouncing the “corruption and unbridled greed that has caused a crisis on Wall Street”.

This kind of ideological whiplash is what happens when an intellectual bull market crashes. The current financial crisis can be traced to three of the central ideas of the Reagan-Thatcher era: the promotion of home ownership, financial deregulation and a fervent faith in the market. Each of these ideas did sterling service for 30 years, increasing prosperity and freedom. But pushed too far – and combined – they have created a disaster.
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Click image to enlarge

Here is a screen grab that I got during my late lunch Pacific Time:



Now here are links and items from three articles which were not picked as the top news item of the moment during Day 15 following the Fannie and Freddie bailout:

Anxious Investors Push Dow Down 372 Points

Here is the second article to get snubbed for headline status:

Starting a New Era at Goldman and Morgan

The transformation of Wall Street picked up pace on Monday as Goldman Sachs and Morgan Stanley, the last big independent investment banks, moved to restructure into larger, less risk-taking organizations that will be subject to far greater regulation by the Federal Reserve.

Investment banking dies on Wall Street! How quickly it gets brushed aside by more important matters–like bailing out capitalism.

Now here is the third:

Crude Oil Prices Up More Than $16

By 11:00pm Pacific time the headline changed to this:

Oil price jumps $25 in a day

Crude oil prices jumped $25 a barrel on Monday – the largest one-day rise – as financial investors betting on falling oil prices were forced to cover their positions ahead of the expiry of the current benchmark futures contract.

The jump to an intraday high of $130 a barrel – a rise of about $40 a barrel from last week’s low – was exacerbated by a weakening US dollar and data showing weaker supplies from Mexico, Nigeria and Saudi Arabia in recent weeks and surging imports by China.

Here is fourth article that the New York Times was not covering at the time because there was a big fire in DC to put out and details of other business had been obscured:

Freddie and Fannie bank losses grow

US regulators have underestimated potential bank losses on preferred stock issued by Fannie Mae and Freddie Mac, the American Bankers Association said on Monday.

Nearly a third of US banks hold preferred stock issued by the two mortgage financiers that were taken into conservatorship this month, according to an industry survey conducted by the ABA. The average bank exposure to such securities relative to core equity capital was 11 per cent.

“The negative impact on banks – particularly Main Street community banks – is far greater than regulators first thought,” wrote Edward Yingling, chief executive of the ABA in a letter to the Treasury, the Federal Reserve and other banking regulators.

The government takeover of Fannie and Freddie all but wiped out the value of $36bn of their preferred shares. This would force exposed banks to take writedowns at the end of the third quarter that could impede future lending, the ABA warned.

“When the actions were contemplated to reduce dividends on Fannie Mae and Freddie Mac preferred stock, the bank regulators estimated that only a dozen banks would be affected by it,” Mr Yingling said.

Regulators said this month only a small handful of banks had “significant” holdings in Fannie Mae and Freddie Mac relative to their capital bases and that they would help develop plans to restore capital at these banks.

However, the ABA survey suggests the impact of writedowns could be more widespread and more severe than regulators initially indicated, particularly among small community banks that engage in lending for small and medium-sized local businesses.

The ABA’s letter called for regulators to reconsider the suspension of dividend payments on Fannie and Freddie preferred stock to alleviate the capital impact on banks and avoid a multi-billion dollar decline in lending.

The fact that none of these got top billing emphasizes the importance of the rest of this post. This previous article should be read by George W. Bush himself so that he cools his heels on pushing haste on the process of Congress to approve his legislation proposal-which he asked zero questions about when he approved the action on Thursday. Here is a graphic that appeared with the headline lunch time article as Congress negotiated amendments to the Executive branches 3 page bailout proposal:

Highlights from that afternoon article:

Stocks Fall as Rescue Plan Is Negotiated

New York Times
By DAVID M. HERSZENHORN

This article was reported by David M. Herszenhorn, Stephen Labaton and Mark Landler, and written by Mr. Herszenhorn.

…Democrats are bracing for a battle over efforts to limit the pay of executives whose firms seek help and over whether to grant bankruptcy judges authority to modify the mortgages of borrowers in danger of foreclosure…

…epresentative Barney Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee, said he had reached a general agreement with the Treasury Department over mortgage aid and Congressional oversight.

But Mr. Bush may find that members of his own party are among the holdouts…

…The Senate Democrats’ proposals includes two bold provisions. One would grant the Treasury “contingent shares” of stock in any financial institution that wants to sell bad debt to the government; the other would grant bankruptcy judges the authority to modify the terms of primary mortgages, a step aimed at helping homeowners at risk of foreclosure.

The bankruptcy provision is staunchly opposed by the banking, lending and securities industries and by many Republicans in Congress, but Democrats insist that it is one of the few mechanisms to provide direct assistance to homeowners caught in the foreclosure crisis.

The contingent shares would give taxpayers an equity stake in companies seeking help through the rescue program, potentially allowing the government not only to recoup however much of the $700 billion it spends on bad debt, but also to profit should the financial firms prosper in years ahead. The legislation would require the value of the contingent shares to equal the value of the assets purchased by the government.

The 44-page Senate proposal, pulled together by Senator Christopher J. Dodd, Democrat of Connecticut and the chairman of the banking committee, would require the Treasury to run the rescue plan through a new “Office of Financial Stability” to be headed by an assistant treasury secretary. It would also establish an “Emergency Oversight Board” to monitor the bailout effort, made up of the Fed Chairman; the chairman of the Federal Deposit Insurance Corporation; the chairman of the Securities and Exchange Commission; and two non-government employees with “financial expertise” in the public and private sectors, one each appointed by the majority and minority leadership in Congress…

…In addition, the Senate proposal would require monthly reports to Congress, rather than the biannual reports that would be required under the Bush administration’s proposal…

The Bush administration’s proposal could prove to be the largest government bailout of private industry in the nation’s history. It calls for nearly unfettered powers for the Treasury secretary in managing the bailout.

Though the jittery state of the financial markets put pressure on officials and legislators to move quickly, some lawmakers said they did not want to be rushed into approving extraordinary new powers for the Treasury secretary and the government without full consideration of the consequences…

Financial companies were already lobbying to broaden the plan. And the Bush administration did indeed widen the scope by allowing the government to buy out assets other than mortgage-related securities as well as making foreign companies eligible for government assistance.

“We will not simply hand over a $700 billion blank check to Wall Street and hope for a better outcome,” House Speaker Nancy Pelosi said.

Top administration officials and senior lawmakers said that the markets could be devastated if Congress and the administration failed to reach agreement on the plan.

Mr. Paulson said he hoped that the government would recoup much of the cost of buying distressed mortgage-related assets. But he did not rule out that the initial cost of the bailout could rise beyond $700 billion, the limit set in the terse proposal sent by the Treasury to Congress on Saturday.

“That doesn’t mean we’ll go all the way there, or it doesn’t mean it will stop there and we won’t ask for more,” Mr. Paulson said Sunday on the CBS program, “Face the Nation.” “What we need is something that is big enough to get the job done. We’ll ask for what we think is a right amount to give us plenty of flexibility.”

Now here are the highlights from the evening article which was written by the same author as the first article (good days work sir!):

Stocks Fall as Rescue Plan Is Negotiated

By DAVID M. HERSZENHORN

…lawmakers in both parties voiced anger over the steep cost and even skepticism about the plan’s chances of success…

Congressional leaders and Treasury officials also said they were close to an agreement over a proposal by some Democrats in which taxpayers could receive an ownership stake, in the form of warrants to buy stock, from firms seeking to sell distressed debt.

Lawmakers want to require an equity stake, while the administration wants flexibility on that matter, a Treasury official said…

“I am concerned that Treasury’s proposal is neither workable nor comprehensive despite its enormous price tag,” Senator Richard C. Shelby of Alabama, the senior Republican on the banking committee, said in a statement. “It would be foolish to waste massive sums of taxpayer funds testing an idea that has been hastily crafted.”

While Congressional leaders in both chambers said they were confident that they could reach a quick deal, it was also clear that Mr. Paulson and Mr. Bernanke would face rough questioning and that initial support for the bailout had begun to fray. Some Democrats said they simply did not trust the president, and drew a parallel to Mr. Bush’s request for authority to wage war in Iraq.

President Bush urged Congress on Monday to act fast. “Americans are watching to see if Democrats and Republicans, the Congress and the White House, can come together to solve this problem with the urgency it warrants,” he said in a statement. “The whole world is watching to see if we can act quickly to shore up our markets.”

The majority leader, Senator Harry Reid of Nevada, said Democrats were prepared to do so. “Democrats in the Senate aren’t going to drag our feet,” he said in a speech on the Senate floor. “We’ll respond with the urgency of action that this situation demands, but after eight years of fiscal dereliction of duty, it’s time for accountability.”

“Should we resolve the issue in one day?” he asked. “I think not.”

Republican leaders who support the administration’s plan warned the Democrats on Monday to exercise restraint and not slow the bailout package, even as they prepared for an aggressive internal campaign to rally Republican support.

“When there’s a fire in your kitchen threatening to burn down your home, you don’t want someone stopping the firefighters on the way and demanding they hand out smoke detectors first or lecturing you about the hazards of keeping paint in the basement,” Senator Mitch McConnell of Kentucky, the Republican leader, said in a speech on the Senate floor. “You want them to put out the fire before it burns down your home and everything you’ve saved for your whole life.”

Mr. McConnell added: “The same is true of our current economic situation. We know that there is a serious threat to our economy, and we know that we must take action to try and head off a serious blow to Main Street.”

“I walked down LaSalle Street on Friday, a great street in Chicago lined with banks and big office buildings,” said Senator Richard J. Durbin of Illinois, the No. 2 Democrat. “A lot of people came up and said ‘hi.’ But a lot of them came up and said: ‘Are you really going to do this? $700 billion bailing out the banks? And I said: ‘I don’t know. At the end of the day, I just don’t know.’ ”

Mr. Durbin, in a speech on the Senate floor, angrily recalled that the administration had similarly requested swift approval of its plan to attack Iraq. “Just as we should have asked more questions about weapons of mass destruction six years ago before we found ourselves in this war,” Mr. Durbin said, “we need to ask questions today about where this is leading.”

Representative Henry A. Waxman, Democrat of California who leads the Oversight and Government Reform Committee, said: “The taxpayer is being asked to risk billions to protect the bonuses of investment bankers.”

The skepticism was equally palpable at the other end of the ideological spectrum.

“This is going way too fast,” said Representative Mike Pence, Republican of Indiana and a conservative leader who said constituents he met this weekend were flabbergasted at the plan. “The American people don’t want Congress to make haste with the financial recovery legislation; they want us to make sense.”

And Mr. Shelby, of the banking committee, said: “Congress must immediately undertake a comprehensive, public examination of the problem and alternative solutions rather than swiftly pass the current plan with minimal changes or discussion. We owe the American taxpayer no less.”…

…In a sign of how complicated the negotiations over specific provisions of the bailout could become, Senator Mel Martinez, Republican of Florida, and a member of the banking committee, said that he would strongly support limiting the pay of executives whose firms seek government aid. But Mr. Martinez said he would oppose any effort to change the bankruptcy laws.

In his prepared testimony, Mr. Paulson sought to underscore the huge risks to everyday Americans. “The market turmoil we are experiencing today poses great risk to U.S. taxpayers,” Mr. Paulson plans to testify. “When the financial system doesn’t work as it should, Americans’ personal savings, and the ability of consumers and business to finance spending, investment and job creation are threatened.”

Mr. Bernanke, in his remarks, will implore the Congress to act. “Despite the efforts of the Federal Reserve, the Treasury and other agencies, global financial markets remain under extraordinary stress,” he says in his remarks. “Action by the Congress is urgently required to stabilize the situation and avert what otherwise could be very serious consequences for our financial markets and for our economy.”…

Officials said there was also a deal to mandate that the government develop a plan to prevent foreclosures by renegotiating any mortgages that it purchases.

Because the markets are eager for a final deal and because Congress is trying to adjourn for the fall elections, lawmakers are bypassing the normal committee process and working toward an agreement in hopes of votes in both chambers within days.

And some lawmakers said it could be done. “We are convinced that inaction could be a disaster,” said Senator Robert Bennett, Republican of Utah. “We don’t believe that inaction is an option, so therefore we are going to do whatever we can to make sure that the action that is taken is as responsible and well thought-out as possible.”

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I do love my fill of this weekly conversation on the NewsHour. Video link:

Wall Street’s woes put the economy at the top of the campaign agendas of John McCain and Barack Obama this week as the two sought to shape their views on government regulation and other issues. Analysts Mark Shields and David Brooks examine reactions to the crisis.

JIM LEHRER: And that brings us to the analysis of Shields and Brooks, syndicated columnist Mark Shields, New York Times columnist David Brooks.

David, you wrote in your column today (full article below the break in this post) that the candidates’ reaction to the financial crisis has been, quote, “moronic,” end quote. Would you flesh that out a little bit?

DAVID BROOKS, Columnist, New York Times: Yes, I guess I’d amend it to say “nauseatingly stupid,” at least for the first four days. I think today was an improvement.

Now, today, I think they did do that.

JIM LEHRER: Both of them?

Assessing the candidates’ reaction

DAVID BROOKS: I think both of them — Obama got there with Bob Rubin, and Laura Tyson, and Larry Summers, and Gene Sperling, serious people, and issued a statement which wasn’t daring by any means. [inaudible...] but it was sober and responsible. It was fine.
McCain gave the speech in South Bend, a pretty substantive speech about what he would do in the foreign — in the — to direct the crisis, not directly on this, but generally.

And so today they stepped it up a notch. And I think they achieved mediocrity for the whole week. But in the beginning, the partisan tone, the standard, you know, “lipstick on a pig” tone prevailed, and it was insane.

JIM LEHRER: Insane, moronic?

MARK SHIELDS, Syndicated Columnist: No, I don’t think so. I think David’s level of expectation, his own standards are quite high.

This was an unprecedented crisis. I think they were too partisan. I don’t think they were — I think it was revealing. A crisis reveals where people come from and how they think.

And in that sense, I think that we have no reason to expect that a policy answer of this complexity, of this cosmic reach is going to be developed by a campaign. Campaigns don’t do that.

JIM LEHRER: Why not?

MARK SHIELDS: Because it isn’t what campaigns do. Look what it took. It took the entire Treasury Department, the Federal Reserve Board, all of their experts, the Congress, the administration, and they had four bites at it and came up with this today.

So, I mean, the idea that on the run a political campaign that is out trying to win votes is going to compete with that in terms of depth and dimension, but, that aside, I think the important question really about this week is the reaction.

And, you know, Jeffrey Frankel of Harvard put it, I thought, perfectly well. He said, “Just as there are no foxholes — there are no atheists in a foxhole, there are no libertarians in a financial crisis.”

I mean, all of the good folks who’ve told us “hands off, laissez-faire, no government,” I don’t know where they are. They’ve suddenly become Marcel Marceau . They’ve gone mute on us. You know, everybody wants Sam in there, and you can feel the irresistible wave for regulation.
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• “…(Congress) seemed alternately grateful and resentful of the new power couple in Washington. Some referred to “President Paulson” and others groused about an unelected central bank chairman doling out hundreds of billions of dollars…

In the end, what left so many lawmakers and economists frustrated was the sense that no one had a better idea. So they waited for Mr. Paulson and Mr. Bernanke to give them more details about what they wanted to do.” – from A Professor and a Banker Bury Old Dogma on Markets

• “(T)he prospect that the government is preparing to wade in deep — perhaps sparing families from foreclosure and banks from insolvency — has muted talk of the most dire possibilities: a severe shortage of credit that would crimp the availability of finance for many years, effectively halting economic growth.

“The risk of ending up like Japan, with 10 years of stagnation, is now much lessened,” said Nouriel Roubini, an economist at the Stern School of Business at New York University. “The recession train has left the station, but it’s going to be 18 months instead of five years.”

If the plan works, it will attack the central cause of American economic distress — the continued plunge in housing prices. If banks resumed lending more liberally, mortgages would become more readily available. That would give more people the wherewithal to buy homes, lifting housing prices or at least preventing them from falling further. This would prevent more mortgage-linked investments from going bad, further easing the strain on banks. As a result, the current downward spiral would end and start heading up.

“It’s easy to forget amid all the fancy stuff — credit derivatives, swaps — that the root cause of all this is declining house prices,” Mr. Blinder said. “If you can reverse that, then people start coming out of their foxholes and start putting their money in places they have been too afraid to put it.”…

…(Financial) institutions are deeply intertwined with the American economy. When the financial system is in danger, it stops investing and lending, depriving ordinary people of financing for homes, cars and education. Businesses cannot borrow to start up and expand…

…The economy has shed roughly 600,000 jobs since the beginning of the year. If healthy companies cannot get their hands on financing, they will not be able to expand and hire.

“What we’re looking at now is simply an amplified version of what we’ve been in since last August,” Mr. Bernstein added. “You’re witnessing a sudden death instead of a slow bleed.”

The impact of the pullback among banks was evident in the interest rates banks pay other banks to borrow money short-term. Traditionally, banks charge one another a little more than 0.2 percentage point over the rate on the safest investment, United States Treasury bills. But on Friday that spread was more than two percentage points, meaning a bank must pay an enormous premium to persuade another to part with its money.

And still no one knows the extent of the carnage. The financial system has acknowledged roughly $400 billion in losses so far, Mr. Roubini estimates, yet as much as another $1.1 trillion may be lying in wait.

As the government steps in to take over bad debts, it is aiming to clear away the detritus and lift the uncertainty, emboldening banks to lend anew.

Whether it will work in the long term is a question that awaits reaction from investors. But even the most skeptical economists say this is the path the government must take for confidence to crystallize that a genuine fix is under way…” – from But Will It Work?

$700 Billion Is Sought for Wall Street in Massive Bailout

New York Times
September 21, 2008 (found on the NYT.com web site one day before publishing)
By DAVID M. HERSZENHORN

WASHINGTON — The Bush administration on Saturday formally proposed to Congress what could become the largest financial bailout in United States history, requesting unfettered authority for the Treasury Department to buy up to $700 billion in mortgage-related assets.

The proposal, not quite three pages long, was stunning for its stark simplicity. It would raise the national debt ceiling to $11.3 trillion. And it would place no restrictions on the administration other than requiring semiannual reports to Congress, granting the Treasury secretary unprecedented power to buy and resell mortgage debt.

Staff members from Treasury and the House Financial Services and Senate banking committees immediately began meeting on Capitol Hill, where negotiations were likely to be complicated but quick. Democratic Congressional leaders have pledged to approve legislation by the end of this week.
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If laws are not strict enough, the credit bubble makes clear that markets cannot be trusted to regulate themselves.

Markets are a useful tool for society. But they are a function of the legal environment created for them, and they can act in ways that are detrimental to the public good…

…you do not need to be Descartes to doubt the planned US bail-out will be a success. Its total cost will be massive. It must be agreed by rival politicians who are not expert in finance, and who face re-election in weeks. And it must rescue fiendishly complicated instruments invented during a historically irresponsible lending binge. Its success is far from a certainty.

Three articles on the present, recent past, and future of Anglo/American Capitalism. These are still the same lessons we were learning this Spring after the Bear Stearns bailout, yet this past week drives the point home that markets must be regulated by the societies they function inside of. At the top, here is the Financial Times call on the plan being brought forward by the Bush Administration:

Proposed Wall St bailout to cost $700bn

Last updated: September 20 2008 17:49

The Bush administration sought congressional support Saturday for a $700bn bailout for US financial institutions to quell the turmoil in financial markets.

The plan would allow the government to buy the bad debt of any US institution for the next two years, raising the legal ceiling on the national debt from $10.6 trillion to $11.3 trillion.

President George W. Bush said: “We’re going to work with Congress to get a bill done quickly.” Treasury officials and members of Congress were meeting throughout the weekend to secure broad agreement on the package by the time world markets reopen on Monday. Legislation could pass early next week.

Saying the administration was faced with preventing the collapse of a financial “house of cards”, Mr Bush said: “People are beginning to doubt our system, people were losing confidence and I understand it’s important to have confidence in our financial system.” he said.

He said the risk of doing nothing far outweighed the risk of the package.

He assured taxpayers that over time they would get a lot of their money back…attention on the crisis has focused on demands that the rescue package should help not only Wall Street but also “Main Street” where ordinary Americans are already faced by foreclosures, job losses, and high food and energy prices.

Presidential candidates Barack Obama and John McCain are vying with each other to convince voters that their plans for the economy have the best chance of succeeding while protecting taxpayers. However, Nancy Pelosi, Democratic speaker of the House has assured the administration Mr Obama’s party is committed to “quick, bipartisan action”.

Charles Schumer, New York Democratic senator, said on Saturday: “This is a good foundation of a plan that can stabilise markets quickly. But it includes no visible protection for taxpayers or homeowners. We look forward to talking to Treasury to see what, if anything, they have in mind in these two areas.”

The plan is aimed at restoring confidence in the financial system by allowing US institutions to transfer their bad debt to the government.

The draft legislation would authorize the Treasury to: “purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United States.”

Henry Paulson, treasury secretary, who would be charged with executing the bailout plan, said: ”We must now take further, decisive action to fundamentally and comprehensively address the root cause of our financial system’s stresses. The federal government must implement a program to remove these illiquid assets that are weighing down our financial institutions and threatening our economy.”

The action came after stock markets around the world roared their approval on Friday to news of plans for significant government action.

Shanghai surged 9.5 per cent, in the biggest daily gain for seven years, to 2,075.091. Hong Kong ’s Hang Seng gained 9.6 per cent to 19,327.73, breaking a seven-day losing streak. In London the FTSE 100 had its biggest daily gain in its 24-year history, jumping 8.8 per cent, while in New York the S&P 500 closed up 4.0 per cent, having risen 4.3 per cent on Thursday. The rallies in London and the US were partially fuelled by bans on short-selling in financial stocks announced on Thursday night.

The political negotiations on the rescue plan, which followed a week of unprecedented stress in global financial markets, envisage the most extensive peacetime expansion of the role of government in the financial system since the Great Depression and appeared to many to mark the end of an era of Reaganite deregulation.

Hank Paulson, the US Treasury secretary, said the programme would initially cost “hundreds of billions of dollars.” But he added it was far cheaper than the alternative – “a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion”.

In addition, the Bush administration also announced a blanket guarantee on all money market mutual funds, in an effort to curtail a brewing crisis in the $3,500bn (€2,422bn) sector. The Federal Reserve announced new plans to support liquidity in the mutual fund sector.

Here is an excellent review covering what has transpired so rapidly over these historic days:

Capitalism in convulsion: Toxic assets head towards the public balance sheet

By John Plender
Published: September 19 2008 19:25 | Last updated: September 19 2008 19:25

In the space of just two momentous weeks, the landscape of global finance has been dramatically transformed. President George W. Bush’s administration has mounted a multi-billion-dollar rescue of the financial system at the cost of inflicting severe damage on the US model of free-market capitalism.

Heavy costs will be inflicted on the American taxpayer, who is now subsidising Wall Street – and indeed financial institutions around the world – in a bail-out of unprecedented size.

The sequence of events that led to this extraordinary socialisation of finance began with the de facto nationalisation of Fannie Mae and Freddie Mac, the bankrupt government-sponsored mortgage lenders at the heart of the US housing finance system. There followed a rise in the cost of insuring against default in the world’s most powerful economy. On some independent estimates, the overall response to crisis could take the outstanding US public sector debt from readily manageable status to a level comparable with such fiscally stretched countries as Italy and Japan.

Concern about the creditworthiness of the US is nonsensical, according to Charles Goodhart of the London School of Economics. It has nonetheless surfaced, along with worried punditry about the dollar’s role as a reserve currency.

Then came the absorption of Merrill Lynch by Bank of America and a bold decision by Hank Paulson, US Treasury secretary, to allow Lehman Brothers, the fourth largest US investment bank, to go to the wall. This constrasted with the government orchestrated rescue of the smaller Bear Stearns by JPMorgan Chase earlier this year.

The disappearance of these two Wall Street securities giants raised questions about the durability of the independent model of investment banking. Shares in the two independent survivors, Morgan Stanley and Goldman Sachs, were quickly savaged by short-sellers. In the UK, such short-selling is alleged to have been what pushed HBOS, the country’s biggest mortgage lender, into its shotgun marriage with Lloyds TSB.

Still more startling was news that the Federal Reserve was advancing $85bn (€59bn, £47bn) of taxpayers’ money to AIG, the world’s biggest private insurer. Thanks to its role in the global market for credit insurance, AIG was so interconnected with other financial institutions that its bankruptcy would have been catastrophic for the whole system.

Yet despite the rescue, the festering lack of trust that has dogged the banking system since August last year worsened after this move. On Wednesday, the interest rate on one-month US Treasury bills turned negative, bearing the astonishing message that investors would rather lose money on government paper where repayment was certain than invest in money market funds. The climactic point had been reached where nobody trusted any credit other than the government’s.

In such circumstances, experience teaches that central banks have to lend freely. In the event, the Federal Reserve injected $180bn into the markets, while other leading central banks said they were taking co-ordinated measures to help short-term dollar markets.

To round off the week, Mr Paulson announced discussions with political leaders to create a government-sponsored vehicle to take on toxic assets created during the bubble, prompting a manic stock market bounce.

The paradox in this remarkable tale is that extreme illiquidity exists in a world awash with the excess savings of Asia and the petro-economies. Russia illustrates the point. Thanks to the oil windfall, it sports high economic growth, the third largest foreign exchange reserves in the world and low public sector debt. Yet Moscow stocks are collapsing and trust in the financial system has eroded to the point where overstretched Russian investment banks are starved of funds and threatened with bankruptcy.

This is what happens when an overleveraged global financial system unwinds. Borrowing is being forcibly reduced across the world after the greatest credit bubble in history. It amounts, says David Roche of Independent Strategy, a research boutique, to a “tectonic shift from leverage to thrift as the means of financing growth and the concomitant dramatic reduction in global imbalances such as the US current account deficit”.

The reality is that the financial system has been operating as if it were an off-balance-sheet vehicle of the government. Private-sector companies and individual bankers have been making huge profits in the bubble. Their risk appetite has been enhanced by previous bail-outs and, in the case of Fannie and Freddie, by the government’s implicit guarantee. Yet their market pricing does not reflect the potential cost to the system of their own collapse.

This inability to handle externalities has again been apparent in the markets over the past two weeks as speculators have engaged in short-selling strategies against AIG and the investment banks in the US and HBOS in the UK. This threatens the financial system because the rating agencies respond to the consequent falls in share prices by cutting credit ratings, so jeopardising the victims’ ability to fund the business.

Once again, property has been at the heart of a financial debacle, in spite of the assurances of central bankers that a nationwide fall in US house prices was an impossibility. Yet the peculiarity this time lies in property being wrapped in complex financial products that few could understand.

When investors go outside their areas of competence, trouble follows. Walter Bagehot, the 19th-century economist who defined the rules for central bank management of financial crises in his book Lombard Street, said: “Common sense teaches that booksellers should not speculate in hops, or bankers in turpentine; that railways should not be promoted by maiden ladies, or canals by beneficed clergymen … in the name of common sense, let there be common sense.”

The twist in the current decade is that even bank boards and bank executives have failed to understand complex mortgage-backed banking products, as have central bankers, regulators and credit rating agencies.

In this off-balance sheet Alice in Wonderland world, the most absurd feature has been a reward system that has granted huge bonuses to those who peddled toxic mortgage-related products and does not permit much of the money to be clawed back now that the going is bad. Almost as absurd has been the degree of leverage racked up by investment banks.

As Michael Lewitt, the Florida-based money manager, puts it: “Allowing investment banks to be leveraged to the tune of 30 to 1 is the equivalent of playing Russian roulette with five of the six chambers of the gun loaded. If one adds the off-balance-sheet liabilities to this leverage, you might as well fill the sixth chamber with a bullet and pull the trigger.”

So what stage in the the crisis have we reached? Bagehot quoted the banker Lord Overstone’s description of the progress of an unstable cycle thus: “quiescence, improvement, confidence, prosperity, excitement, overtrading, CONVULSION [Bagehot’s capitals], pressure, stagnation, ending again in quiescence”.

Over the past two weeks we have experienced convulsion. Yet it ought to be possible to avoid stagnation, because the authorities are following the prescriptions of Hyman Minsky, the economist whose work Stabilizing An Unstable Economy best explains the dynamics of this crisis.

Minsky saw fiscal activism by big government, alongside last-resort lending by central banks, as the modern way of coping with financial distress. That is now taking place. In effect, the US government is replicating what happened in the private banking system earlier in the crisis, when institutions were obliged to take entities they had created, such as structured investment vehicles and conduits, back on to their balance sheets as funding dried up.

Having implicitly guaranteed Fannie and Freddie and underpinned the operations of irresponsible bankers at AIG and elsewhere, the US government is putting bankrupt institutions back on to the public sector balance sheet via nationalisation. Now, Mr Paulson’s proposal for the system’s toxic assets has the makings of a turning point.

What will the banking landscape look like after this saga? Much depends on the regulatory response. At the very least, tougher capital requirements will be imposed, which could mean the banking system reverts to a lower-risk, utility-like function. Yet one of the most important questions concerns the independence of central banks.

If central banks have to be recapitalised, as seems likely, politicians may want to extract a price that diminishes their operational independence. That could have damaging consequences. For a central point of Minsky’s thesis is that fiscal activism and last-resort lending set the stage for serious inflation.

That, together with an increased burden on future generations of taxpayers, could be the cost of the last two weeks’ frantic efforts to stave off deflation and keep some semblance of the Anglo-American model of capitalism afloat.

The writer is an FT columnist and chairman of Quintain

Now for a look into the crystal ball to see what the future might hold or, more appropriately, how these events will put limits on how future financial systems will be allowed to behave by the societies that they function inside of:

Long View: Increased regulation of financial markets
By John Authers, Investment Editor
Published: September 19 2008 21:41 | Last updated: September 19 2008 21:41

“I think therefore I am.” That was the one certainty the philosopher Descartes could find after he set himself a discipline of radical doubt – trying to doubt everything, so that he would be left only with what was certain, starting with his own existence.

This exercise is useful after a week that changed the parameters of global capital markets, probably for generations. More news of huge import will come this weekend, as politicians in the US try to hammer out a rescue vehicle for the US mortgage market.

After this week, is there anything we cannot doubt?

First, the independent investment bank, as a business model, is over. Much more capital, of the kind boasted by big universal banks, is needed if you want to take the kind of risks the investment banks have been taking.

Second, the model that will emerge triumphant will look a lot like a traditional commercial bank, built around deposit-taking and strong balance sheets, with lending decisions taken by humans, not markets. Among the few winners from this crisis are Bank of America (which won Merrill Lynch), and Lloyds TSB, which gets HBOS for a knockdown price.

Third, the market for credit derivatives – swaps of debts between banks that created a myriad of financial relationships – is also dead in its current form. Any doubt about this was extinguished when the US swallowed hard and spent $85bn of US taxpayers’ money to rescue American International Group only two days after it had tried to draw a line in the sand by refusing to bail out Lehman.

Why? AIG was more central to the credit derivatives market. This proves beyond doubt that credit derivatives were too important to be left unregulated: if this market is to be reinvented, it will be based on some kind of exchange.

Fourth, the fate of New York as the unquestioned capital of global finance is sealed. And London’s pretensions to take over are dead. Not even two years ago, London was trumpeting the success of its “light-touch” financial regulation, and Wall Streeters complained of over-regulation. Such claims now seem both distasteful and foolish.

Finally, the regulation system that has overseen the globalisation of finance for the past decade has, beyond doubt, failed. It must be replaced, with something more intrusive. That means the profitability of the financial services industry, even if the US can bail out its worst excesses, will stay below the levels that it had been enjoying, probably for a generation. We now see, beyond doubt, that banks are a public utility and must be treated as such.

What can we doubt? We can doubt market timers, who say the bear market has hit bottom. They have points on their side. The panic in midweek was of historic proportions. The yield on three-month Treasury bills, the world’s safest investments, dropped to 0.02 per cent, its lowest since 1941, when the world was at war. That was plainly senseless. Extreme panics generally come before rallies, so a “bear market rally”, like others in the past two years, is likely.

But the extent of the problems for US banks, and the drag they could place on the economy, suggest that stocks could still go much lower than their low of this week in the long run. At its worst, the S&P was down only 26 per cent. If the market can really limit the damage to that, it will have escaped very lightly. A rally followed by new lows seems likely.

But it is possible to doubt these things. A balanced portfolio remains as advisable as ever.

More radically, we can doubt capitalism. The US government evidently does. Most of the time, markets are efficient instruments for raising and allocating capital. Hence democratic governments have an interest in letting them get on with the job.

But the past week rams home that market outcomes should not be endowed with any moral glow. Market participants are motivated by fear and greed. They will do what they can get away with, and laws are necessary to regulate them. If laws are not strict enough, the credit bubble makes clear that markets cannot be trusted to regulate themselves.

When governments intervene in markets, they can have perverse effects – as seen when the decision not to bail out shareholders in Lehman and AIG turned short-selling financial stocks into a one-way bet and forced a crude ban on short-sellers.

Markets are a useful tool for society. But they are a function of the legal environment created for them, and they can act in ways that are detrimental to the public good. It may be a generation before the free-marketeers’ contention that governments should never interfere in markets gets taken seriously again.

Finally, you do not need to be Descartes to doubt the planned US bail-out will be a success. Its total cost will be massive. It must be agreed by rival politicians who are not expert in finance, and who face re-election in weeks. And it must rescue fiendishly complicated instruments invented during a historically irresponsible lending binge. Its success is far from a certainty.