Bailout or Not, Credit Will Be Crunched
Special Report: Where to Put Your Money Now - Don't exhale yet: The credit crunch has only just begun.

THE GOVERNMENT'S SWEEPING FINANCIAL BAILOUT plan may have cheered Wall Street -- but it will take a lot more to lift spirits on Main Street.

The bailout could go a long way in stemming the freefall of financial asset prices, helping to stabilize banks and Wall Street firms. Unfortunately, that won't be enough to truly stoke lending or ease the economic vise that's squeezing American businesses and consumers.
Scott Pollack for Barron's
Taking the Economy's Measure: Bank capital remains scarce, businesses are apt to contract, and consumers face both rising unemployment and falling wages.

Bank capital will likely remain scarce, businesses will find it tougher to get financing at the same time demand for their wares fades, and consumers are coming under the twin pressures of rising unemployment and falling wages just as their net worths are declining and their ability to borrow is being crimped.

"The risk is increasing for the state of the economy as we move forward because of the substantial stresses," says A. Marshall Acuff Jr., chairman of the investment committee of Richmond, Va.-based Cary Street Partners, and formerly U.S. equity strategist at Smith Barney. "There'll be slow growth in the world; it won't be the end of the world but it will be slow. There'll be no quick fix."

The crumbling of some of the biggest and best known financial institutions in the world in a matter of days is causing jitters throughout American industry. That was clear last week during a conference call arranged by the principals of a $140 billion investment-management firm. One caller, from Boeing, wanted to know how to explain to management what the federal bailout of AIG, once the world's largest insurance company, meant for the giant aerospace company. He was told that Boeing should minimize its own counterparty risk, keep liquidity high and preserve cash flow, especially as the fourth quarter approaches and projections call for record losses at financial institutions.

Another caller, from consulting firm Mercer, wondered about the implications of a long and deep recession. He was told U.S. credit growth could fall as low as 2%, the minimum needed for sustainable economic growth and a level only seen in one decade in the last century: 1930-39.
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The current crisis is as much one of confidence as it is of credit. That prompted moves late last week by the U.S. government to restore order, bolster security and alleviate the stresses in the system by announcing a comprehensive plan to safeguard the banking system, instead of waiting to deal with individual cases on the brink of collapse. Meanwhile, the Federal Reserve and major central banks around the world made billions available to ailing commercial financial institutions aiming to free up credit.

All the same, the growth of world economies is slowing sharply. International Strategy and Investment Group in Manhattan is forecasting 1% growth in U.S. gross domestic product through the first quarter of 2010. Germany is on the edge of a severe recession; a wage price spiral is unfolding in Eastern Europe; Asian economies are slowing; and declining commodity prices and deteriorating growth in developed markets are pressuring growth in emerging economies.

Yes, there have been some upbeat signs. The outlook for inflation has improved, the manufacturing sector has picked up, mortgage rates have fallen and energy prices are lower (See story on oil prices). The problem is, it's not enough.

"This is not the end of the credit crunch -- the credit crunch is just beginning," asserts Larry Jeddeloh, publisher of the Market Intelligence Report and founder and chief investment officer of Minneapolis-based TIS Group, an independent research service. "What we have seen thus far are just the first signs of deleveraging at the banks, the consumer level and among corporations. Savings are in. Consumption based on leverage is going out of favor." And he adds: "If you think Wal-Mart and the Dollar Menu at McDonald's rule the roost now, wait a few years... Saving and reducing debt and value shopping are the new trends."

ALREADY, YEAR-OVER-YEAR growth in nonfinancial credit-market debt collapsed to a 3.5% seasonally adjusted annual rate in the second quarter from 9.1% in the third-quarter of 2007, according to the calculations of economists John Ryding and Conrad DeQuadros, founders of RDQ Economics.

Household credit growth is at its lowest level since 1970 and the rate of growth of household liabilities slowed to 3.9%, the lowest growth rate since the fourth quarter of 1970. Yet, as a share of net worth, household liabilities rose to a record high of 25.9%, according to Ryding and DeQuadros.

"It's the consumer's turn to go through a restructuring," says Nancy Lazar, vice chairwoman and economist at Manhattan's ISI Group. "The lack of credit availability combined with a decline in net worth and cyclical forces are creating the beginnings of a sustained slowdown in the U.S. consumer."

That, in turn, will have severe implications for emerging economies, which have become the world's suppliers of consumer goods.

Lazar expects the consumer savings rate to rise sharply, a development that hasn't occurred in 17 years and will likely trigger a significant and prolonged slump in consumer spending, which represents two-thirds of the U.S. economy.

Lazar expects the consequences of this to be most severe for retailers -- we are potentially "overretailed" and "internationally oversupplied," she says. And she is most concerned about non-durable, heavily discretionary areas such as travel, entertainment, casinos and luxury goods because durable goods, such as autos and furniture, have already been hit hard.

"We're on the downside of the credit boom," says Jeremy Grantham, co-founder and chairman of Boston-based investment manager GMO with $120 billion under management. "Acquiring leverage for any purpose will be made harder."

For the first time, he points out, a global credit crisis has coincided with asset prices that have been overpriced around the world and that will exacerbate the problem.

"There'll be a material slowdown in global growth," he says, and "this is going to echo around for a long time."

Real-estate prices have peaked, energy and commodity prices have peaked, and financial assets have peaked.

The Bottom Line
U.S. gross domestic product may grow by just 1% through the first quarter of 2010, by one estimate. Germany is on the edge of recession and Asian economies are slowing.

One notable exception has been the art market. Indeed, in a two-day period last week, as some of the world's mightiest financial firms fell by the wayside, Sotheby's held a record-shattering, single-artist auction of 223 works done in the past two years by London's Damien Hirst.

The auction, titled Beautiful Inside My Head Forever, brought $200.7 million, well above the auction house's high estimate of $177.6 million. While Americans were missing from the bidding, the Russians were out in force as were collectors from the Middle East and Asia.

But, don't be surprised if the auction proves to be the peak in the art market, says Grantham, just as Sam Zell's sale of Equity Office Properties in early 2007 to Blackstone Group marked the top of the real-estate market and Blackstone Group's subsequent initial public offering was the beginning of the end for the private-equity boom.

The Hirst auction, notes Grantham, in retrospect might become known as "the Hirst peak," in which the price paid for the works will, indeed, be beautiful only to Hirst and Sotheby's.

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The Pain of Deleveraging Will Be Deep and Wide
Felix Zulauf, Founder, Zulauf Asset Management
AN INTERVIEW WITH FELIX ZULAUF: A bleak long-term view on stocks.

AS THE CREDIT CRISIS INTENSIFIED LAST WEEK, radically altering the Wall Street landscape and the government's role in stabilizing the financial system, Barron's sought out Switzerland-based Felix Zulauf for a global macro perspective. A longtime member of Barron's Roundtable, the founder of Zulauf Asset Management is now equity-averse -- he prefers gold and government bonds -- but further out, sees untapped growth potential in emerging-markets.
Gary Spector

Barron's: It's been an unprecedented time in the financial markets, with Lehman filing for bankruptcy protection, Merrill Lynch being bought by Bank of America and AIG getting rescued by the U.S. government. What's the fallout going to be?

Zulauf: The leveraging-up in this cycle is reversing, and we are now deleveraging. When a huge system -- that is, the global credit system dominated by the investment-bank giants that have been the major creators of credit in the last cycle -- turns down, the fallout is going to be terrible.

Deleveraging is a very painful process, and will run longer and deeper than anybody can imagine. I've been fearful of this.

So far, what we're seeing is the pain in the financial system. Later on, we'll see the echo effect of the pain in the real economy. I can't understand economists talking about no recession or mild recession. This is the worst financial crisis since the 1930s. It's different than the '30s, but is the worst since then, and the consequences will be very, very painful for virtually everybody in our economies.

So it's a global downturn?
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That's right. It started out in the U.S., but it is a global event, led by the [excessive lending practices that grew up in the] housing boom in the U.S. But we also had housing booms in some of the European countries, and in some of the emerging countries. People are already talking about a glut of unsold homes in China.

How will these countries fight this severe downturn?

Governments, particularly those in the industrialized economies, will use fiscal stimuli to prop up the system and prevent them from collapsing. Usually, those stimuli are a little too small to really have a lasting impact, which is usually spent after two to three quarters. So we could have a pop in the market in '09 and the economy into 2010, and then it disappears again; then there is the next fiscal program, and so on. That can go on for a long time.

By issuing more debt, all of these governments are trying to stimulate deteriorating economies. But what do you see as some of the other consequences of all that additional debt?

Government debt is going to rise dramatically over the next five to 10 years. Government debt is at 300% of [gross domestic product] in most industrialized countries, if you calculate correctly. That can increase to 400% and 500%, but at some point the government-bond market will not take this without any consequences. That will lead to rising long-term interest rates. But because the economy is not on solid footing yet, short-term rates will stay low for a long time. So you will have a very steep yield curve for many, many years, and this is bearish for bonds since their prices keep falling.

What's your take on the inflation outlook?

Most governments and central bankers are still concerned about the inflation rate. I think for cyclical reasons that inflation will probably drop sharply into '09, partly due to lower commodity prices. But what's more important thereafter is that there will be a secular rise of the inflation rate, because governments and central bankers will be forced to reflate these economies in a big, big way, and this will be bad for nominal assets, whose value decreases because of less purchasing power. But it will be good for real assets at some point of time in the future. For example, companies can adjust by raising their prices and growing their incomes.

What does all of this deleveraging, in which firms try to get various forms of debt off their balance sheet, mean for those involved?

When the deleveraging starts due to declining asset prices, there is no one there to reverse it. I cannot see the private sector stopping this and turning it around. It has to be the government, together with the central banks, and they are starting to do that.

What's your assessment of the steps Federal Reserve Chairman Ben Bernanke and U.S. Treasury Secretary Henry Paulson have taken to stem these problems?

It's a challenging job. Bernanke and his team and Treasury are doing the utmost, but doing the utmost means they're always one step behind. So far, it seems that the Fed is constrained by not being able to expand its balance sheet. It has replaced a lot of Treasury paper with other paper of lower quality, and the level of Treasury paper on the Fed's balance sheet has now reached such a low point that it cannot expand more without really monetizing debt.

You can't stop this [downturn] or turn it around without going to monetization, a step the central bank hesitates to take. But eventually the developments will force the Fed to do it.

What's your reaction to Friday's announcement that Paulson is crafting a plan for the federal government to buy illiquid assets from various financial firms?

Treasury, together with the Fed, is taking a big step forward to keep the system from melting down. It will work, but it has to be at least $1 trillion in size and the Fed has to help by cutting rates. The idea is good; now the Treasury has to make it solid and the Fed has to lend its support. This is probably the beginning of a medium-term bottom. Usually a good bottom, even medium term, doesn't stand on one leg. In the coming three or four weeks, the low will be tested, but from there we have a chance for a good medium-term rally.

Could you elaborate?

What the Fed has to do is buy paper in the asset market, including Treasuries and corporate bonds, and create new money in the financial system -- because the deflationary process created by the deleveraging is at work. Deflationary power is growing dramatically, and the Fed has to replace the dollars that have disappeared into a black hole. The private credit system cannot do that anymore. The Fed and government are really the lenders of last resort.

From your vantage point, what do you see happening to the Eurozone's economy?

Short term, it will probably get a little bit worse in Europe, because we have a different policy mix than in the U.S. Your central bank has cut rates. They've been aware of the problem. The fiscal situation is expansive already, whereas in Europe we have tightening fiscal policy, and we have still a restrictive central bank that's looking at holding the value of the euro. So Europe could get hurt a little more than the U.S. in the short term, but I think it will do better over the medium term.

Why is that?

First of all, Europe can finance itself, meaning it's not dependent on outside money. It runs a slight current-account surplus and, net-net, it is not indebted to the rest of the world. The U.S. is indebted to the rest of the world; that's a major difference. Also, Eurozone households [collectively] run a financial surplus, while U.S. households have deficits. So when you look at the large European economies such as those in Germany or France, the consumer is in much better shape and the banks are probably in a little bit better shape than in the U.S., although some internationally active banks and investment banks are like their U.S. competitors.

What about emerging-market economies?

Even emerging economies are getting hurt. We have seen how real-estate prices in some emerging economies, from the Baltic States to some Asian countries, are coming down. But these countries have a better situation from a very, very long-term point of view because of demographics. They are much younger nations. They are much lower in their standard of living, they are going up the ladder, and they are competitive.

Another thing to consider is that current-account and trade deficits will shrink. So what used to be a big stimulus for emerging economies will be curtailed and it will hurt those economies in the short run much more than the markets assume.

What do you see ahead for the U.S. economy and elsewhere?

The U.S. economy goes flat for several years, and from time to time there probably will be major fiscal programs, each one bigger than the previous one, to help the economy. Europe will be similar; its potential growth is relatively low, with a stagnating population.

The emerging economies have much higher potential growth rates. They are going through a down-cycle, but they will come up again in the next cycle and have higher growth rates. But it is going to be a very tough 2009, a global recession. Whoever gets elected president in November will come through with a fiscal program. Monetary policy is really ineffective in this situation. When you have a balance-sheet recession and everybody is deleveraging, monetary policy cannot do the trick. It doesn't work because there is no one willing to leverage up their own balance sheet.

Around these parts there has been a lot of focus on Merrill, Lehman and AIG, not to mention Fannie Mae and Freddie Mac, which the U.S. government bailed out recently. What does the future hold for financial firms globally?

Bankers have to learn that banking is an industry like any other industry. The financial sector has grown dramatically over recent decades, and I think it has grown to a level that is too big in proportion to total GDP.

Global financial-sector debt has gone up fivefold in the last 25 years relative to GDP. So what you now see is a reversal back to the mean. That means that the financial sector as a profit generator, as an employer and as a provider of services will shrink over many years -- back to a level that is more normal than in recent years. The financial-services industry has been treated extremely well for a long time and people made a lot of money and created careers, etc. But it is going to be much, much tougher in the next 10 years globally.

Do you see any industries that look promising at the macro level?

First, we go through a down-cycle, and it will affect virtually every industry. After that down-cycle is over, particularly in the emerging economies that have higher growth potential, it will turn up again. It could again be infrastructure-related assets or commodity-related assets that will perform very well. If I'm right in this scenario, what will happen is we will create a stimulus to grow in the future. And those who grow the best in a world of stimuli will be those that have the highest growth potential, namely the emerging economies. And then we will see rising bond yields. They will go in cycles, of course, and they will not shoot up straight. But they will go up.

What investments look interesting to you?

In this environment, those who do not lose win. For the average guy, I'd say go into the most defensive position. I'm not really interested in any longs in equities. I'm holding a lot of government bonds on the long side. I suggest that American investors stick to shorter-term Treasuries with maturities of up to two years.

Any other suggestions for equity holdings?

If you have extra money left and want to be more aggressive, you can play the markets short-term. There are going to be a lot of runs up and down in a declining market.

This is all sounds very bleak, Felix.

I'm not interested in any longs in equities. If you are an optimist by nature and if you want to be long, the one area that you should look at is daily necessities, notably consumer staples. Companies like Procter & Gamble [ticker: PG], General Mills [GIS] and maybe Johnson & Johnson [JNJ]. Those are the defensive names. But I have absolutely no interest in investing on the long side in anything that is cyclical in nature, because this cycle could last longer on the downside and go deeper than most investors assume.

Thanks very much.

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The Broken Buck Stops Here -- or Does It?
Not-so-safe money funds.

WALL STREET TOLD US AUCTION-RATE SECURITIES WERE just like money-market funds but with bigger yields. They also told us money-market funds were just like cash. What's next? The check's in the mail?

Well, sort of, but it's from the federal government, not the Street.

Treasury Secretary Henry Paulson on Friday played the role of white knight for the $3.4 trillion money-market-fund industry, which was looking like the next financial domino to fall. As part of a broad plan to ease the credit-crisis contagion, he announced a temporary guaranty program for the U.S. money-market mutual-fund industry, the gold standard for bond investors wanting safety, liquidity and yield.

The industry was rocked earlier in the week after the then-$62 billion Reserve Primary Fund said its net asset value fell below the all-important $1-per-share level, hurt by the now bankrupt Lehman Brothers debt it owns. That's called breaking the buck. Investors are getting 97 cents a share.

"It was a seminal event because the fund was so big and it breaks a solemn pledge that owning shares of a money- market fund is as good as cash," says Don Phillips, managing director at Morningstar.
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Ironically, the Reserve Fund's manager is veteran Bruce Bent, the creator of money-market funds and critic of many of his peers for taking on too much risk. He didn't return Barron's call.

His many peers wasted little time assuring clients their investments were safe. Fidelity, Vanguard, BlackRock and others posted notes on their Websites saying their money funds have no exposure to Lehman. But Putnam closed and will distribute the assets of the $12.3 billion institutional Putnam Prime Money Market Fund because of a surge in redemptions. And, oddly, it said it has no exposure to Lehman, AIG (ticker: AIG) or Washington Mutual (WM).

In all, money-fund assets fell by a record $89.38 billion in the week through last Tuesday, with institutions withdrawing $93.57 billion while individual investors added $4.19 billion, according to the Money Fund Report, published by iMoneyNet. Institutional investors are very nimble and quick on the trigger while individual investors are a bit slower to respond, said Connie Bugbee, managing editor at iMoneyNet.

"Money funds are only as safe as people think they are," says Lance Pan, director of credit research at Capital Advisors Group. "If people believe they're unsafe, they'll pull out, creating a cascading effect," he adds.

Paulson has put his finger in the dike.

The actions "will go a long way toward...building investor confidence after a period of extraordinary turmoil that has affected money market mutual funds" and others, said Paul Schott Stevens, CEO of Investment Company Institute, a mutual fund trade group, in a news release.

What's next? Congress has to pass on the rescue package. And, yes, Wall Street will still respect you in the morning.
Whipsawed Money: Equity funds' net inflows averaged a weekly $753 million for the four weeks ended Wednesday, reports AMG. Money funds had net outflows averaging $33 billion. Taxable bond funds drew a weekly $1.56 billion. Muni funds averaged $692 million in inflows.

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Week of the Living Dead
Is the rescue "Bernanke's Blunder" in the making?

SOME ARE BORN TO MANAGE AMERICAN FINANCIAL COMPANIES; some achieve management of American financial companies; some have the entire industry thrust upon them. Federal Reserve Chairman Ben Bernanke and Treasury Secretary Hank Paulson must see themselves in the third category this weekend after taking over responsibility for a trillion dollars or so of bad debts.

Actually, the amount of liabilities are unknown, possibly unknowable. The pack of banks and private-capital firms that turned on American International Group last week could attest to that. In only a couple of days of free access to the books, they found unfunded liabilities mismatched with unpriced assets for a vulnerability reaching nobody-knew-how-far beyond $80 billion. They wouldn't risk their capital against AIG's liabilities, knowing that the books of many other financial firms, possibly including their own, would look no better.

Only the federal government could perform a rescue, and it stepped up last week. But should the Federal Reserve, the Treasury and the Securities and Exchange Commission insure everyone in Wall Street?

Certainly not. The federal government is usurping the legitimate functions of its own bankruptcy judges. If financial companies are insolvent, let the creditors fight over the corpses in court.

Unknowable Unknowns

The dangers, as Bernanke and Paulson see them, are in the liabilities. Who knows where they might lead? They include AIG's obligations to pay off credit-default swaps -- private contracts in which AIG promised to support billions of dollars of bonds if their issuers defaulted. These were developed to comfort speculators and make them believe they were investing.
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It was a delusion: At the worst, credit-default swaps on Lehman Brothers Holding still were quoted at about 5% of the face value of the bonds being protected less than five days before the firm went under. It was like selling flood insurance on Galveston Island, while Hurricane Ike was in the Gulf of Mexico.

Credit-default swaps created a nation of speculators who don't want to take their losses. The financial establishment has been afraid to start unwinding these swaps. They know that when you pull on a loose bit of yarn dangling from a sweater, you never know how much sweater you will have left at the end. So the government is buying the sweater. As President Bush declared in the Rose Garden Friday, "These are risks America cannot afford to take." Too bad. The risks have already been taken. Now: Can America afford to cover its bets?

Federal Resuscitation Board

Bernanke is sometimes described as the world's leading expert on the mistakes that the Fed made after October 1929. He is determined not to make those mistakes, so much so that he vowed years ago to distribute $100 bills by helicopter if it would avert deflation. The weeks just past prove that he will make his own mistakes.

Consider AIG: The Fed has given AIG an $85 billion line of credit, and AIG has supplied the Fed with collateral in the form of newly printed stock warrants. AIG is a zombie walking among the living. Shareholders are reduced to shadows of their former selves.

No sooner done for AIG than done for the rest of the world: The Fed also increased the supply of dollars for foreign markets and central banks. The message: The Fed and its fellow central banks will print money until the cows come home. No big borrower will be left in pain, no big lender left unsaved.

Then Friday, the SEC ordered an end to pessimism: No one may sell the financial system short until further notice -- which will not be given until the storm clouds pass, if ever. No one should profit from falling stock prices and that's supposed to help them rise.

Finally, the Treasury restored confidence by guaranteeing money-market mutual funds and ordaining a happy ending to the mortgage mess. It told Fannie Mae and Freddie Mac to buy more mortgages -- as if they don't have too many now. The Treasury, meanwhile, will purchase mortgage-backed securities, including those backed by mortgages well on the way to default. Even worse paper, which existing safety regulations would prohibit any agency or bank from holding, will be snarfed up by a new agency.

Unfortunately, this is how we got into this mess. Banks lent more money than they should have to people who were borrowing more money than they should have, mostly on the strength of the idea that real estate would appreciate enough to cover up any problems.

As it came to pass that everyone who could afford a house already had one, or more than one, so it may turn out that everyone who wants dollars already has more than enough of them.

The Worst Kind of Help

Listen carefully to the cries of "chaos" on Wall Street: Some of those shouting loudest are trying to make others pay for bankers' and borrowers' mistakes. Finding no others willing to step up, the Fed and Treasury are becoming the nation's stand-in speculators.

The Treasury will borrow to buy mortgages and the Fed will print money to buy Treasuries. The danger is that they are igniting a great inflation to stave off a great depression. If so, this week will enshrine President Bush with President Carter, and Ben Bernanke with G. William Miller.

Just as the Weimar Republic printed money to pay war reparations that the Germans couldn't afford, the United States of America is putting its full faith and credit -- until neither remains -- behind mortgages that its citizens can't afford. All investors can do is hope that the ultimate sacrifice of capital destruction won't be necessary.

To avert further capital destruction, it's important to take an audit of the capital that remains. By regulation, by law or by the reasonable demand of investors seeking information, companies should open their books to continuous public scrutiny. Every weekly or daily financial report that would go to the CEO or the CFO also should go out to investors on the company Website.

Shareholders don't get to decide how companies are run, but they should know the results of management and mismanagement as quickly as the managers do. Without such information, they lack the knowledge to help them navigate away from storms.

Editorial Page Editor THOMAS G. DONLAN receives e-mail at tg.donlan@barrons.com.
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Diamond and Kashyap on the Recent Financial Upheavals

By Steven D. Levitt

As an economist, I am supposed to have something intelligent to say about the current financial crisis. To be honest, however, I haven't got the foggiest idea what this all means. So I did what I always do when something related to banking arises: I knocked on the doors of my colleagues Doug Diamond and Anil Kashyap, and asked them for the answers. What they told me was so interesting and insightful that I begged them to write their explanations down for a broader audience. They were kind enough to take the time to do so. In what follows, they discuss what has happened in the financial sector in the last few days, why it happened, and what it means for everyday people.

The F.A.Q.'s of Lehman and A.I.G.
By Douglas W. Diamond and Anil K. Kashyap
A Guest Post

For most of the last 20 years we have been studying banks, monetary policy, and financial crises. So for us the events of the last year have been especially fascinating.

The last 10 days have been the most remarkable period of government intervention into the financial system since the Great Depression. In talking with reporters and our noneconomist friends, we have been besieged with questions about several aspects of these events. Here are a few of the most frequently asked questions with our best answers.

1) What has happened that is so remarkable?

This episode started when the Treasury nationalized Fannie Mae and Freddie Mac on September 8. Their combined assets are over $5 trillion. These firms help guarantee most of the mortgages in the United States. The Treasury only got authority from Congress to take this action in July, and in seeking the authority had insisted that no intervention would be needed.

The Treasury has replaced the management of both companies and will presumably oversee their operation. This decision marked an acknowledgment by the government that the mortgage market and the institutions to make it operate in the U.S. are broken.

On Monday, the largest bankruptcy filing in U.S. history was made by Lehman Brothers. Lehman had over $600 billion in assets and 25,000 employees. (The largest previous filing was WorldCom, whose assets just prior to bankruptcy were just over $100 billion.)

On Tuesday, the Federal Reserve made a bridge loan to A.I.G., the largest insurance company in the world; perhaps best known to most of the world as the shirt sponsor of Manchester United soccer club, A.I.G. has assets of over $1 trillion and over 100,000 employees worldwide. The Fed has the option to purchase up to 80 percent of the shares of A.I.G., is replacing A.I.G.'s management, and is nearly wiping out A.I.G.'s existing shareholders. A.I.G. is to be wound down by selling its assets over the next two years. (Don't worry, Man U will be fine.) The Fed has never asserted its authority to intervene on this scale, in this form, or in a firm so far removed from its own supervisory authority.

2) Why did these things happen?

The common denominator in all three cases was the inability of the firms to retain financing. The reasons, though, differed in each case.

The Fannie and Freddie situation was a result of their unique roles in the economy. They had been set up to support the housing market. They helped guarantee mortgages (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government. The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this hardly occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the "conforming" mortgage market. Regardless, many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities and snapped it up eagerly.

Fannie and Freddie were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.

But once the debt was guaranteed to be secure (and the government would wipe out shareholders if it carried through with the guarantee), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over.

Lehman's demise came when it could not even keep borrowing. Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets. When it is hard for lenders to monitor their investments and borrowers can rapidly change the risk on their balance sheets, lenders opt for short-term lending. Compared to legal or other channels, their threat to refuse to roll over funding is the most effective option to keep the borrower in line.

This was especially relevant for Lehman, because as an investment bank, it could transform its risk characteristics very easily by using derivatives and by churning its trading portfolio. So for Lehman (and all investment banks), the short-term financing is not an accident; it is inevitable.

Why did the financing dry up? For months, short-sellers were convinced that Lehman's real-estate losses were bigger than it had acknowledged. As more bad news about the real estate market emerged, including the losses at Freddie Mac and Fannie Mae, this view spread.

Lehman's costs of borrowing rose and its share price fell. With an impending downgrade to its credit rating looming, legal restrictions were going to prevent certain firms from continuing to lend to Lehman. Other counterparties that might have been able to lend, even if Lehman's credit rating was impaired, simply decided that the chance of default in the near future was too high, partly because they feared that future credit conditions would get even tighter and force Lehman and others to default at that time.

A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real-estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.'s), were hemorrhaging.

Furthermore, the possibility of further losses loomed if the housing market continued to deteriorate. The credit-rating agencies looking at the potential losses downgraded A.I.G.'s debt on Monday. With its lower credit ratings, A.I.G.'s insurance contracts required A.I.G. to demonstrate that it had collateral to service the contracts; estimates suggested that it needed roughly $15 billion in immediate collateral.

A second problem A.I.G. faced is that if it failed to post the collateral, it would be considered to have defaulted on the C.D.S.'s. Were A.I.G. to default on C.D.S.'s, some other A.I.G. contracts (tied to losses on other financial securities) contain clauses saying that its other contractual partners could insist on prepayment of their claims. These cross-default clauses are present so that resources from one part of the business do not get diverted to plug a hole in another part. A.I.G. had another $380 billion of these other insurance contracts outstanding. No private investors were willing to step into this situation and loan A.I.G. the money it needed to post the collateral.

In the scramble to make good on the C.D.S.'s, A.I.G.'s ability to service its own debt would come into question. A.I.G. had $160 billion in bonds that were held all over the world: nowhere near as widely as the Fannie and Freddie bonds, but still dispersed widely.

In addition, other large financial firms — including Pacific Investment Management Company (Pimco), the largest bond-investment fund in the world — had guaranteed A.I.G.'s bonds by writing C.D.S. contracts.

Given the huge size of the contracts and the number of parties intertwined, the Federal Reserve decided that a default by A.I.G. would wreak havoc on the financial system and cause contagious failures. There was an immediate need to get A.I.G. the collateral to honor its contracts, so the Fed loaned A.I.G. $85 billion.

3) Why did the Treasury and Fed let Lehman fail but rescue Bear Stearns, Fannie Mae, Freddie Mac, and A.I.G.?

We have already explained why Fannie, Freddie, and A.I.G. were supported. In March, Bear Stearns lost its access to credit in almost the same fashion as Lehman; yet Bear was rescued and Lehman was not.

Bear Stearns was bailed out for two reasons. One was that the Fed had very imperfect information about what was going on at Bear. The Fed was not Bear's regulator, the amount of publicly available information was limited, and its staff was not versed in all of the ways in which Bear might have been connected to other parts of the financial system.

The second problem was that Bear's counterparties in many transactions were not prepared for the sudden demise of Bear. A Bear bankruptcy might have triggered a wave of forced selling of collateral that Bear would have given its counterparties. Given the potential chaos that would have resulted from Bear Stearns filing for bankruptcy, the Fed had little choice but to engineer a rescue. In doing so, the Fed argued that the rescue was a rare, perhaps once-in-a-generation, event.

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.

It was not surprising that they drew the line at helping Lehman. Based on all the publicly available information, this was clearly the right thing to do.

4) I do not work at Lehman or A.I.G. and do not own much stock; why should I care?

The concern for the man on Main Street is not the bankruptcy of Lehman, per se. Rather, it is the collective inability of major financial institutions to find funding.

As their own funding dries up, the remaining financial firms will be much more cautious in extending credit to normal firms and individuals. So even for people whose own circumstances have not much changed, the cost of the credit is going to rise. For an individual or business that falls behind on payments or needs an increase in short-term credit because of the slowing economy, credit will be much harder to obtain than in recent years.

This is going to slow growth. We have not seen this much stress in the financial system since the Great Depression, so we do not have any recent history to rely upon in quantifying the magnitude of the slowdown. A recent educated guess by Jan Hatzius of Goldman Sachs suggests that G.D.P. growth will be just about 2 percentage points lower in 2008 and 2009. But as he explains, extrapolations of this sort are highly uncertain.

5) What does it mean for the Fed and Treasury going ahead?

A reasonable reading of the recent bailouts suggests a simple rule: if a firm is on the verge of collapse and its ties to the financial system will lead to a cascade of chaos, the firm will be saved. A bankruptcy will be permitted only if the failure can be contained.

Assuming the level of chaos is sufficiently high, this dichotomy is probably consistent with the mandate of the Federal Reserve. The rescue of A.I.G., however, raises some major challenges.

One is where to draw the line. A.I.G. was an insurance company, not a bank or a broker dealer, so the Fed had no special relationship with A.I.G. Presumably, if a very large airline or automaker had been involved in the C.D.S. market, the same reasoning that led to the rescue would apply.

A second challenge comes with defining the acceptable level of chaos. We will never be able to find out what would have happened if A.I.G. had been allowed to fail. Furthermore, there are some reasons to believe that even if A.I.G. continues to operate, the fundamental stress in the financial system will remain. If the rescue does not mark a turning point, the bailout may be viewed quite differently down the road.

Should the government intervene if it merely postpones an inevitable adjustment? Creditor runs can make adjustment too fast; blanket bailouts can make adjustment too slow. Has the Fed found the speed that is just right?

Third, now that A.I.G. has been lent to, how will regulation have to be adjusted? Surely the Fed cannot be called upon to provide backstop financing whenever a large member of the financial system runs into trouble. How does it prevent a replay of this scenario, and can it be done without stifling innovation?

6) What does this mean for the markets going ahead?

Letting Lehman go means that the remaining large financial services firms now must understand that they need to manage their own risks more carefully. This includes both securing adequate funding and being prudent about which counterparties to rely upon. Both of these developments are welcome.

If the remaining investment banks, Goldman Sachs and Morgan Stanley, do not get more secure funding in place, they may be acquired or subject to a run too. In the current environment, relying almost exclusively on short-term debt is hazardous, even if a firm or bank has nothing wrong with it.

7) When will the turmoil end?

The inability to secure short-term funding fundamentally comes from having insufficient capital. There are many indicators that the largest financial institutions are collectively short of capital.

One signal is that there were apparently only two bidders for Lehman, when the ongoing value from operating most of the bank was surely far above the $3.60 share price from Friday. Another is the elevated cost of borrowing that banks are charging each other. A third indicator is the reluctance to take on certain types of risk, such as jumbo mortgages, so that the cost of this type of borrowing is unusually high.

The fear of being the next Lehman ought to convince many of the large institutions that, despite however much they already raised, more is needed. It may be expensive to attract more equity financing, but the choice may be bankruptcy or sale. The decision by the Federal Reserve to not cut interest rates suggests the Fed also recognizes that the short-term interest rate is a very inefficient way to address this problem.


Cash for Trash

Some skeptics are calling Henry Paulson's $700 billion rescue plan for the U.S. financial system "cash for trash." Others are calling the proposed legislation the Authorization for Use of Financial Force, after the Authorization for Use of Military Force, the infamous bill that gave the Bush administration the green light to invade Iraq.

There's justice in the gibes. Everyone agrees that something major must be done. But Mr. Paulson is demanding extraordinary power for himself — and for his successor — to deploy taxpayers' money on behalf of a plan that, as far as I can see, doesn't make sense.

Some are saying that we should simply trust Mr. Paulson, because he's a smart guy who knows what he's doing. But that's only half true: he is a smart guy, but what, exactly, in the experience of the past year and a half — a period during which Mr. Paulson repeatedly declared the financial crisis "contained," and then offered a series of unsuccessful fixes — justifies the belief that he knows what he's doing? He's making it up as he goes along, just like the rest of us.

So let's try to think this through for ourselves. I have a four-step view of the financial crisis:

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.

2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they haven't been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the "paradox of deleveraging."

The Paulson plan calls for the federal government to buy up $700 billion worth of troubled assets, mainly mortgage-backed securities. How does this resolve the crisis?

Well, it might — might — break the vicious circle of deleveraging, step 4 in my capsule description. Even that isn't clear: the prices of many assets, not just those the Treasury proposes to buy, are under pressure. And even if the vicious circle is limited, the financial system will still be crippled by inadequate capital.

Or rather, it will be crippled by inadequate capital unless the federal government hugely overpays for the assets it buys, giving financial firms — and their stockholders and executives — a giant windfall at taxpayer expense. Did I mention that I'm not happy with this plan?

The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don't go to the people who made the mess in the first place.

That's what happened in the savings and loan crisis: the feds took over ownership of the bad banks, not just their bad assets. It's also what happened with Fannie and Freddie. (And by the way, that rescue has done what it was supposed to. Mortgage interest rates have come down sharply since the federal takeover.)

But Mr. Paulson insists that he wants a "clean" plan. "Clean," in this context, means a taxpayer-financed bailout with no strings attached — no quid pro quo on the part of those being bailed out. Why is that a good thing? Add to this the fact that Mr. Paulson is also demanding dictatorial authority, plus immunity from review "by any court of law or any administrative agency," and this adds up to an unacceptable proposal.

I'm aware that Congress is under enormous pressure to agree to the Paulson plan in the next few days, with at most a few modifications that make it slightly less bad. Basically, after having spent a year and a half telling everyone that things were under control, the Bush administration says that the sky is falling, and that to save the world we have to do exactly what it says now now now.

But I'd urge Congress to pause for a minute, take a deep breath, and try to seriously rework the structure of the plan, making it a plan that addresses the real problem. Don't let yourself be railroaded — if this plan goes through in anything like its current form, we'll all be very sorry in the not-too-distant future.


Banks Won't Be as Profitable in Future

In a SPIEGEL interview, Harvard academic and former International Monetary Fund chief economist Kenneth Rogoff, 55, discusses Wall Street's never-ending crisis.

The New York Stock Exchange: "You just can't make money out of think air like this."

The New York Stock Exchange: "You just can't make money out of think air like this."

SPIEGEL: Last week, the United States government rescued mortgage finance companies Fannie Mae and Freddie Mac, and only a few days later investment bank Lehman Brothers was forced to file for bankruptcy protection. Is there any end to this debacle on Wall Street?

Kenneth Rogoff: It's the worst financial crisis since World War II -- there's really no hyperbole anymore. At the same time, it had to happen. The US financial system was bloated and overgrown and reckless to some extent. Now it is being reigned in.

SPIEGEL: What went wrong?

Rogoff: In 2006, the financial sector accounted for a third of corporate profits in the US, although it only represents 2 or 3 percent of total gross domestic product. Goldman Sachs alone distributed $16.5 billion in bonuses to its 26,000 employees. I'm sorry, I think it's unbelievable. You can't just make money out of thin air like this, and underlaying this there were enormous risks being taken.

SPIEGEL: What do you think willl happen now?

Rogoff: What we're seeing is a shrinking industry -- perhaps by 20 or 25 percent and in some segments perhaps as much as 50 percent. But these finance products based on fancy rocket science and derivatives just aren't coming back, and that's very painful. The industry is not going to make the same profits in the future as it did in the past. And this isn't just about subprime and mortgage losses. Investors are starting to realize that the profit model these investment banks were running on has been trimmed.

Former IMF chief economist Rogoff: "There are so many people to blame for what happened."

Former IMF chief economist Rogoff: "There are so many people to blame for what happened."

SPIEGEL: The US Federal Reserve Bank is intervening ever more often and ever more massively.

Rogoff: If the system just continues to implode, it's going to be very difficult for the Fed to step back and let all the banks go under. They're clearly going to have to throw taxpayer dollars in -- even if there's long been a debate about the fairness of that. I wouldn't be surprised if, at the end of the day, we see the US taypayer out $1 trillion.

SPIEGEL: What would that mean for the US economy as a whole?

Rogoff: All the evidence shows that when you have a recession accompanied by a financial crisis, it takes much longer to dig your way out of it. The economy is going to grow very slowly in 2009, perhaps by only 1 percent.

SPIEGEL: At the end of the day, who bears responsibility for the debacle?

Rogoff: There are so many people to blame for what happened. It would be like the title credits at the end of a movie if you were to name them all. But the people most to blame are President George W. Bush and the US Congress. The political system has willfully ignored this problem and at many points pressed the regulators to do nothing.

Interview conducted by Frank Hornig.


In Financial Food Chains, Little Guys Can't Win

IMAGINE, if you will, that a man who had much to do with creating the present credit crisis now says he is the man to fix this giant problem, and that his work is so important that he will need a trillion dollars or so of your money. Then add that this man thinks he is so indispensable that he wants Congress to forbid any judicial or administrative questioning of anything he does with your dollars.

You might think of a latter-day Lenin or Fidel Castro, but you would be far afield. Instead, you should be thinking of Treasury Secretary Henry M. Paulson Jr. and the rapidly disintegrating United States of America, right here and now.

But I am getting ahead of myself. First, I am furious at what the traders, speculators, hedge funds and the government have done to everyone who is saving and investing for retirement and future security. Millions of us did nothing wrong, according to the accepted wisdom of the age. We saved. We put a large part of our money into the stock market, as we were urged to do. Because the market wasn't at ridiculously high levels, it seemed prudent to invest in broad indexes, foreign indexes and small- and large-cap indexes.

Now we have had the rug pulled out from under us. Our retirements have been put into severe jeopardy. The "earnings" part of those price-to-earnings ratios turns out to have been fiction for some financial companies, which normally account for a big part of total corporate earnings. In fact, earnings of giant finance players were often wildly negative, creating a situation rarely seen since the Great Depression, when the aggregate earnings of the Dow 30 were negative.

The current negativity occurred because of wild, casino-type operations of big finance players, creating liabilities way beyond anything we could have reasonably expected. This looks a lot like theft on a spectacular scale — of our wallets, our peace of mind, our futures.

Second, according to what I hear from my betters in the world of finance, the most serious problems are not with the bundles of subprime mortgages themselves — a large but not lethal quantum as far as I can tell — but with derivatives contracts tied to subprime and other dicey debt. These contracts are superficially an attempt to "insure" against risks of default, hence the name "credit-default swaps." In fact, they are an immense wager — which anyone with lots of money or borrowing ability can enter — about how mortgage-backed bonds, leveraged loan bonds, student loan bonds, credit card bonds and the like will perform.

These wagers entail amounts many times larger than the total of subprime loans. In fact, there are roughly $62 trillion in credit-default swap derivatives out there, compared with about $1 trillion of subprime mortgages. These derivatives are "weapons of financial mass destruction," in the prophetic words of Warren E. Buffett. (Apparently believing that the worst is over, at least for one big investment bank, Mr. Buffett is now investing in Goldman Sachs.)

The swaps market has been unregulated. It has been just a lot of people making bets with one another. Some of them made incredibly fortunate payoff wagers against the mortgage bonds, using credit-default swaps as their wagering vehicle. I am not sure who the big winners are, but they are out there, and the gains were big enough to cripple the part of Wall Street on the losing side of the bets.

Almost no one (except Mr. Buffett) saw this coming, at least not on this scale. But let's get back to the man of the hour. Why didn't Mr. Paulson, the Treasury secretary, see it? He was once the head of Goldman Sachs, an immense player in the swaps world. Didn't people at Treasury have a clue? If they didn't, what was going on in their heads? If they did, why didn't they do something about it a year ago, when saving the world would have been a lot cheaper?

If Mr. Paulson and Ben S. Bernanke, the chairman of the Federal Reserve, didn't see this train coming, what else have they missed? What other freight train is barreling down the track at us?

All of this would be bad enough. But by far the most terrifying item I read in my morning paper last week was this: Mr. Paulson demanded that Congress forbid judicial review of his decisions on use of the money in the mortgage bailout. This would amount to an abrogation of the Constitution. Not only would his decisions be sacrosanct and above the law, but so would the actions of his pals in the banking world in connection with this bailout.

The people whose conduct got us into this catastrophe have not only taken our money, hopes and peace of mind, but they apparently also want a trillion or so more dollars to put into their Wall Street Buddy System Fund. This may be the most dangerous attack on the law in my lifetime. What anarchists even dared consider this plan? Thank heaven that minds more devoted to the Constitution on Capitol Hill are questioning this shocking request.

By the way, if we are actually thinking about tossing the Constitution out the window, why not simply annul these credit-default swap contracts? With that done, the incomprehensibly large liability of the banks would cease, and we wouldn't need this staggering bailout. Shouldn't we consider making the speculators pay some of the price?

WE have survived housing-price corrections before. Why is this one causing so much anguish? It must be the side bets, the credit-default swap bets, multiplying the effect of the housing downturn many times over. Maybe we should just get rid of these exotic bets and start again without them. "Insurance" on market moves is always a bad idea, because it does not tamp down market disruptions but instead greatly magnifies them — as in the disastrous effect of "portfolio insurance" in the 1987 crash.

Then there was Mr. Paulson's insistence that there be no compensation caps for executives of companies being bailed out by the factory workers, the farmers, the schoolteachers and the medical doctors. He told a skeptical Congress on Tuesday that if these caps were put into place, bank executives simply wouldn't participate in the bailout or sell us suckers their debts. Fine with me. If the banks are in good enough shape so that petulant executives can simply opt out rather than live on a few million a year, maybe we don't need the bailout at all. Maybe we would be better off if those executives simply bailed out and were replaced by people with more sense and more patriotism.

One final little thought bubbles into my mind: Maybe the bailout should not be of the banks at all, but of homeowners themselves. Maybe if we make the government the buyer of last resort of homes, we will stabilize the markets, stabilize the debt associated with the markets and take the gain out of the credit-default swaps for the speculators. Yes, price would be a huge issue, but so it is for Mr. Paulson's plan for buying debt from banks.

Why not? We do it for farmers. Why not for the individual homeowner? Oh, right. Because Treasury secretaries don't know any of those people.

Ben Stein is a lawyer, writer, actor and economist. E-mail: ebiz@nytimes.com.

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