Lehman Bros. fails, stock market falls, US faces major economic uncertainty

As the BBC put it, "Lehman Brothers, the fourth-largest US investment bank, has filed for bankruptcy protection, dealing a blow to the fragile global financial system" after losing billions of dollars in the US mortgage market.

In the recent past, the Federal Reserve has offered financial backing to prop up other struggling financial institutions. In March, the Fed offered a $30 billion loan to help JP Morgan take over Bear Stearns. Just last week it intervened to save Fannie Mae and Freddie Mac because of their crucial role in the mortgage market. This time, the Fed refused to offer financial incentives to potential buyers of Lehman Brothers.

Maybe this is a good thing. Like so many other financial institutions, Lehman Brothers got itself into trouble by making spectacularly bad investments. By letting the company fail, the Fed sent the word to other investment bankers that they can't expect the taxpayers to protect them from their own stupid mistakes.

On the other hand, there are also large risks to allowing Lehman Brothers to fail. Economist Paul Krugman explains:

Like many financial institutions, Lehman has a huge balance sheet - it owes vast sums, and is owed vast sums in return. Trying to liquidate that balance sheet quickly could lead to panic across the financial system. That's why government officials and private bankers have spent the weekend huddled at the New York Fed, trying to put together a deal that would save Lehman, or at least let it fail more slowly.

Meanwhile, Bank of America purchased another troubled investment bank, Merrill Lynch.

The New York Times reports that the US stock market suffered its worse one-day drop since the terrorist attacks back in 2001. The BBC reports that following stock market drops in the US and Europe, stocks in Japan, South Korea, China and Taiwan fell by five to six percent.

I think that Krugman's New York Times piece (via truthout) gives the best description of the underlying situation. It's short and well worth checking out.

Basically, "depository banks"--banks that physically take money from depositors and lend it out to borrowers--are now much less important to the economy than is something called the "shadow banking system." Our current banking regulations and deposit insurance system weren't designed to protect "non-depository" banks like Bear Stearns and Lehman Brothers.

As Krugman puts it:

The real answer to the current problem would, of course, have been to take preventive action before we reached this point. Even leaving aside the obvious need to regulate the shadow banking system - if institutions need to be rescued like banks, they should be regulated like banks - why were we so unprepared for this latest shock? When Bear went under, many people talked about the need for a mechanism for "orderly liquidation" of failing investment banks. Well, that was six months ago. Where's the mechanism?

And so here we are, with Mr. Paulson apparently feeling that playing Russian roulette with the U.S. financial system was his best option. Yikes.