Thursday, September 18, 2008

A Fairly Understandable Explanation of the Financial Mess and What It Means

Steven Levitt of the Freakonomics blog admits he can't explain the mess on Wall Street and the federal governments' apparent mish-mash response. So Levitt asked his colleagues, who put together a pretty good description. They admit that this is a most extraordinary moment and a remarkable invervention into the financial markets by the federal government, perhaps teh biggest since the Great Depression (as much as I hate saying that phrase.

I would like to point out, that the financial crisis is not necessarily the worst since the Great Depression, but the government's response, i.e. intervention, probably is, so there you go.
2) Why did these things happen?

The common denominator in all three cases was the ability of the firms to secure financing. The reasons, though, differed in each case.
The explanation is somewhat long, but fairly understandable even to non-economists. A little heavy on some lingo, but if you can read it, you can understand it--probably.
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.
And this, I think, is going to be the biggest challenge, that is where to draw the line and how much market chaos to accept.

Yes, the market is pretty chaotic, but there are patterns to it and those patterns provide the ability for firms, investors and ultimately the government to determine when and where to intervene. From this description, I am a little more comfortable with the A.I.G. bailout, but still nervous. Will size matter? Will the manner in which their debt is financed matter?

Right now, my belief is that the government is not pursuing a rational course of action. Not in terms of bailouts anyway, since I am not sure whether or not there are criteria for intervention. That is the fear, not that bailouts are needed, but that bailouts will be given for little or no reason nor any consistent reason. And no, I don't like the "too big to fail" descriptor as it implies that any big company has a case for intervention to protect it from its own stupid decisions.

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