On January 2nd of this year, in one of my initial posts, I warned that we were entering “financial hell” and sourced the quote to Warren Buffet who said that derivatives like those that have caused the credit crisis are like ”hell… easy to enter and almost impossible to exit”. The next ten days are going to be one of the scariest times for financial regulators since October of 1929. As the normally calm Wall Street Journal wrote this morning,
A year into a credit crisis that started with troubled mortgages to sketchy borrowers, the financial system is reeling once again, casting a pall over a widening array of financial institutions just days after history-making efforts by policy makers to contain the problem. With the share prices of Lehman Brothers Holdings Inc., Merrill Lynch & Co. and other financial firms on a roller coaster, the crisis could be entering a critical stage.
For Hank Paulson and Ben Bernanke, the potential collapse of Lehman Brothers poses perhaps the most excruciating dilemma.
Treasury Secretary Henry Paulson has said that institutions must be allowed to fail and that markets can’t expect the government to lend money or support every time there’s a crisis. “For market discipline to constrain risk effectively, financial institutions must be allowed to fail,” Mr. Paulson said in a speech in July.
But Paulson’s credibility is in the tank after the Fannie and Freddie rescue. No bigger institution is going to takeover Lehman Brothers without the same kind of government backstop of all the toxic paper Lehman holds that Paulson and Bernanke gave J.P. Morgan in the Bear Stearns rescue. If the Treasury steps in to save Lehman then there are potentially many other institutions that can be assumed “too big to fail”. The “adverse feedback loop” death spiral I have talked about before, will begin to accelerate.
These two processes — deleveraging and soft consumer spending — can feed on each other, something economists call an adverse feedback loop. Deleveraging puts downward pressure on home prices. That, in turn, forces financial institutions to deleverage more. In the same way, falling home prices squeeze households, which forces them to cut back on spending and puts off a housing recovery, further weighing on home prices.
Hang on to your hats.