Answers to questions about Wall Street turmoil

McClatchy NewspapersSeptember 15, 2008 

WASHINGTON — Average Americans have a lot at stake in how the widening financial crisis plays out. Here are some answers to questions about it:

Q. What does all this Wall Street volatility mean to me?

A. If you have a 401(k), you shield some of your income from taxation through an IRA or a lot of your retirement savings are in stocks, you've already seen a sharp drop in the value of your nest egg. The Dow Jones Industrial Average is on pace for one of its worst years ever, but even if you've parked your cash in a bank, today's rising inflation is eroding its value.

Q. Is this like 1929, when the stock market's crash led to widespread bank failures and the Great Depression?

A. No one talks in terms of the Great Depression, and there are safety cushions in place that didn't exist 80 years ago, such as federal deposit insurance for national bank customer accounts. Still, today's financial turmoil could spread, and the economy could suffer more.

Q. Will the collapse of Lehman Brothers make things worse?

A. It could, or it could make things better. The weekend meetings between top federal regulators and senior executives of Wall Street firms resulted in the surprise takeover of Merrill Lynch by Bank of America and a lack of suitors for Lehman. Some analysts feared a Great Depression type of financial-market meltdown Monday morning, but markets were orderly, not panicked, as news of the events sank in.

With the government-brokered sale of investment bank Bear Stearns in March, Bank of America's absorbing of Merrill Lynch and the bankruptcy filing by Lehman, Wall Street's weakest players have been pushed off the field.

Goldman Sachs, Morgan Stanley and JP Morgan remain the biggest traditional investment banks, and Merrill is expected to keep operating under its own name. The consolidation in investment banking has taken most insolvency concerns off the table, and over a longer horizon this could point toward a return to stability.

Q. What about the shorter horizon?

A. The chief executive officer of Bank of America, Kenneth Lewis, said Monday that he didn't see the clouds parting for his industry until 2010. Banks that still have exposure to the complex mortgage bonds that are at the heart of the crisis continue to get hammered. That includes Charlotte, N.C.-based Wachovia and Swiss giant UBS.

This financial crisis is still rooted in bad mortgages that were packaged into bonds and sold to investors. As long as home prices keep falling, investment and commercial banks that own vast piles of those bonds will keep taking write-downs and their bleeding will continue.

Q. How do these banking-sector problems affect me?

A. Problems in the banking sector spill into the broader economy. As these complex Wall Street investments sour, banks need to keep more capital on hand to assure investors that they can weather any future losses from loan portfolios. That means banks are playing defense.

If you want a business loan, a car loan, a home loan, a student loan or virtually any other kind of loan, they're hesitant to lend, lest they wind up with more bad loans. With lending drying up, auto dealers are sitting with inventory they can't move and realtors are showing homes they can't sell. The economy is slowing as credit is squeezed.

The crisis feeds on itself. As banks and corporations are perceived to be short of capital and their stock prices fall, their need to raise capital grows even as lenders are defensive. That forces them to sell assets at low prices, and it becomes a vicious circle. That's what insurance and finance giant American International Group now faces.

Q. Given all these risks, why isn't the government bailing out Lehman Brothers?

A. Bailouts are in the eye of the beholder. The Treasury Department and Federal Reserve determined that Lehman's problems had been well publicized since at least spring, other financial players had made adjustments to that and Lehman's failure thus didn't pose a risk of contaminating the broader global financial system the way the sudden failure of Bear Stearns would have if the feds hadn't intervened for it. But make no mistake, a bailout of Wall Street has been under way since last March, and deepened this weekend.

What the Federal Reserve began in March and expanded Sunday is the practice of taking all kinds of collateral in exchange for short-term emergency loans to investment banks. Previously, investment banks had never enjoyed this sort of borrowing because they aren't regulated the same way commercial banks are. The Fed now accepts as collateral a wide range of debt, securities and even the controversial mortgage bonds issued by the private sector and by Fannie Mae and Freddie Mac. The Fed also is now lending to financial institutions that it doesn't regulate.

That can be seen as a bailout because the Federal Reserve is putting lots of suspect collateral on its books. That puts the taxpayer on the hook should there be a failure.

Q. Is there any good news for consumers?

A. Yes. One immediate consequence of Monday's Wall Street earthquake is that oil prices sank sharply as investors fled anything considered a risky bet, despite Hurricane Ike's disruption of oil facilities in the Gulf of Mexico area. The price for contracts of next-month deliveries of oil fell almost $6 a barrel. If prices stay lower than $100 a barrel, inflation pressures should ease substantially. That means gasoline prices should drop in the weeks ahead.

Another positive is that pressure is building on the Fed to cut already historically low interest rates. It could happen Tuesday, when the Fed's rate-setting Open Market Committee meets, or it could come in October, but banks and corporations need capital, and cutting rates lowers the cost of obtaining it.

To ask a question about this story or any economic question, go to McClatchy's economy Q&A

McClatchy Newspapers 2008

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