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Fed Aims to Stabilize Markets as Jittery Investors Watch AIG

September 16, 2008 at 6:10 PM EDT
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With the financial industry still reeling from Monday's collapse of key institutions, the Federal Reserve pumped another $70 billion into the teetering system Tuesday. Two business journalists discuss the Fed's relief efforts.

MARGARET WARNER: It was another anxious day on Wall Street. After Monday’s Lehman Brothers bankruptcy and the sale of Merrill Lynch, concern shifted to whether the credit crisis might claim an even larger victim.

The insurance giant American International Group, or AIG, saw its stock price sink further after agencies slashed its credit rating last night. That sent AIG scrambling to raise tens of billions of dollars in new cash to shore up its position, as Wall Street watched nervously.

GOV. DAVID PATERSON (D), New York: I have directed our superintendent of…

MARGARET WARNER: New York Gov. David Paterson, who yesterday authorized AIG subsidiaries to loan its parent company $20 billion, said this morning that the company could survive only one day without additional financing.

There was other bad news. The investment bank Goldman Sachs, which has been involved in industry efforts to save AIG, reported third-quarter profits 70 percent lower than last year.

And the nation’s largest savings and loan, Seattle-based Washington Mutual, had its bond ratings slashed to junk status amid concerns over its mortgage-related losses.

Yet, after dropping more than 500 points yesterday, the stock market today seesawed between negative and positive territory, even after the Federal Reserve declined to cut a key interest rate.

In Washington, Treasury Undersecretary David McCormick said righting the financial markets long term depends heavily on stabilizing the housing industry.

DAVID MCCORMICK, Undersecretary of the Treasury: The sooner we turn the corner on housing, the sooner we will see house prices stabilize, the sooner we will see more people buying homes, and the sooner housing will again contribute to economic growth. Still, it will take some time to work through these stresses.

MARGARET WARNER: Late in the afternoon, it was reported that the Federal Reserve was considering extending a bridge loan to AIG.

Senate Banking Committee Chairman Democrat Christopher Dodd was asked whether he’d support such a move.

SEN. CHRIS DODD (D), Connecticut: I don’t think anything is too big not to be able to fail, that notion, but I don’t have that — apply that across the board in every fact situation.

Tell me why this situation deserves that kind of infusion of support, whereas Lehman Brothers did not. I’m willing to listen. I’m skeptical, I’ll tell you quite candidly, but I’m willing to listen.

But I want to have them come to me as they’re thinking about it, not announcing it and expect us to necessarily go along with it.

MARGARET WARNER: The day on Wall Street ended with the Dow up more than 140 points.

Reasons for AIG concerns

Joe Nocera
The New York Times
[I]f AIG were to fail, it would have a ripple effect that would be dramatic potentially and would go far beyond Wall Street across the country and potentially have a global effect.

MARGARET WARNER: And for more on today's developments and the turmoil continuing to ripple through the financial system, we turn to two people covering it all. Greg Ip is the U.S. economics editor for the Economist magazine. And Joe Nocera is a business columnist for the New York Times.

Welcome to you both.

Greg, first, tell us what's the latest on the effort to find an infusion of capital for AIG?

GREG IP, The Economist Magazine: Well, Margaret, as you said, the Federal Reserve has taken into consideration the possibility of making some kind of a short-term loan to the company.

Now, this afternoon it's been reported in the media that the Treasury is considering another option, which is conservatorship, which is a slightly less diversion of receivership, which would basically put the company under government control while it raises the money it needs.

MARGARET WARNER: And, Joe, why is everyone so concerned about AIG? Is there something about its role in the markets or in the marketplace that makes its survival more essential than, say, Lehman Brothers?

JOE NOCERA, Business Columnist, New York Times: Well, actually, yes. First of all, it's a much bigger institution.

Secondly, it's an insurance company. It has tentacles everywhere, and it affects a lot more people.

Third, it has something on the order of $440 billion in insurance products, such as credit default swaps, which are being used to insure other people's risks.

So if AIG were to fail, it would have a ripple effect that would be dramatic potentially and would go far beyond Wall Street across the country and potentially have a global effect. So people are worried about AIG in a way they weren't really with Lehman Brothers.

MARGARET WARNER: So, Greg, with all of this angst about Washington Mutual and AIG, in the other order, and the Fed not lowering the interest rate today, why did the market end up, up?

GREG IP: Well, first of all, it didn't make back even half of the big drop it took on Monday, so let's not get too carried away.

But, also, the reports late in the day that the Treasury might be considering some form of help or the Federal Reserve might be extending some kind of a loan gave some optimism that, in fact, AIG would not end up in bankruptcy.

Cause of the accelerated crisis

Greg Ip
The Economist
[I]f you read the language of the statement really carefully, [the Fed is] clearly more pessimistic than they were a month ago.

MARGARET WARNER: And what was the Fed's -- how did you parse what the Fed said about why it decided to leave the interest rate unchanged?

GREG IP: Well, going into this weekend, before the Lehman bankruptcy, there was no expectation at all that the Fed would cut interest rates. In fact, all the debate was, when will they start raising them, given that there are inflation concerns out there?

Clearly, the disruption of the markets that has occurred in the last few days have increased the risks to the economic outlook. The message from the Fed was they don't yet see enough to conclude that the outlook has been so severely downgraded that a rate cut is necessary.

But if you read the language of the statement really carefully, they're clearly more pessimistic than they were a month ago. They said they have significant concerns about risks to the economy, that there have been severe strains in the financial markets, unemployment has risen a lot.

And they added a word near the end which gave me the sense that they will not rule out the possibility of lowering interest rates before their next meeting, if these disruptions in the markets do become quite severe.

MARGARET WARNER: Let's look at the deeper problems behind this. And, Joe, you had an interesting or a provocative column in the Times today in which you likened Wall Street to Main Street and said it was a problem of denial. What did you mean by that?

JOE NOCERA: Well, all through this, one reason this crisis has continued to accelerate and won't stop is that it's very, very hard for Wall Street to acknowledge how much these mortgage securities have dropped and how little they're worth -- how little they're worth.

And the analogy I was making is to someone who wants to sell their home in a down market. And you see the value of your home going down, but it's really hard to price your house at a price that would allow people to buy it, because you're kind of holding onto the idea that it has more value.

And in a very simplistic way, that's very, very much what's happened at Bear and Lehman Brothers and a lot of other institutions that have had just a hard time pricing these illiquid -- and they are pretty illiquid these days -- securities appropriately and then taking the appropriate write-offs.

MARGARET WARNER: And is that, Joe, because they really don't understand the mortgage-backed securities, these various products, or because just psychologically they can't bring themselves to do it?

JOE NOCERA: Well, part of it, don't forget, is that the market has paralyzed for these securities. Nobody wants to buy them. So there's a lack of liquidity.

So you can't -- you know, market -- you can't mark to market, as they call them. You can't price them by trading them. You have to price them by gauging what you think they're worth, you know, in a potentially liquid market. I don't know quite how else to describe it.

So there's a little bit of delusion here. There's a little bit of wishful thinking and, in some cases, there may be a little bit of dishonesty.

MARGARET WARNER: What's your view of this, Greg? Do you think that they really are like imprudent homeowners?

GREG IP: Well, part of it has just been a failure to realize just how bad things were going to get out there. I mean, if you talk to the heads of any of these investment banks, like Merrill Lynch, certainly Lehman, Bear Stearns, if they had known a year ago what they know now, they would have taken the opportunity to sell a lot more stock and beef up their capital base.

But they thought at the time, you know, things can't possibly be that bad. And why do I want to dilute my current shareholders by selling stock?

Well, of course, by the time they realized how bad things were, nobody wanted to buy their stock because the companies were in so much trouble. But that's really just a symptom of the larger problem afflicting the economy and the global markets, which really begins with the housing bubble, which elevated real estate prices far beyond their sustainable values.

And a lot of money was borrowed against those real estate values. As those values have come down, that debt is going bad. That is forcing a lot of banks to write off those loans. And when they write off those loans, it cuts into the capital base they need to make new loans. That is creating a credit crunch, which is really constricting the entire economy.

Concerns limited to Wall Street

Joe Nocera
The New York Times
[Wall Street is] making a legitimate point that they don't know that AIG can still survive even with this loan, so it's a case of fearing throwing good money after bad.

MARGARET WARNER: And, Joe, bring in the international picture here. I mean, isn't a lot of this debt or these instruments held by foreigners, foreign banks?

JOE NOCERA: Well, yes, some are. I mean, it's not -- I mean, let's be clear here. I mean, the crux of the problem is Wall Street and the Wall Street institutions.

And the banks, foreign banks that are holding the most of this stuff, I mean, this is not Chinese banks we're talking about. This is institutions like Deutsche Bank, which are heavily involved in the U.S. financial activities.

And so, yes, there are European and foreign banks that hold this stuff, but, you know...

MARGARET WARNER: That's not the problem?

JOE NOCERA: ... the chances of this being a kind of a worldwide thing beyond Wall Street are not that great yet, although we could get there.

MARGARET WARNER: Let me follow up by asking you this. OK, now you have a situation today, AIG, a company with more than $1 trillion at least in declared assets is having trouble borrowing, you know, $20 billion or $30 billion. The other big institutions don't want to lend to it. Are the Wall Street firms now overcompensating?

JOE NOCERA: Well, I mean, not really, because, you know, AIG has no capital to back up its balance sheet. So, you know, people are scared.

I mean, would you lend somebody $75 billion if you weren't sure you were going to get it back? It's really that simple.

I would say they're not overcompensating. They're, you know, making a legitimate point that they don't know that AIG can still survive even with this loan, so it's a case of fearing throwing good money after bad.

A need to 'change psychology'

Greg Ip
The Economist
The lesson from other big crises, both in the United States and overseas, is that when you get into these adverse feedback loops eventually the government with taxpayer money has to step in...

MARGARET WARNER: So let's end with the cosmic question beginning with you, Greg. What will it take to turn the corner?

GREG IP: Well, I think fundamentally, as we heard David McCormick from the Treasury Department say, you need housing prices to basically hit bottom. When that happens, the loans will stop going bad. The banks will stop, you know, running up big losses. They'll be willing to lend again, and the crisis will slowly come to an end.

The thing that I worry about is that we're into this adverse feedback loop where the declining housing prices are causing loans to go bad. Banks are cutting back lending. That hurts the economy. And home prices keep going down further.

The lesson from other big crises, both in the United States and overseas, is that when you get into these adverse feedback loops eventually the government with taxpayer money has to step in, buy those bad assets, and take them out of the system. That's what we saw, for example, with the savings and loan crisis.

MARGARET WARNER: Joe, what's your prescription?

JOE NOCERA: Well, I mean, I agree with Greg. It's hard to see how else it will happen. I mean, you need a change in psychology.

And for a change in psychology to take place, there has to be enough confidence among Main Street to start buying homes again. And there has to be enough confidence on Wall Street that these bad loans and these bad assets can somehow be dealt with.

So in the S&L crisis, they put them in the resolution trust, and they started to sell them off as the market came back. You know, so far nobody has been willing to do anything like that, but something like that really kind of needs to happen.

MARGARET WARNER: All right, we'll be watching. Joe Nocera and Greg Ip, thank you both.

JOE NOCERA: Thank you.

JIM LEHRER: On our Web site, you can read economics correspondent Paul Solman's take on the financial crisis and listen to an interview with BusinessWeek finance editor Adrienne Carter. Just go to, then scroll down to Online NewsHour Reports.