As Federal Reserve and Treasury officials huddled on Wall Street to try to find a way to save struggling insurer American International Group from bankruptcy Tuesday, Fed policy makers did nothing to ease the market pressure. They left the fed fund rates unchanged, deciding that fighting inflation was still a top priority.
In a statement released after the Federal Open Market Committee Meeting, the central bank said that while "strains in financial markets have increased significantly and labor markets have weakened further... the downside risks to growth and the upside risks to inflation are both of significant concern ..."
After a Monday in which Wall Street experienced its worst losses since 2001, investors today seemed to take a breath. The Dow Jones industrials gained 141 points Tuesday.
Last night, top rating agencies Standard & Poor's and Moody's Investors Service cut AIG's debt rating. That means the giant insurer will need to come up with more collateral — or raise cash — to cover its debts. It is unclear whether AIG will be able to do so.
Even before the ratings decision, the company was in a cash crunch. It has incurred some $18.5 billion in losses in the past three quarters because of its exposure to mortgage-backed securities.
On Monday, New York Gov. David Paterson tried to give the company some breathing room by allowing AIG to access some $20 billion of capital in its subsidiaries. That might not be enough.
"I think AIG has a day" to get a deal done, Paterson told CNBC on Tuesday morning. "I don't know if anyone is really understanding the ramifications of this crisis. We're in a terrible situation if we let the world's largest industrial and technical insurance company go down."
Experts agree that the failure of AIG would have tremendous consequences for the financial industry. It has insured some $441 billion in fixed income assets for banks and other investors. Because of that, most major banks have significant exposure to AIG.
The two biggest Asian stock markets — Tokyo and Hong Kong — plummeted Tuesday on the news of the downgrade of AIG's debt rating. Stocks in Europe also fell.
The sell-off started Monday after news broke that the largest U.S. brokerage, Merrill Lynch, had to sell itself to Bank of America just to stay afloat, and the nation's fourth-largest investment bank, Lehman Brothers, was forced to file for Chapter 11 bankruptcy. The Dow Jones industrial index closed Monday down more than 500 points, and the Standard and Poor's 500 closed down 59 points at 1,192.70, the lowest level since October 2005.
Asian markets followed the U.S. lead. On Tuesday, Tokyo's Nikkei 225 index sank nearly 5 percent to 11,609.72, its lowest close since July 2005. Hong Kong's Hang Seng Index fell 5.4 percent to close at its lowest level in almost two years.
The Federal Reserve has asked JPMorgan and Goldman Sachs to put up some $75 billion in lending that might help AIG weather the storm, but so far the two banks have balked. If AIG doesn't get some sort of lifeline, it will have to file bankruptcy.
'Rough Spots Along The Road'
Speaking to reporters Monday, Treasury Secretary Henry Paulson tried to put the best face on what had transpired. He said an "archaic" regulatory system was to blame for the turmoil in the markets.
Critics have been harsher. They say that reckless lending practices by Wall Street firms during the housing boom are now coming home to roost.
Paulson said until the slump in U.S. housing prices levels off, "we're going to continue to have turmoil in the financial markets." He didn't sound hopeful about the slump ending anytime soon.
"I believe that there is a reasonable change that the biggest part of that housing correction can be behind us in a number of months," Paulson said, adding, "I'm not saying two or three months, but in months as opposed to years." He warned that there would be some "real rough spots along the road."
Paulson and other Treasury and Federal Reserve officials traveled to New York City over the weekend to huddle with Wall Street bankers in an effort to try to smooth those rough spots. The goal was to keep Merrill and Lehman afloat after the two institutions reported billions in losses related to mortgage-backed securities.
The plan had been to arrange some sort of shotgun wedding like the one they engineered for Bear Stearns earlier this year. In that case, the government provided some guarantees against losses, and JPMorgan Chase got Bear Stearns at a bargain-basement price.
The sessions over the weekend were only partly successful. Merrill agreed to sell itself to Bank of America for $50 billion so it could avoid bankruptcy, but Lehman was not so fortunate.
Both Barclays Bank and Bank of America flirted with the investment bank but in the end said that without some sort of guarantee that would shield them from additional losses, they were not willing to take the plunge. Without a white knight, Lehman was forced to file for bankruptcy on Monday. Lehman has some $60 billion in bad real estate debt.
"The situation and facts around Bear Stearns are very, very different," Paulson said when asked why the government wouldn't extend the same sort of guarantees against losses for Lehman as it had for Bear Stearns. "I never once considered putting taxpayer dollars on the line in the Lehman situation."
'At Some Point You Have To Say No'
Wall Street Journal economics editor David Wessel said Monday that the federal government didn't come to Lehman Brothers' aid because of the barrage of criticism it got for saving Bear Stearns, which put some $30 billion of taxpayer money at risk.
"It realized that at some point you have to say no or the entire financial system, every time there's a problem, is going to come to the Federal Reserve and the taxpayers and say 'we need your help here,' " Wessel told Renee Montagne.
So Paulson, Federal Reserve Chairman Ben Bernanke and New York Fed President Tim Geithner decided to draw a line in the sand, "and now we're going to find out if they did the right thing or not," Wessel said.
"If things start to get better now, it will be seen as the right decision. If they made a mistake and they should've put taxpayer money into this, they'll go down in history as the guys who made the biggest blunder since 1930."
To provide some sense of scale of the crisis: Merrill Lynch — one of the country's top issuers of mortgage-backed securities — reported it had lost more than $45 billion on its mortgage investments. That's about two times more than all of its profits in the two years before the subprime mortgage crisis. So far, financial institutions around the world have written off hundreds of billions of dollars in losses related to mortgage-backed securities.
Now all eyes are on AIG. The government announced Monday afternoon that it would not bail out the company or provide the guarantees it needed to stay afloat. It is pressuring a consortium of investment banks to do so, but it is unclear whether that will work.
Paterson announced that New York state would allow AIG to shift some $20 billion in assets to shore up its balance sheet. Investors didn't seem to think that would be enough. AIG's shares traded Monday for as low as $3.50 a share — a far cry from its 52-week high of $70.13 a share.
President Bush also tried to calm investors' jangled nerves during a news conference at the White House on Monday. He said he had been in close touch with Paulson throughout the weekend and added that he knew Americans were concerned about the financial markets. He said his administration was working to reduce further disruptions and any impact the credit crisis would have on the broader economy.
"In the short run, adjustments in the financial markets can be painful," the president said. "Both for the people concerned about their investments and the employees of the affected firms. In the long run, I am confident our capital markets are flexible and resilient and can deal with these adjustments."