A wild week transforms Wall Street

In a dizzying sequence that shook the global financial system to its foundations, the U.S. government this week forced a major Wall Street investment bank into bankruptcy, midwifed a hasty takeover of America’s best-known investment firm, and committed $85 billion to an extraordinary rescue of one of the world’s biggest insurance companies. The dramatic events came just two weeks after Treasury Secretary Henry Paulson spearheaded the federal takeover of mortgage giants Fannie Mae and Freddie Mac. Although the moves were aimed at calming investors, markets seesawed wildly, with most global stock indexes recording heavy losses. “It’s the worst news out of Wall Street since I’ve been alive,” said mutual fund manager Steve Romick.

The financial drama began Monday with the bankruptcy filing of Lehman Brothers, a 158-year-old investment bank with 26,000 employees that has been crippled by heavy debt and investments in failed mortgage securities. Lehman sought bankruptcy-court protection after Paulson refused to grant federal help to facilitate a sale to a private buyer. Hours later, Merrill Lynch, recognizing that it couldn’t count on federal assistance, accepted Bank of America’s

$50 billion takeover bid. A day later, the Federal Reserve agreed to lend insurer AIG $85 billion, forestalling a bankruptcy filing that could have precipitated a worldwide financial panic.

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Congressional leaders and both presidential candidates praised the government’s actions, but said the turmoil underscored the need for tighter regulation. “The private market screwed itself up,” said Rep. Barney Frank, chairman of the Financial Services Committee, “and needs the government to come help them unscrew it.”

What the editorials said

It’s “politically convenient” for Congress to call for more regulation, said The Wall Street Journal, but that impulse must be resisted. Already, “the banking system is reforming itself right before our eyes.” Banks are reducing their own debt, acknowledging their losses on bad investments, and rediscovering prudence in lending. Let the process play itself out without meddling from Washington.

Unrestricted market forces are exactly what created this crisis, said the Los Angeles Times. Fueled by cheap money and the illusion that housing prices would rise forever, the free market inflated the housing bubble now exploding all around us. More convulsions will follow unless Washington develops a “mechanism to guard the financial system as a whole against future bubbles.”

What the columnists said

Say this for Treasury Secretary Paulson: “He knows when to hold ’em and when to fold ’em,” said Steve Pearlstein in The Washington Post. Paulson “was desperate to demonstrate” that the government was not going to bail out every troubled financial institution in the land. So he gambled that the system could survive the failure of Lehman, and his resolve spurred Merrill Lynch to seek a deal while it was still worth something. The shakeout wasn’t “neat or even fair,” but Wall Street—and America—will probably be better for it.

Paulson made a carefully calibrated choice when he rescued AIG but let Lehman die, said Vincent Reinhart in The Wall Street Journal. He decided, rightly, that “Lehman did not cast a long enough shadow over markets to warrant support.” AIG—along with Fannie Mae and Bear Stearns, whose debt the government essentially guaranteed—were very different cases. So many other institutions depended on their products and services that their collapse could have paralyzed the whole financial system.

But does the federal government actually have a coherent strategy? asked David Leonhardt in The New York Times. Ever since the government-assisted sale of Bear Stearns in March, Paulson has sprinted from crisis to crisis “with little attention to the underlying reasons that the economy has gotten into this mess.” Until Washington goes “beyond short-term fixes” and tackles the root causes of our economic problems—too little savings and too much spending on unproductive investments—we’re doomed to repeat this miserable cycle of bubbles and busts.

What next?

Following the AIG deal, Wall Street turned its attention to Washington Mutual, the nation’s largest savings and loan. A growing portion of the bank’s $300 billion mortgage portfolio is in default or foreclosure, and the firm is nearly insolvent. Federal officials have canvassed major banks to gauge their interest in acquiring the thrift, but none seems inclined to take on WaMu’s problems—at least not without federal assistance.