Hank Paulson’s refusal to rescue Lehman has been a rude shock to bond holders. Until last Sunday, the main losers in the financial crisis has been equity holders, while bond holders have seen their assets protected by the government. As a result, Treasury yields plunged to new lows on Monday as bond investors fled bank and commercial bonds and flooded into the safety of government bonds. To restore stability in the credit markets, the Fed had to inject massive amounts of liquidity to maintain the target Fed funds rate, as well as agree to backstop AIG with $85 billion of loans. It remains to be seen whether these actions will work.
The latest panic in the credit markets, caused in my opinion by the mis-steps of the Treasury, has considerably darkened the prospects for the recovery of the US economy. Bond investors are by nature extremely risk-averse, and any uncertainty will cause panic; Paulson, with his years of experience in the financial world, should have known this. Now, US companies and banks have effectively lost the ability to issue bonds and incur additional debt. New initiatives for growth will go unfunded. Companies with existing debt which need to be refinanced will likely be unable to do so, and will go bankrupt. Banks will seize every opportunity to terminate credit lines to preserve their own capital. All this adds up to more people being laid off, the economy sliding further into recession, and a massive decline in the stock market.
Investors who had made ill-considered investments in risky subprime mortgages should not be rescued. However, the government has failed to clearly specify its criteria for rescue, and has chosen to haphazardly mount rescues on an ad-hoc basis. As a result, otherwise sound bonds, such as those backed by student loans and commercial bonds, have also became risky in the short term as bond holders flee the entire bond market. In other words, the government has failed to contain the crisis to the subprime mortgage sector, and contagion of healthy bonds has begun. In order to salvage the situation, the government needs to formulate a clear industry-wide criteria for rescues. In addition, the Fed must apply monetary stimulus and tolerate a short-term period of increased inflation, which will stimulate exports, reduce the current account deficit, and hasten the bottoming of housing prices (in real terms).
