As Lehman turns to lemon, central banks pour more juice

A week after the deals on Fannie Mae and Freddie Mac, we're being treated to yet more turmoil in markets. MarketWatch reports the carnage on Wall Street.

Stocks tanked on Monday, with the Dow Jones Industrial Average plunging 500 points -- the most since September 2001 -- after Lehman Brothers Holdings Inc. filed for bankruptcy and insurance giant American International Group Inc. scurried to raise capital even as its market value was cut in half by distraught investors...

In addition to AIG, investors focused on Seattle-based thrift Washington Mutual Inc. which has entered talks with J.P. Morgan Chase & Co., but no deal is in place...

In the face of the global financial storm, Merrill Lynch & Co. agreed to be bought by Bank of America Corp. in an all-stock deal valued at $50 billion...

The dollar declined the most against the Japanese yen in 10 years, but gained against the euro and the British pound on thinking the Federal Reserve would cut interest rates Tuesday.

Treasury prices jumped, pushing yields down the most since September 2001...

Gold futures also rallied as Wall Street's troubles raised demand for safe-haven investments, with the contract for December delivery gaining $22.5 to close at $787 an ounce on the New York Mercantile Exchange.

Oil futures tumbled to a seven-month low, with key refineries in the Gulf of Mexico apparently spared major damage from Hurricane Ike, with crude for October delivery falling $5.47 to close at $95.71 a barrel on Nymex.

The latest financial turmoil will only add to problems in the real economy.

Economic data had the Fed reporting U.S. industrial output fell 1.1% in August, the largest drop since Hurricane Katrina three years ago, and far worse than the 0.3% predicted by analysts.

Separately, the New York Federal Reserve Bank reported manufacturing activity in the region declined earlier in the month, with the Empire State index falling to negative 7.4 in September from 2.8 in August.

Meanwhile, central banks aren't sitting on their hands. Reuters reports:

Central banks mobilized worldwide on Monday to reassure financial markets after Lehman Brothers filed for bankruptcy protection and news that Merrill Lynch, another Wall Street giant long seen as too big to fail, was being sold...

[The Federal Reserve] announced emergency measures for lending operations which effectively relax the terms on which commercial banks can borrow from the U.S. central bank...

The ECB held a money market operation where it allotted 30 billion euros in one-day liquidity to banks, only a third of the level demanded...

The Bank of England put an extra 5 billion pounds into the financial system after receiving bids of nearly five times the amount of three-day funds available. The Swiss National Bank also provided extra liquidity to the money market.

And China is easing monetary policy. Again from Reuters.

China's central bank acted decisively on Monday to prop up the country's slowing economy by cutting the cost of bank loans for the first time since February 2002.

Against a background of acute stress in global financial markets, the People's Bank of China also lowered the reserve requirement for all banks, except the five largest and the Postal Savings Bank, by 1 percentage point.

But Paul Krugman wonders whether policymakers -- specifically US Treasury secretary Henry Paulson -- could have done more.

... [T]here was no aid, and apparently no deal. Mr. Paulson seems to be betting that the financial system...can handle the shock of a Lehman failure. We’ll find out soon whether he was brave or foolish.

But maybe Krugman is wrong about Paulson. Maybe Paulson is just being realistic -- the government can't afford to put more public funds on the line. From Willem Buiter:

[S]ince Bear Stearns crashed, the US Treasury has, through its de-facto nationalisation of Freddie and Fannie, taken an additional $1.7 trillion of debt on its balance sheet, as well as a $3.7 trillion exposure to mortgage- and MBS-guarantees, with a fair value of around $350 bn...

If the US Treasury, either directly or indirectly...were to offer financial support for a rescue of Lehman or for any other investment bank (or commercial bank, for that matter), the floodgates could open and the fiscal-financial position of the US Federal government could be materially affected. Japan not that long ago shared a sovereign credit rating with Botswana. A trillion here, a trillion there and the US Federal debt could lose its triple-A rating.