Turmoil on Wall Street could mean lower interest rates for home buyers, but any benefit for housing markets could be outweighed by higher unemployment and a prolonged recession if the credit crunch becomes an even greater drag on the economy.

Lehman Brothers Holdings Inc. today filed for Chapter 11 bankruptcy protection, and Bank of America announced a $50 billion deal to acquire another troubled investment bank, Merrill Lynch. Giant insurer American International Group Inc., which reportedly needs to raise up to $40 billion in capital to avoid a downgrade from credit-rating agencies, reached a deal with New York regulators to raise about half of that amount from its subsidiaries.

As a whole, the day’s news prompted a "flight to quality" by investors away from stocks and other risky investments into safer investments like bonds, pushing down long-term interest rates such as fixed-rate mortgages. Short-term rates soared, however, as banks became more reluctant to loan each other money. Central banks poured billions of liquidity into markets to stave off a lending freeze and bring short-term rates back down to targets.

The Federal Reserve said it was stepping its twice-monthly injections of capital through short-term auctions of cash to a weekly basis, and will take a broader range of collateral — including stock — for the loans, which will be increased from $175 billion to $200 billion a month. The European Central Bank held a $42.5 billion money-market auction, and 10 large international banks established a $70 billion emergency fund to to provide additional liquidity.

When the Federal Reserve’s Open Market Committee holds its previously scheduled meeting Tuesday, some economists expect it will cut its target for the federal funds overnight rate by 25 or even 50 basis points. The committee halted a string of seven consecutive cuts in the federal funds overnight rate in June because of fears that inflation could get out of hand.

There’s been speculation that the Fed would soon be forced to raise the overnight rate, currently at 2 percent, to combat inflation. But oil prices, which have been a major driver of inflation, fell well below $100 a barrel Monday, down from nearly $150 a barrel in July.

Lehman Brothers was reportedly forced to file for bankruptcy after the U.S. Treasury declined to finance a buyout of the nation’s fourth-largest investment bank, as it did in March when it provided $29 billion in financing to help J.P. Morgan Chase take over Bear Stearns. Shares of Washington Mutual also plummeted today on fears that the bank won’t be able to raise capital needed to offset mounting losses. In afternoon trading, the Dow Jones Industrial Average was off nearly 400 points.

Mark Zandi, chief economist at Moody’s Economy.com, said there are two schools of thought on what the latest developments in the credit crunch could mean. They may be the catalyst for a chain of failures throughout the financial system, or a "cathartic event" in which weak links in the financial chain are repaired through mergers like the Bank of America and Merrill Lynch deal.

Under the darker scenario, there may be an additional $1.4 trillion in investor losses on top of the $600 billion seen so far, and unemployment could rise sharply into 2010, Zandi said in a commentary for Moody’s Economy.com’s Dismal Scientist newsletter. Under the more optimistic scenario — which Zandi favors — the financial crisis is closer to its end than its beginning. Investor losses are likely to total closer to $1 trillion total, and although the economy will remain "recession-like" well into 2009, employment will peak next fall, he said.

"Unlike Japan during the 1990s, the U.S. is willing to take its financial pain upfront," Zandi said. The Treasury Department’s refusal to finance a buyout of Lehman suggests that policymakers don’t envision collapse of the financial system.

With oil prices falling, strong growth in exports, and a sweeping housing bill signed into law in July set to take effect Oct. 1, optimists see the financial crisis at its apex, winding down by this time next year, Zandi said.

Zandi said evidence supporting an optimistic view includes improvements in housing affordability as prices decline; a peak in inventories of unsold homes; and the fact that mortgage loans are "cheaper and will soon be more ample given the government takeover of Fannie Mae and Freddie Mac."

In the short term, today’s developments look certain to cause more pain for those working in the U.S. financial services sector, which has already seen nearly 103,000 layoffs this year. According to outplacement consulting firm Challenger, Gray & Christmas, the financial services sector could see another 50,000 jobs slashed in 2008, and break last year’s record of 153,105 layoffs.


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