What sparked these losses was Lehman Brothers (a major investment bank) going broke, and Merril Lynch being bought by Bank of America, under the weight of mountains of bad debt stemming from the subprime crisis.
Unlike other major players in the mortgage market who went kaput, like Bear Stearns and Fannie May and Freddie Mac, there was no government bailout forthcoming today. Perhaps it was getting too hard to justify spending tens of billions of taxpayer dollars bailing out investment banks that really have no one to blame but themselves.
The repercussions to the economy may be grave, but continual bailouts have a negative effect as well. It's what economists like to call "moral hazard". What incentive is there to follow the rules and avoid risky ventures (like subprimes) if there's an omnipotent central authority waiting to bail you out, should anything bad happen? It provides a perverse incentive to be greedy and take risks that you have no business taking.
The Fed is reasoning that it's time for some of these institutions to pay the piper and live up to their bad debt, whatever the consequences.
Of course, this is all a product of the housing bubble and insanely irresponsible practices by the major US banks, for which I will now give a brief summary to anyone who's interested:
Interest rates were kept low in the years after 9/11 to prop up the economy, and people started buying houses. Why not, with all the easy access to credit, and low mortgage rates? And the banks, sensing opportunity, decided to try and make even more money by offering mortgages to people who had no business having a mortgage. At a low "subprime" interest rate, which would gradually increase to something more difficult. The reasoning was that house prices would keep increasing, and it would be easy for homeowners to refinance later on. But they didn't keep increasing. Mortgage rates spiked, and the real estate bubble popped. People stopped buying houses. Prices started to decrease (though only moderately at first). Suddenly, lots of new homeowners owed more on their mortgage than their house was worth. As mortgage payments rose, more and more people who had been enticed with subprime rates defaulted, and forclosures exponentially increased.
This is all bad, but what made it really bad is that all these banks and investment brokerages had started packaging and selling their bad mortgages and repackaging and reselling them as part of these things called mortgage backed securities (MBS). Traditionally, these securities have been almost as good as hard currency, since even if someone defaults on their mortgage, the bank still has the house as collateral. But with the subprime fiasco, this was no longer true; now the house wasn't worth as much as the mortgage, and these bad loans had been shuffled and spread around to such an extent that the whole system came tumbling down like a deck of cards.
The whole scheme was based around the short-sighted idea that house prices would continue going up. Few players really trusted this to be true, but they kept passing around the risk like a hot potato, thinking this would protect them. As we saw in the case of Bear Stearns, and now Lehman Brothers, Merril Lynch, and AIG, it didn't, as investors scurried to protect their investments and unload risk in what Krugman calls a "post-modern bank run".
Of course, this whole situation has a political aspect to it as well. It would seem that we have more than enough evidence to declare that deregulation of the financial sector was probably a bad thing. One would think this would help the Democrats. Especially when the Republican nominee for President is spewing nonsense:
This morning, campaigning in Florida, in the midst of a crisis on Wall Street, McCain repeated his argument that "the fundamentals of our economy are strong." Not surprisingly, the Obama campaign wasted no time in bringing attention to McCain's odd remarks.
This afternoon, carefully reading from a prepared text, McCain insisted that the fundamentals of the economy really are strong, just so long as he gets to redefine the word "fundamentals."
"My opponents may disagree, but those fundamentals of America are strong," McCain said this afternoon in Orlando. "No one can match an American worker. Our workers sell more goods to more markets than any other on earth. Our workers have always been the strength of our economy, and they remain the strength of our economy today."
Fascinating. Most policy makers would look at "fundamentals" like economic growth, wages, unemployment, inflation, trade imbalance, value of the dollar, budget deficit, interest rates, etc. But not McCain, who believes the "fundamentals" of the economy are the American people. I see.
So, by McCain's reasoning, the only time the "fundamentals" of the economy are weak is when Americans are awful. Or, as Atrios put it, "McCain has now defined the fundamentals of the economy as 'workers and small businesses,' so if you suggest something is wrong with the economy you're insulting workers. This follows the Bush strategy of saying that criticizing his Iraq policies is insulting the troops."
That last bit is a very astute observation. Criticize the war? You're insulting the troops! Criticize the economy? You're insulting American workers! Utterly and totally dishonest, but at this point, I expect nothing less from the McCain campaign.