A financial hurricane rages on Wall Street

When the housing bubble popped, it wasn’t supposed to produce a hurricane.

But over the last year, what had been a crisis in the subprime mortgage market has been sending storm surges down Wall Street. Now, with the survival-by-buyout of Merrill Lynch and the outright collapse of Lehman Brothers, rising winds are whistling through financial markets in Europe and Asia.

The question now: Is this Ike, or is this Katrina?

The 504-point plunge Monday in the Dow Jones industrial average felt like Katrina, especially to investors who’ve already been swallowing relentless losses in the stock market. That includes the vast numbers of workers and retirees who’ve got money in mutual and pension funds.

America’s financial system is built on confidence, and the fate of Leh-man Brothers and Merrill Lynch delivered a hard blow to that foundation. Both investment companies survived the Great Depression; Lehman Brothers – founded 158 years ago – survived the Civil War. They’ve been symbols of Wall Street itself.

Now they’ve been felled by the same whirlwind that knocked down other giants: Bear Stearns, Freddie Mac and Fannie Mae.

Behind all this: A doomed runup in home values and a long orgy of reckless, irresponsible mortgage lending. These left countless unsuspecting banks and investors – across the world – awash in bad loans. The resulting debacle just keeps on sending shock waves through the world of finance.

Merrill Lynch and Lehman Brothers – once bywords for financial judgment – both wound up sitting on many billions of dollars in rotting real estate holdings. Merrill Lynch will now “survive” only by being bought by Bank of America, which in turn is drawing down its capital reserves below federal standards to cover the $50 billion purchase.

Lehman Brothers will simply die; it filed for bankruptcy on Monday.

Merrill Lynch and Lehman Brothers both tested the definition of “too big to fail.” Everyone in finance feared the consequences of their collapse, but Treasury Secretary Henry Paulson was adamant that the federal government would not intervene to save them, as it had Bear Stearns, Freddie and Fannie.

His reasoning makes sense: The Treasury cannot put the public credit at risk to bail out every major company threatened by this and other financial problems. The line has to be drawn somewhere.

But the nation’s leading bank CEOs – whom Paulson assembled over the weekend to pursue a private bailout – also refused to cover Leh-man Brothers’ liabilities. They calculated they’d be hurt less by the company’s failure than by the possibility it might help breach the levees and swamp everyone in a much larger international panic.

These people are supposed to be smart. Let’s hope they are also right.