Fed to Wall Street: Drop dead
Posted
Sep 15 2008, 05:54 AM
by
Jon Markman
Rating:
The fate of the world financial system hangs from a thread today after the New York office of the Federal Reserve stood up to the big Wall Street financial houses on Sunday and essentially told them, "thanks but no thanks" on their request for a bridge loan to nowhere.
It's about time. For years, the country’s major broker-dealers and banks have competed with each other to become the No. 1 underwriter of loans, bonds, mergers, mortgages, swaps and equities. The industry’s compensation system is focused on rewarding managers who took big risks, and could bring home top rankings in dealmaker lists.
All the while, banks figured that if they really got into trouble, the federal government would back them up with taxpayer funds. And the government reluctantly complied twice this year, backing up the reckless behavior of high-flying bankers at Bear Stearns in March, and Fannie Mae and Freddie Mac last week with loan guarantees costing untold billions.
But when Lehman Brothers chief Richard Fuld came to the Fed with his hand out on Friday, the central bankers had finally had enough – and told the banking industry that it needed to come up with its own solution to its problems. In meetings over the weekend in New York that must have frozen the veins of bankers used to bullying the government into doing their bidding, the government left Lehman Brothers and all its creditors out to dry, figuring it was better to let the financial system burn to the ground than to risk any more of the Federal Reserve’s withering balance sheet.
It may be hard for most people to realize what a shocking development this was. Virtually no one on the Street anticipated that the Federal Reserve would put its foot down on the throat of the bankers who had always gotten their way. If anyone had believed this would happen, global banks’ stock prices would have been a lot lower last week as Lehman Brothers’ liquidity unraveled, for anyone who had looked at the investment bank’s books as a potential buyer knew that it owed its 10 largest unsecured creditors more than $157 billion – and had no virtually no hope of paying up.
Treasury Secretary Hank Paulson and New York Federal Reserve Bank President Tim Geithner may have dumbfounded the world with their gutsy decision to call Wall Street’s bluff, but now the fallout will stretch well beyond Manhattan. Lehman Brothers was forced by the decision to declare bankruptcy on Sunday night, and due to rules that penalize broker-dealers more than normal companies, it has no hope of simply reorganizing, canceling its debts and returning to the field of play.
Instead, it must now liquidate all of its holdings to pay creditors, and that will result in the dumping of hundreds of billions of dollars worth of real estate, Treasuries and stocks into an already frozen market. No one knows all the totals, but Lehman is believed to have a Treasuries book worth $1 trillion all by itself.
Of course, this is not just Lehman’s problem. Any bank, brokerage, hedge fund, hotel chain, limo service or caterer that did not demand full collateral from the bank for its services or loans will be waiting in line for money that may never come. The business that this will affect the most is the massively leveraged credit default swap industry, which is a mere $65 trillion in size, since Lehman was one of the largest CDS "counterparties" in the world – the middleman for hundreds of billions of dollars in trades between entities that more often than not don’t know each other. Indeed, Merrill Lynch, American International Group and Morgan Stanley may be the most at risk, since they are believed to have the greatest amount of CDS counterparty exposure to Lehman. And that is why their shares prices were teetering on oblivion Monday in pre-market trading.
But equity holders will be affected as well, for every hedge fund that was owed money by Lehman, and in turn owes someone else, will now feel the need to liquidate anything that isn’t nailed down in order to meet their margin calls, which is the financial equivalent of a bank’s request for more collateral to back up a loan. Unless something changes the psychology fast, any momentary wave higher in the stock market will be met by another round of selling as financial firms worldwide dump their paper assets in order to accumulate the cash needed to stay solvent.
Since the U.S. Treasury already fired one of its biggest bullets in the Fannie Mae/Freddie Mac deal by bringing those entities’ $5 trillion in troublesome home loans into federal custody, its hands may be tied. So one of the few policy actions that can be taken now to change the psychology would be a cut in interest rates by the Federal Reserve.
More on the meltdown: The markets in crisis
The current Federal Funds rate is at 2%, and futures market is pricing in expectations of a cut of half a percentage point this week, a move that would flummox market players even more than they already are since Fed governors just last month said their next move was most likely to raise, not cut rates – and they hate to be seen as inconsistent. However, my guess is that a rate cut will not be in the cards unless the European Central Bank also cuts rates. A unilateral rate cut in the United States would have the effect of crushing the dollar, an event that would open a whole new set of problems.
In summary, the banks got themselves into this mess by taking massive risks in credit and equity deals and paying themselves like kings in the process. And now some of them are finally paying the price, as the 25,500 loyal Lehman Brothers employees who owned 30% of the company, just to name one group, are ruined.
Ultimately the market will recover, but don’t expect it real soon, as the folks around the world who have the most meaningful caches of money to invest now are going to be very wary, at least for a while, at plunking it down with the crooked bosses of the Wall Street casino. The government's actions this weekend are one small step to lay down the rule of law, but considering that federal regulators were asleep for years as banking excesses accumulated, there are miles to go before U.S. financial credibility is restored.
To learn more about the origins and development of the problems that have led the market to this juncture, here are a few of my columns of the past year on the subject:
Sept 20, 2007: Are we headed for an epic bear market?
Dec. 20, 2007: Stock market winter is moving in
Jan. 10, 2008: How the smart money got it so wrong
Jan. 24, 2008: Bad Market? You ain't seen nothin'
Feb. 21, 2008: Why Wall Street rescues are failing
April 24, 2008: As loans dry up, so will the economy
July 24, 2008: Maket at bottom? Don't believe it
Aug. 7, 2008: One L of a banking crisis
Aug. 22, 2008: Warning: Worldwide wipeout ahead
