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Sifting Through the Carnage
By: Dr. Charles Lieberman
Date: 9/22/2008
Just one week ago, I wrote: "Treasury has wanted to avoid encouraging financial firms from taking undue risk by bailing them out of their past mistakes. That's a good principle, but it should not override all other considerations. By allowing Lehman to fail, Treasury is allowing its problems to afflict other financial firms that will now scramble to determine their exposure to Lehman. If some firms suffer large losses due to their exposure to Lehman, more failures could result. In effect, Treasury is accepting systemic risk to discourage moral hazard. It is not a good trade, since Treasury could be forced to spend even more money if the losses spread and other firms need to be bailed out to contain the problem and avoid a systemic problem. Similarly, Treasury placed the GSEs into receivership, but devastated the preferred stock market in the process, inflicting losses on banks and financial firms, while damaging their ability to tap preferred to raise capital."
The adverse consequences of the Treasury's policy choices in managing the credit crisis did not take long to come home to roost. Treasury allowed Lehman to fail, reflecting Paulson's desire to discourage moral hazard. Money market funds that owned Lehman commercial behavior quickly started reporting losses and a few "broke the buck", causing investors to flee and adding yet another dimension to the credit market's problems. Once again, Paulson was forced to clean up another mess of his own creation, by announcing Treasury would protect money market fund investors. Also, Treasury committed to buying hundreds of billions in illiquid securities. To flee any possible "help" they might receive from Paulson, Merrill Lynch sold out to Bank of America. Good move. With friends like Paulson, these firms don't need any more enemies.
The primary issue is whether Treasury and the SEC have finally stabilized the situation, or has Paulson laid yet more land mines that will disrupt the financial system in the coming weeks? The moratorium on short selling will buy some time for markets to settle down. Fewer targets are left for the hedge funds to go after, even if they could short such stocks. Washington Mutual appears to be close to selling out, removing another target. However, as companies that own Lehman or AIG paper reveal their losses, investor's confidence will be shaken periodically, so the road ahead is sure to remain volatile. But, is the worst over?
Anytime the government has been forced to "bail out" companies in the past, they succeeded and made a bundle in the process. In time, it is very likely that Treasury will get the same outcome this time. In fact, I expect Treasury to make billions from its corporate takeovers. (Just don't expect a rebate check for your share of the profits.) If Treasury's expected purchases of illiquid assets helps restore some liquidity to the market, concerns will lessen with regard to other financial companies. Investors seem to believe the worst is now over, as reflected by the rebound in stock prices. That seems reasonable, partly because of the reduced number of companies now at risk, partly due to the increased supply of credit that will be placed into the market by Treasury's purchases of mortgages and illiquid assets. Mortgage refinancing started to soar within one week after Treasury assumed control over the GSEs. Still, the safest bet is that the market will remain highly sensitive to any bad news and volatile. Treasury also needs to help restore calm, so business and consumers regain confidence to invest and spend.
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