Saturday, September 20, 2008

Why just the FM twins, why not Lehman?

So the US government okays a $700 billion bailout package for its distressed financial institutions.

I began to think about the nature of the lifeline. What exactly does a bailout mean? Will the US treasury buyout bad assets and refinance the failed lenders so that they can resume business? Will it float a freshly funded SPV to absorb the bad assets, clean up the muck from the rogue lenders’ books and then eventually sell them? Or will the Fed just go and print fresh notes equal to $700 billion and honor the bonds as they come back to collect?

I look up federal bailout history. The handling of the great depression of 1930’s, the savings & loan scandal of 1989 and a few other. Nothing has been this big. Even more were allowed to go under. They were just not qualified for a bailout, bit like Lehman Brothers.

So where did Lehman goof up? Why only the FM twins (Fannie Mae & Freddie Mac), Bear Stearns and Merrill Lynch? What gives?

To be eligible for a bailout, firms must also demonstrate a particular genius for screwing up. Before it went bust, Bear Stearns had a monstrous $33 of debt for every dollar of capital, and hedge funds it owned destroyed hundreds of millions of dollars of clients' cash. It got a bailout.

Financial intermediaries like Bear Stearns and the FM twins function like the heart of the global financial system. If they go into cardiac arrest, the whole body is in danger. Since Bear Stearns was a counterparty to (and guarantor of) trades and financial arrangements with the world's major financial players, its failure would have triggered a cascade of losses. In the same vein, huge quantities of the $5.4 trillion in debt issued and insured by FM twins sit on the balance sheets of central banks and financial institutions around the globe. For the U.S. government simply to let this debt — which it had been implicitly backing for decades — go bad would have meant inflicting severe damage on America's most significant diplomatic and trading partners. Fannie Mae wasn't too big to fail, it was too Chinese to fail.

So now I get it. To be eligible for a bailout it’s not enough to be just too big. Screw it up real bad that it should threaten the global financial system. So much so that the ensuing stress on financial markets should mean massive job losses, devastated retirement accounts, further erosion of asset values and absent loans – not just in your country, across the world.... New world order, period.

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