President Bush's frontier justice

Former Lehman Brothers CEO Richard Fuld was on Capitol Hill today taking abuse from the House Oversight and Government Reform Committee.

He said federal regulators were fully aware of everything that was going on in the investment bank. He said he does not understand why Lehman Brothers was "the only one" that was not rescued with a federal bailout. "Until the day they put me in the ground I will wonder," Fuld said.

Hmmm.

Let's see if we can figure it out.

On March 15, 2008, the day the Treasury Department orchestrated a bailout of Bear Stearns and Company by JP Morgan and the New York Federal Reserve, the president of the United States gave an interview to CNBC's Larry Kudlow.

"You have said time and again that you oppose government bailouts, that you oppose the use of taxpayer money to bail out," Kudlow said, "I want to ask you if that opposition applies to these large banks."

This was President Bush's answer:

"Well, these are unusual times. These are times that -- where there's a confluence of housing market risks and financial risks that require unusual action. And it's very important for the American people to know that the Fed and the Treasury carefully weigh the -- necessary to bring some order and stability versus moral hazard. And I think they've struck the right balance in this case, particularly when people look at the details of the transaction."

Then he explained his Treasury Secretary's role.

"I think the Treasury was just part of making sure that the transaction was done in such a way as to balance stability and moral hazard," the president said.

What did he mean, exactly?

It sounds like he wanted to use the power of the U.S. government to save the financial markets from a nasty downturn, but he didn't want to protect certain individuals who took risks that should not be rewarded, for fear that other people would take similar risks and expect the same cushioned landing.

The bailout of Bear Stearns and Company was carefully engineered to wipe out the value of the shares of stock held by the company's executives, or as they're known this close to an election, Wall Street fat cats.

Wiping out the value of the stock wiped out the investment of a lot of innocent bystanders, like pension funds, widows and orphans, and small investors who held the company's stock in their portfolios after socking away hard-earned money for years and years.

Frontier justice can be rough.

That's what the CEO of Lehman Brothers discovered on Friday night, September 12, when New York Federal Reserve President Timothy Geithner called the executives of Wall Street's top firms to the Fed's headquarters for a weekend of secretive meetings about the future of Lehman Brothers.

In the end, potential buyers of Lehman, once the top underwriter of mortgage-backed securities, were not offered the government backing that JP Morgan had received to take over Bear Stearns.

This time, the government decided, the knife's edge separating stability and moral hazard would cut the other way.

Lehman Brothers was liquidated.

If you were one of the innocent bystanders holding Lehman Brothers stock, your investment was wiped out by the government's decision.

During the weekend of September 27-28, the government suddenly decided that Wachovia Bank should be seized by regulators and forced into a sale to Citigroup. The complex deal required taxpayers to shell out as much as $270 billion to cover potential losses stemming from sub-prime mortgage loans.

Wells Fargo said it would happily acquire Wachovia for six or seven times as much as Citigroup agreed to pay, and without a dime in taxpayer money. Yet right now, the government is doing everything in its power to block Wells Fargo from offering Wachovia shareholders a better deal than the officially sanctioned Citigroup offer.

Why?

Let's see if we can figure it out.

Wachovia bought Golden West Financial in May, 2006, making the bank the nation's leading provider of payment-option adjustable-rate mortgages.

Those are the kind of loans that start out affordable, then reset at higher rates and higher monthly payments a few years down the road, chewing up your home equity in the meantime by adding the unpaid interest and principal to the loan balance.

If home prices have appreciated during that time, homeowners can refinance or sell when the loan resets. If home prices have declined, homeowners can put the key in the lock, call the bank and say, "Come get your house."

Which is what a lot of them have now done.

What makes this market decline different from previous ones is that in recent years, investment bankers invented a market for "collateralized debt obligations," which means mortgages were bought up from the banks that made the loans and turned into financial meatloaf, cut into slices and sold to investors. "You'll make ten percent on your money by buying this security," investors were told. They may not have been told that as soon as the underlying mortgages reset to ten percent, vast numbers of those loans could become, in industry parlance, "non-performing."

By then, the loosey-goosey glad-handing that passed for regulation of investment banks had allowed financial institutions to use the shaky mortgage-backed securities as collateral for loans.

The crisis began when house prices declined, mortgages reset, some homeowners defaulted, and the mish-mashed mortgage-backed securities were feared worthless. The loans that had been secured with mortgage-backed securities as collateral were feared to be on the verge of default. Suddenly no one in the financial world knew if an institution would be alive tomorrow to pay back an overnight loan. Banks held onto their cash and refused to loan money to other banks that might be seized by regulators or forced into bankruptcy without warning, as Wachovia and Lehman had been. The credit markets froze, putting pressure on businesses across the U.S. economy and threatening to cause massive layoffs, six weeks before an election.

It's not hard to imagine President Bush sitting at his desk in the Oval Office between bike rides, squinting at his Treasury Secretary and muttering, "Git a rope."

Maybe that's why Richard Fuld and Lehman Brothers didn't get a bailout.

Maybe that's why the government forced the unfavorable Citigroup buyout on Wachovia and is now battling to stop Wells Fargo from offering Wachovia shareholders a better deal.

Moral hazard, meet frontier justice.

Then again, maybe it's not frontier justice.

Maybe it's what Johnny Carson said after Ed Ames famously threw a tomahawk at the painted outline of a man and hit it right in the crotch.

"Welcome to Frontier Bris!"


Copyright 2008

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