Federal Reserve Chairman Ben S. Bernanke may be running for a "Hero of Wall Street" award. Over the last few months, he has opened up the Fed's coffers for banks and brokerages to the tune of hundreds of billions, and is accepting riskier loan collateral than ever before. Last week, he threw his body -- or, more accurately, ours -- over the railroad tracks to slow an onrushing Bear Stearns trainwreck.
This time, at least, the acrobatics may have worked. On Sunday, JP Morgan Chase announced that it would buy Bear at a tiny fraction, less than 2 percent, of its market value last fall. According to early reports, the Fed is also kicking in $30 billion of taxpayer money to sweeten the deal.
Is Wall Street happy? Of course not. David Rosenberg, the chief economist of Merrill Lynch kvetched that the Fed's actions do "not materially improve the solvency of the institutions exposed to assets under stress...and does nothing to put a floor under home prices."
Rosenberg makes Merrill and its pals sound like Katrina victims -- just innocent bankers quietly going about their business when they got hit with all these "assets under stress." Who knew?
Bear Stearns's most recent financial filings with the Securities and Exchange Commission make rich reading. The largest chunk of its assets, $46 billion, are in home mortgages and home mortgage-backed securities. They're funded 20-1 with borrowed money, a lot of it very short-term. They're clearly culled from the riskier end of the market, and recent delinquency rates are far higher than the (very high) industry norm.
Given that housing values are falling by some 10 percent a year, a reader would naturally conclude that this is a company on the brink of insolvency -- as, indeed, it turned out to be. But JP Morgan Chase still got a bargain. The $30 billion from the Fed will cover most of Bear's mortgage losses, and JP will pick up Bear's lucrative back office business for a song.
Why did the the Fed think it had to pay to make a deal happen, instead of just letting the market take its course? According to Bernanke and Treasury Secretary Hank Paulson, who made the rounds of the Sunday talk shows, it is because Bear is at the center of a web of other funds that look a lot like Bear - heavily leveraged and holding lots of mortgage-backed paper. If the Fed didn't act, a lot of them, perhaps most of them, would also fail.
Would that be so awful? That depends on what kind of assets we're propping up. Bear skimps on loan detail, but Countrywide Financial is another big mortgage lender on federal welfare -- $50 billion worth, all from Atlanta Federal Home Loan Bank. It is a rich target for litigators, so its lawyers must have insisted on unusually detailed disclosure.
Almost all the mortgages on Countrywide's book are so-called "prime" mortgages. But if you look closer, it turns out about a third of them are nasty things called "pay-option loans." Borrowers can defer both principal and interest. Most of the loans are ARMs (adjustable interest) with monthly interest resets and annual payment resets for deferrers, plus unlimited resets every five years. Countrywide goes on to tell us that 81 percent of such loans - about $24 billion worth - were underwritten "with low or no stated income documentation;" 71 percent are "electing to make less than full interest payments," and - surprise - delinquencies went up about nine times in 2007, from 0.65 percent in 2006 to 5.71 percent now. Although they're carried at full value on the Countrywide balance sheet, in reality, they're junk.
This is the kind of garbage that Bear had on its books, and is precisely the kind of mortgages likely to back the complex "Collateralized Debt Obligations" and other mortgage-backed instruments preferred by yield-seekers like hedge funds. But Paulson and Bernanke seem determined to keep the Ponzi game going. Shamefully, the two biggest rating agencies, Standard & Poors' and Moody's, are playing along by maintaining triple-A ratings on mortgage bonds that probably qualify as junk.
But Wall Street is even marking down bonds from Fannie Mae and Freddie Mac, the complaint goes. That's crazy, right? Everyone knows they're guaranteed by the federal government.
But there is no federal guarantee. In its annual report, for example, Fannie insists that "We are a stock-holder owned corporation...funded exclusively with private capital," with no guarantee "either directly or indirectly" from the federal government. Of course they would say that -- how else to justify a $14.5 million pay package for the boss?
But Paulson and Bernanke seem to be hinting that there really is an "implicit" federal guarantee, as Wall Street has always suspected. They should stop insisting. Fannie and Freddie, between the two of them, have $225 billion in subprime and 'Alt-A' mortgages on their books. (The Countrywide pay-option loans would be categorized as Alt-A.) People with eight-digit pay packages, we have learned, like taking risks with other people's money. If they get into trouble, that shouldn't be a taxpayer problem, and bond-buyers should mark Fannie and Freddie paper for what it's really worth.
The hard truth is that a decade of flooding markets with easy money enabled greedy and stupid lending, and probably a good deal of conscious fraud. Houses, like most other leveraged assets, are now grossly overpriced relative to home-buyers' ability to pay. Home prices have perhaps another 15-20 percent to fall - maybe even more as the recession starts to bite.
"Placing a floor under home prices" benefits nobody but the banks and hedge funds, and will delay essential market adjustments. It's time to start letting the dominoes fall.
Originally published in the Washington Independent.