Wall Street as Black Hole

Originally published at the Washington Independent

Stock markets rebounded mightily yesterday, dazzled by yet more center-stage virtuoso turns by Federal Reserve Chairman Ben S. Bernanke. Over the weekend, he out-Greenspanned Greenspan by engineering a takeover of Bear Stearns, and then opened the Fed's resources to investment banks in addition to the commercial banks that are its normal constituency. Tuesday he cut the Fed fund rate target, or the bank funding rate, to only 2.25 percent, a full 3 percent rate cut since the fall.

(Matt Mahurin) Surely now, with crises once more brilliantly contained and Fed money flowing freely, consumers will get back to borrowing and buying, housing markets will stabilize and the economy will turn smartly upward.

Not a chance. The Fed has now committed all the ammunition it has to prop up Wall Street, and shore up shaky mortgages. All that's left in its trick-bag is to turn on a Weimar-style printing press.

With all the attention focused on the Fed, investors may not have noticed that the so-called Government-Sponsored Entities, (GSEs) Fannie Mae, Freddie Mac and the utterly obscure Federal Home Loan Bank, have been pouring even more money than the Fed into housing, with little effect. The mortgage mess, it now appears, is a black hole that can swallow up the Fed without a trace.

Consider the sequence of events during the Bear Stearns takeover negotiation over the weekend, as participants have described them to the media. JP Morgan Chase apparently came into the Saturday session expecting to do a deal in realm of $10-$12 a share, without any guarantees from the Fed. Bear, after all, owns lucrative low-risk businesses like stock-clearing, plus a trophy Skidmore, Owings building in midtown Manhattan. The equity in the building is worth at least $6 a share by itself.

Then JP Morgan looked at Bear's books and had a drastic change of heart. The deal was finally done only after Morgan's price was cut to $2 a share, or $236 million, and the Fed ponied up a line of credit of $30 billion (that's 'billion' with a 'b') to cover potential losses. Morgan, that is, got the entire company for less than 1 percent of the total investment, while accepting almost no risk until all of the Fed's $30 billion is burnt through.

What made Morgan demand such terms, and why would the Fed agree? Or to rephrase the question, what did the Morgan executives see on Bear's balance sheet that made them so terrified?

Bear's published balance sheet is perfectly standard -- tradable assets are mostly liquid corporate stocks and bonds -- except for a $46 billion dollar slug of mortgage-backed securities. The only evidence that they're worth $46 billion is that Bear Stearns said so. But they are almost all opaque strips of the same kind of 'CDOs' and other "structured securities," that have brought Citigroup, Merrill Lynch and UBS to grief. As Bear explains in the fine print, you have to value them partly or wholly with sophisticated internal models because their values are difficult to tie closely, if at all, to "observable" market data.

The obvious inference is that Morgan looked at those securities with its own models and said, "Hell no." Even Bernanke's -- or the taxpayers' -- $30-billion deal sweetener must not have fully covered the risk in Morgan's eyes, or the stock price wouldn't have been cut so drastically.

According to the widely accepted calculations of intrepid Fed-watcher and blogger Steve Randy Waldman, the Fed can plow, at most, $400 billion into Wall Street balance sheets. After last weekend, they've already used up $90 billion of it. In the second half of 2007, however, the three housing GSEs poured more than $600 billion in new money into the mortgage markets, obviously without "fixing" the problem. In the third quarter, when GSE financing peaked, according to analysts at BNP Paribas, it was equivalent on an annualized basis to 15 percent of GDP.

The huge volume of GSE financing, of course, has begun to push up the cost of GSE borrowing, despite the winks and nods from the Treasury and the Fed that this is really federal debt. Congress and the Bush administration, in the meantime, are working on legislation that will raise GSE borrowing limits and allow it to lend on lower-grade paper.

If you're into housing bubbles, the thinking seems to be, you might as well make it a really big one - like a dirigible. We could call it the Hindenberg.