Titanic and iceberg

Titanic and iceberg

So, yesterday when it became clear Lehman wasn’t going to be rescued the Fed relaxed its rules about what it would lend money to banks and brokerage houses and added 25 billion to that loan facility. Ten major banks kicked in 70 billion into a fund they can borrow against if they have problems and overnight the Fed added 70 billion to the banking system’s reserves. In other words, a ton of money was built into a wall to backstop the market, not just today, but going forward and to give banks and brokerage houses the ability to offload any lousy security they feel like.

Despite that both the Dow and the S&P500 crashed over 4%. I don’t think investors are all that reassured. Which is interesting, because we’re talking about some real serious money here. The Fed may not have rescued Lehman, but they did backstop financial firms in a significant way.

What I think Bernanke and Paulson have decided is that they need to start clearing the books. Letting Lehman go under, letting AIG get chopped up, which is how I read the (yet another) 75 billion dollar lending facility led by Goldman and Chase, means that some real numbers are going to be put on a lot of securities and a lot of mark to market is going to occur. That will occasion write-downs. The idea is to try and set a floor by setting some actual market prices, have the firms take their lumps, force the ones that can’t survive to either go bankrupt or to be bought up and to stop the death by a thousand cuts.

Will it work? That depends just how bad everyone’s books really are, and it depends on how bad they keep getting. If the housing market keeps getting worse, the books keep getting worse.

But Bernanke and Paulson are really going all in on this, they’re letting banks play with depositor money:

The Fed added that it was suspending a rule that normally prohibits deposit-taking banks from using deposits to help finance their investment banking subsidiaries to allow them to fund activities normally funded in the repo market on a temporary basis until January 30 2009.

This is a dangerous game, because instead of firewalling that money away from investment subsidiaries, it allows banks to gamble that with depositor money they may be able to turn it around. This was exactly the sort of thing that Glass-Steagall was designed to make impossible – banks to not be in the brokerage business, insurance companies not in banking, and so on. Glass-Steagall was partially repealed in 1980 (part of what made possible the Savings and Loan fiasco), further parts in 99 under Clinton, and now the Fed has violated the fundamental principle that banks shouldn’t be gambling with depositor money. Because, be real clear, if you don’t really know how much in the hole you are, or how much further you could get, lending money to the unit that’s in the hole is gambling.

It’s also putting the FDIC (the organization which insures deposits) even more on the hook, and the FDIC does not have infinite money except in the sense that the Treasury can lend it infinite money. At this point the FDIC has about 50 billion. Banks have about 4.7 trillion in insured deposits. Yes, that’s a bit of a gap.

So we’ll see where it goes from here. Anyone who says they know where it’ll stop is wrong, because losses are being amplified by strong leverage, and losses are ongoing as the economy worsens. If you could somehow figure out what the damage is at this instant (and you can’t) you still wouldn’t know how bad it’s going to get.

This has been coming for a long, long time. For years Wall Street made record profits, many multiples of GDP growth and higher than other industries’ profits. What they were doing is using heavy leverage, ignoring actual default risk, assuming that housing prices would always rise, and booking future profits in the present as income. Imagine if you could say "well, I think I’ll make 1 million over the next 10 years, so I’ll just sell that money to investors now, pay them later, and book the sale price of 900K this year." Works, till it doesn’t.

All of this has created a huge pile of securities that are worth, at best, cents on the dollar, but are booked as much more. It’s the bottom of that pile that Bernanke and Paulson have decided they need to get to. So hang on tight while they go looking for it because as they jump in, grabbing the public’s hand at the same time, we better hope the bottom isn’t over our heads.

(What would the correct solution be? To create a bottom to the pile rather than jump in looking for one. More on that another time.)

Ian Welsh

Ian Welsh

Ian Welsh was the Managing Editor of FireDogLake and the Agonist. His work has also appeared at Huffington Post, Alternet, and Truthout, as well as the now defunct Blogging of the President (BOPNews). In Canada his work has appeared in Pogge.ca and BlogsCanada. He is also a social media strategy consultant and currently lives in Toronto.

His homeblog is at http://www.ianwelsh.net/