Botched rescues are killing markets

By Jim Jubak

Save us and the financial markets from the folks at the U.S. Treasury and the Federal Reserve who are now riding to the rescue. They're making a terrible mess even worse.

Nobody in the financial markets believes these guys. On Sept. 16, when the Federal Reserve's Open Market Committee voted to hold interest rates steady at 2%, the federal funds rate fell to 1% in the markets, way below the 2% target.

Think the markets are convinced the Fed will have to cave and cut interest rates no matter what it said Sept. 16? Of course they are. And they're almost certainly right. That's why stocks rallied on what was bad news.

More importantly, for any of us who hope to see the economy start to deliver jobs and growth again, watching the Treasury and the Fed try to "save" us is a horribly graphic reminder of how they got us into this mess.

We can thank their addiction to flooding the market with liquidity and their inclination to look the other way for inflating the housing bubble, when they should have exercised their regulatory powers to deflate it. And we can now thank their "solution" for making the damage worse.

By saying one thing one day and doing something else the next, they've left the financial markets without any reasonable guidance. Remember how they told American International Group (AIG, news, msgs) that there would be no bailout, then bailed out the company anyway? Anybody have any idea which companies the Fed and Treasury will save and which they won't?

• Talk back: Which company is next? WaMu? Morgan Stanley?

In the name of an apparently newfound belief in the free market, they destroy one of the few remaining ways that stressed financial companies can raise money in the public financial markets. And in the name of creating an orderly liquidation of a company such as Lehman Bros. (LEH, news, msgs), they create a mad scramble to get paid before the bankruptcy court can act. And their most recent intervention, the $85 billion bridge loan to AIG, makes it clear the Fed and Treasury no longer understand what's at stake in this crisis -- if they ever did.

Playing favorites

Let me give you some examples of exactly how the Fed and Treasury have made a bad situation worse in the past week.

Start with the government takeover of mortgage giants Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs). Most questioning of this deal has focused on whether the danger to the financial markets justified U.S. taxpayers stepping in to guarantee $5.9 trillion in debt and debt guarantees issued by these two private companies.

I happen to think the deal was justified in those terms: Regulators allowed those two companies to get so big and to make so many reckless loans that their failure would have wiped out the financial markets that fund mortgages.

But just because I think the takeover was the best course in a bad situation doesn't mean I think the Treasury and Fed struck a good deal. In a good workout deal -- and this was a workout -- everybody takes a hit, and the size of the hit depends on where an investor stands in the ranks of company creditors. Owners of common stock almost always get wiped out. Holders of junior debt, called subordinated because it ranks below senior debt, take a bigger haircut than senior debt. But no debt holder walks away from a situation like this unscathed.

Except this time. Holders of senior debt got paid 100 cents on the dollar, and so did holders of subordinated debt. Common shareholders got zip, and so did owners of dividend-paying preferred shares.

Overseas investors and speculators cash in

The precedent here is terrible. Investors in Fannie and Freddie got paid not depending on what they owned but by who they were. Because so many overseas central banks and investment funds owned the senior debt and the guaranteed paper, they got paid 100% -- because the Fed and Treasury were scared that even delivering a 10% haircut to sophisticated investors who should have recognized the risk in what they were buying was too risky for a country that's as dependent on the money of strangers as the U.S. is.

Fannie Mae and Freddie Mac had, without a strong dissent from anybody in Washington, marketed their debt to overseas investors by encouraging them to think it came with a U.S. government guarantee. Maybe the Treasury and Fed genuinely believed Fannie Mae and Freddie Mac had put the credit of the U.S. government on the line.

But what about the junior debt? We're not talking about a huge amount of money here --just $11 billion and $4 billion in subordinated debt from Fannie and Freddie, respectively. The original holders of this debt knew they were buying riskier paper. Recent buyers of the junior debt weren't investors but speculators betting that they could buy this debt cheap and that the U.S. government would make them rich.

And you know what? They were right. The Treasury and the Federal Housing Finance Agency told The Wall Street Journal that they don't know who holds this junior debt now, but the owners, The Journal speculated, include Treasury Secretary Henry Paulson's former company, Goldman Sachs (GS, news, msgs), and bond guru Bill Gross' Pacific Asset Management and its Pimco bond funds. This kind of investor needs a government rescue?

Continued: Wiping out dividends

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