Botched rescues are killing markets

The deal didn't have to be structured this way. For example, in a Sept. 6 letter to Paulson, investment company Pershing Square Capital Management suggested that the subordinated debt be exchanged for warrants for common stock. The warrants would turn out to be valuable or worthless depending on how Fannie Mae and Freddie Mac performed.

Wiping out dividends -- and trust

The deal had another, bigger flaw, one far more important to any fix for the financial system than merely dishing out a few extra billion to speculators who didn't need the money. By wiping out the Fannie Mae and Freddie Mac preferred stock, the Fed and Treasury killed off any possibility that some other financial institution in need of capital could raise cash by selling these dividend-paying shares.

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

One of the problems confronting any financial company trying to raise cash is that because the price of its common shares has fallen so far, selling enough common shares to raise the required capital becomes impossibly expensive. If Washington Mutual (WM, news, msgs) needed to raise $8 billion, for example, selling common shares wouldn't be a viable solution because the entire company is now worth just $4 billion, according to the stock market.

But because preferred shares come with a dividend that gets paid before any dividend on the common shares (and in the case of cumulative preferred, the dividends pile up for future payouts if the company misses a pay date), they've held up better in this crisis. As long as the shares paid a dividend, investors were willing to buy them. And, critically to strapped banks, the capital raised by selling preferred shares counts as Tier 1 capital, the highest-quality and hardest-to-raise capital.

The "rescue" of Fannie and Freddie finished that possibility. By wiping out the dividend on the $36 billion in preferred shares at the two companies, the Treasury and Fed have ensured that no conservative, income-seeking investor in his or her right mind would buy preferred stock from a troubled financial company looking for capital.

Playing taps

What were they thinking?

Maybe they weren't. After watching the hash that the Treasury and Fed have made of the Lehman bankruptcy, I sure have to entertain the possibility that the folks in Washington don't know what they're doing.

And maybe the Fed and Treasury hadn't remembered that Congress amended the bankruptcy code in 2005 to carve out special rules that applied to swaps, repurchase agreements and the other derivatives that have proved so toxic to Lehman.

In most bankruptcy proceedings, all of a debtor's assets are frozen. The bankrupt company can't even pay a bill without permission of the bankruptcy court once the bankruptcy petition is filed. The point of this rule is to create an orderly distribution of the company's assets to the company's creditors. The creditors, ranging from the company's employees to its coffee service to its landlord to the big investors who own its bonds, all get in line by seniority. The bankruptcy court then doles out the liquidated assets of the bankrupt company until there are no more.

The 2005 exception threw that process out the window for the derivatives that Lehman owns. The counterparties in those deals are free to sell those deals on the market, if anyone wants them. They're free to take the collateral they'd given to Lehman as part of one of these derivative deals. Lehman took out hedges in the derivatives market to protect against a deal going bad or the value of a security (or another derivative) falling. The financial companies that were the counterparties to those hedges can now just rip them up, taking away critical protection for the company's portfolio just when creditors need it most.

And because the derivative market is so lightly regulated, it's likely that no one will even know if an asset walks out the door at Lehman in this way before it could be liquidated and distributed to creditors. In essence, the companies that were parties to derivative deals with Lehman are free to strike the best deals they can without having to clear them with the bankruptcy court or inform other creditors. Creditors' claims against Lehman come to $613 billion, according to bankruptcy court filings.

The AIG about-face

Now you may find it odd that the Fed and Treasury have created a Lehman bankruptcy that's so unfair and chaotic while at the same time defending the deal as the best way to achieve an orderly liquidation of Lehman.

But that's the quality of the rescue that we can expect from the Fed and Treasury. Need a final example? Try the $85 billion takeover of AIG. After drawing a line in the sand and saying no more bailouts, the Fed and Treasury ponied up $85 billion in taxpayer cash to go into the insurance business. Their excuse for the about-face: Though the Fed had planned for a Lehman bankruptcy, it hadn't modeled a failure at AIG and couldn't predict the consequences of letting the company go into bankruptcy.

That's not reassuring.

Right now it looks like the Fed and Treasury are so focused on fighting today's fire that they've lost track of what's at stake. This crisis isn't about the U.S. housing industry or mortgage-backed assets anymore. What we're seeing is a challenge to the future health of the global financial system that makes the world's economy grow. I'll lay out that challenge in my next column.

Continued: Developments on past columns

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