Is market 'fix' tomorrow's crisis?

By Jon Markman

It has been a full year now since the collapse of two Bear Stearns credit-focused hedge funds ushered in the modern era of low finance. Over the past 12 months, that once-great brokerage has fallen, a couple of managers have been indicted, and U.S. banks have seen at least half a trillion dollars in equity go up in smoke.

But all of that is just money and reputation. The real change is yet to come, as the anniversary of the biggest credit disaster of the past 50 years finds the Bush administration on the verge of throwing out decades of laissez-faire posture toward the finance community on the theory that a handful of bureaucrats in Washington know how to run world markets better than anyone.

Normally, you'd have to be skeptical. If you liked the Iraq war, you're going to love Wall Street 2.0, right? But let's face it, the geniuses on Wall Street have left a lot of room for improvement.

Fifteen months ago, Merrill Lynch (MER, news, msgs) was in a race to become the world's leading underwriter of high-yielding credit derivatives known as collateralized debt obligations, or CDOs. This week, new management sheepishly announced the sale of $30 billion worth of its inventory for 22 cents on the dollar, and it had to lend the buyer 75% of the sale price to boot.

What we're about to witness next is an unprecedented realignment of the investment universe:

• The nation's two largest mortgage bankers, Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs), are essentially nationalized.

• A secretive state-owned cabal in Singapore called Temasek Holdings is allowed, without protest, to become the largest institutional holder of the leading U.S. broker. Dozens of regional banks are headed for receivership.

• The Bush administration grows closer to becoming the ultimate arbiter of how money is borrowed, lent, distributed and deployed in an America already racked by plunging home values, a disappearing auto industry, a shattered dollar and a stressed middle class.

Expect unexpected consequences

It's virtually impossible to tell what will happen over the next year as a result of these developments. Emergency legislation is typically passed with more speed than study. But it's likely that, as David Kotok of institutional fund manager Cumberland Advisors told clients this week, the "seeds of the next crisis are being sown right now" as a set of presumed fixes create unexpected consequences.

Hazarding a guess, Kotok suggests the next crises may emerge in federal guarantees as private entities are let off the hook for their obligations. Beware of stresses that the new era will place on the Federal Deposit Insurance Corp., which is responsible for faltering banks' deposits; the federal Pension Benefit Guarantee Corp., which is responsible for making good on companies' unfunded pensions; and the Securities Investor Protection Corp., which is responsible for making good on brokerage customers' cash losses. No one really knows whether they have the funds to carry out their missions.

In any case, it's easy to see that foreign investors are skeptical about Washington's ability to press at lightning speed into new supervisory roles on the Street. A type of private insurance that pays off if Fannie Mae and Freddie Mac bonds go bad -- instruments called credit default swaps, or CDSs -- have strangely grown more expensive in the past two weeks since rescue plans for the pair were announced.

Even though the U.S. government has more or less said it would back those obligations with taxpayer funds, the cost of those swaps reportedly has doubled. Kotok notes that CDS costs on the quasi-governmental Fannie Mae and Freddie Mac bonds are now twice the price of similar bonds issued in Germany, though both are low compared with those of other countries. So forget what you see in the equity market, where finance stocks were up a touch this week. Watching the default insurance costs widen is like watching the global investment community bet on the likelihood of further turmoil in U.S. credit markets and seeing them turn more negative.

Of course, the government won't let our financial system spiral out of control without a fight, so look for the possibility that Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke will use this opportunity to effect a radical shift in regulatory policy to give banks a shortcut to recovery, and the Republicans a better shot at retaining the White House.

Here's how, according to analysts at TIS Group in Minneapolis:

• Paulson has made it clear, albeit in the form of hints, that he will protect shareholders of Fannie Mae and Freddie Mac, in part because he actually wants private companies, not the government, to provide capital for the two mortgage titans in the future. Fannie and Freddie won't be able to raise equity in the private markets if their need is greater than their market caps, so the government has to do something to boost confidence in their stocks and bonds.

• TIS Group analysts believe the government will ease standards for writing down all illiquid assets. For instance, regulators might allow banks to take years to write off bad mortgage loans rather than making them mark them all to market right away. That would immediately improve the earnings outlook for banks, which would then lift their stock prices.

• Moreover, federal regulators could speed the process of ensuring that weak banks were taken over by stronger banks by changing the capital requirements for the new entities. If they did this soon and forcefully, they could encourage private capital to flow more quickly into bad banks, which would again have the effect of lifting prices for the entire sector.

Continued: Helping the taxpayers -- and the GOP?

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