Domino Effect of Takeovers Pushes Bernanke, Paulson to Congress

By Craig Torres

Sept. 19 (Bloomberg) -- The Federal Reserve and Treasury's efforts to solve the financial crisis may have only undercut the ability of banks and Wall Street firms to raise new equity capital, leaving them to fail or be taken over.

Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson are now working with Congress on what Paulson described as a more ``comprehensive approach,'' after finding that case- by-case bailouts only produce runs on more firms. The new plan will help banks get rid of ``illiquid assets'' on their books, he said after meeting legislators late yesterday.

Over the last six months, each decision on the fate of a failing firm prompted traders to speculate on the outcome at others. The Fed's $114 billion in loans to protect the creditors of Bear Stearns Cos. and American International Group Inc., and the U.S. Treasury's backstopping of $5.2 trillion in Fannie Mae and Freddie Mac debt and securities added to the domino effect.

``Bailouts are creating weird incentives,'' said Raghuram Rajan, a University of Chicago economist and former chief economist at the International Monetary Fund. ``When you point out the guys you are going to back, you point out the next sitting duck.''

While the Fed and Treasury refused to commit public resources to Lehman Brothers Holdings Inc., the negotiations pointed to large risks inside investment banks. Shares of Morgan Stanley plunged more than 40 percent this week before gaining 3.7 percent yesterday following news of the talks on creating an authority to buy up illiquid assets.

`Unintended Consequences'

The ``unintended consequences of bailouts are at work,'' said Gerald O'Driscoll, a former vice president of the Dallas Fed and a scholar at the libertarian Cato Institute in Washington. ``Lehman Brothers came under attack because investors rationally assumed it was plagued by some of the same problems that ailed Fannie and Freddie: failure to mark assets to market.''

Now, Treasury and the Fed are in discussions with congressional leaders on a wider plan to break the cycle.

Shareholders lost in the rescues of creditors to Fannie Mae, Freddie Mac, AIG, and Bear Stearns Cos. Shares of Fannie Mae closed at 43 cents yesterday after trading above $7 two weeks earlier. Shares of AIG closed at $2.69 after ending last week at $12.14.

Paulson said after yesterday's meeting that he and Bernanke are working on ``an approach to deal with the systemic risk and the stresses in our capital markets. We talked about a comprehensive approach that will require legislation to deal with illiquid assets'' held by financial institutions.

Bankers Complain

The meetings on Capitol Hill came as the banking lobby complained that the federal seizure of Fannie Mae and Freddie Mac hurt commercial banks by devaluing their holdings in the government-sponsored enterprises.

``The unexpected losses to holders of GSE preferred shares will inhibit a sizable number of banks from making new mortgages or providing other financing,'' American Bankers Association President Bradley Rock said in a letter to Bernanke and Paulson. Rock asked for ``prompt, comprehensive action to alleviate the unintended consequences'' of the takeover of the GSEs.

Bernanke came into office advocating rules and transparency as a matter of public accountability. Now, the central bank's Board of Governors, advised by the New York Fed, has been determining on a case-by-case basis who wins and who fails.

``Random bailouts confuse markets so that investors have no idea what to do,'' said Joseph Mason, a Louisiana State University finance professor who served in the bank-research division of the Office of the Comptroller of the Currency from 1995 to 1998. ``Such a policy will certainly draw out the economic effects of the crisis for far longer than would otherwise be the case.''

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net.