Paulson, Bernanke Brave `Raptors' in Resisting Aid for Lehman

By Craig Torres and Shannon D. Harrington

Sept. 13 (Bloomberg) -- Henry Paulson and Ben S. Bernanke may have to weather more speculative attacks on financial institutions as they resist using public funds to aid the sale of Lehman Brothers Holdings Inc.

``The raptors test the fence for weak spots,'' said Vincent Reinhart, a former director of the Federal Reserve Board's Division of Monetary Affairs who is now a resident scholar at the American Enterprise Institute in Washington. ``The speculators think the authorities will blink, and the authorities think the speculators will run out of funds.''

By shutting the door on assistance for Lehman, Treasury Secretary Paulson and Fed Chairman Bernanke accelerated a plunge in the shares of other institutions perceived to face similar capital constraints. Merrill Lynch & Co., American International Group Inc. and Washington Mutual Inc. fell yesterday after a person familiar with Paulson's thinking said he was ``adamant'' that no government money be used in resolving Lehman's capital constraints. Fed officials are taking a similar stand.

Paulson and Bernanke are struggling to define which firms aren't too big to fail after the March bailout and merger of Bear Stearns Cos. and last weekend's seizure of Fannie Mae and Freddie Mac protected creditors, creating the perception the government would insure other firms against disorderly collapse.

Paulson, New York Fed President Timothy Geithner and Securities and Exchange Commissioner Christopher Cox late yesterday met with Wall Street chiefs to discuss this week's market slump. New York Fed spokesman Andrew Williams declined to comment on the details of the discussions at his bank.

No-Win Decision

After Bear Stearns, regulators face a no-win decision with Lehman, said former Representative Richard Baker, a Louisiana Republican who served on the House Financial Services Committee. ``You bail them out, you are putting taxpayers' money at risk,'' Baker said. ``You don't bail them out, you are facilitating the short sellers.''

Former Fed Chairman Alan Greenspan said in a Bloomberg Television interview yesterday that avoiding the use of government funds in the case of Lehman would be ``the ideal solution.'' He wouldn't make odds on whether that would be the case.

``Once you put the line under Bear Stearns, that whole structure of financial and non-financial institutions above that automatically became too big to fail,'' Greenspan said.

The showdown comes at a precarious moment for the Fed and Treasury. The presidential elections are two months away. The central bank's interest-rate cuts, 3.25 percentage points over the past year, haven't translated into a free flow of credit at low rates for consumers, the Fed's own surveys show.

Fed's Meeting

Fed policy makers meeting next week will likely leave the benchmark rate unchanged, according to futures trading that also indicates a one-in-three chance central bankers will need to resume easing credit by year-end.

Reports this month point to a heightened risk of a recession. Unemployment rose to a five-year high of 6.1 percent last month, and retail sales fell 0.7 percent, excluding autos, the biggest decline this year.

``Financial conditions are extremely fragile,'' said former Fed governor Lyle Gramley, now a senior economic adviser for the Stanford Group Company in Washington. ``With the Lehman situation deteriorating, this tends to have knock-on effects.''

In a sign that creditors don't expect Paulson to blink, the cost to protect against defaults by AIG, Merrill, WaMu and Wachovia Corp. reached records. Credit-default swaps on Seattle- based WaMu are trading at levels that imply a 75 percent chance the company will default in the next five years, a JPMorgan Chase & Co. valuation model shows.

`Coming to Grips'

``All of these firms are exposed to the real-estate market,'' said Len Blum, managing director at Westwood Capital LLC, a New York-based investment bank. Investors are ``coming to grips with the reality that real-estate markets have been and will be in a decline.''

An index created by New York-based Credit Derivatives Research LLC that tracks credit-default swaps on 15 banks and securities firms, known as the CDR Counterparty Risk Index, rose 51 basis points the past week to 215 basis points, the highest since the collapse of Bear Stearns in March.

A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

The Fed, Treasury and financial system ``are in a horrible situation,'' said Thomas Garcia, head of equity trading at Thornburg Investment Management Inc. in Santa Fe, New Mexico, which oversees about $46 billion. ``You have investors at large firms like Lehman saying: Why can't you do it again?''

Resolution Mechanism

One problem hobbling regulators is that they don't have a transparent process for dealing with investment banks in the same way that the Federal Deposit Insurance Corp. does for handling troubled commercial banks. That leaves Fed and Treasury officials with emergency decisions that set new precedents and change market incentives with every bailout or failure.

``The big policy question is, do you need to preserve investment banks in the public interest?'' 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. ``We are at the inflection point,'' he said. ``Failures keep getting bigger and bigger.''

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Shannon D. Harrington in New York at sharrington6@bloomberg.net