Paulson-Bernanke Steps Created `Big Ripples,' Leading to Rescue

By Craig Torres and Eric Martin

Oct. 3 (Bloomberg) -- The $700 billion rescue that the U.S. House considers today reflects the unintended consequences of decisions made by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke since March.

Beginning with the orchestrated purchase of Bear Stearns Cos. by JPMorgan Chase & Co., each step was a bold effort to forestall a collapse of the financial system. The economy grew in the first two quarters of this year, and financial distress eased for a while after the Bear Stearns rescue. Still, each decision to bail out or not created more instability, leading to further runs on securities firms, banks and insurers.

``Every time you tinker with this delicate system even small changes can create big ripples,'' said Dino Kos, former head of the New York Fed's open-market operations and now a managing director at Portales Partners LLC in New York. ``This is the impossible situation they are in. The risks are that the government's $700 billion purchase of assets disturbs markets even more.''

Paulson and Bernanke insist that the program to buy troubled mortgages and other securities is needed to revive lending and restore stability to markets. What they haven't discussed is the risk that they inadvertently make matters worse. By creating a government pool of distressed real-estate and bad debt, they could depress the housing market further. Risk may become even more concentrated through a wave of bank mergers that, if unsuccessful, would stick taxpayers with an even higher bill.

Conference Call

The decision to launch the biggest bailout in history came on a Sept. 17 conference call, when Bernanke and Paulson pulled the trigger on a proposal etched out over several months. Over the previous two days, they let Lehman Brothers Holdings Inc. fail and seized American International Group Inc. The reaction to their visible hand: a rout in financial stocks, paralysis in the trillion dollar inter-bank loan market, and flight from money market mutual funds.

Treasury and Fed officials had long been uncomfortable with the way the safety net had to be expanded to catch Bear Stearns. Not a single creditor had suffered a default as the company was swept into JPMorgan Chase & Co. with the help of a $29 billion Fed loan. Stock investors received about $10 each.

Their decision to pull back and let shareholders get wiped out in Fannie Mae, Freddie Mac, and then Lehman ``sent shivers through investors,'' said Peter Kovalski, who oversees financial-services stocks for Alpine Woods Capital Investors LLC's $12 billion portfolio. ``Everybody kind of backed off and said if this is the way the government is going to play the game, we don't want to risk our capital.''

Assumptions Thrown Out

Lehman's bankruptcy toppled other assumptions that investors had made. Bear Stearns, deemed too big to fail by the Fed and Treasury, had $399 billion in total assets. Lehman Brothers had $639 billion in total assets, possibly posing a bigger systemic risk than Bear.

``There was a perception, right or wrong, that after Bear Stearns, that in any firm as big, the senior debt holders would be okay,'' said Karl Haeling, head of debt distribution at Landesbank Baden-Wuerttemberg, New York, Germany's largest state-owned bank. ``Obviously, that was the wrong bet.''

Bernanke and Paulson began their discussions at the end of the day on Sept. 17, when the Standard & Poor's 500 Financials Index fell 8.9 percent.

Investors concluded after the AIG takeover -- the price of an $85 billion loan -- that any future federal aid would come at a similar cost, and they fled.

`Oh, My God'

``Are we imploding right here?'' Joseph Saluzzi, co-head of Themis Trading LLC in Chatham, New Jersey, and his colleagues asked each other on Sept. 17. Shares of Goldman Sachs Group Inc. were down 21 percent at noon and Morgan Stanley lost 36 percent. ``People thought, `Oh, my God, if Goldman's going out, we've got a real problem.'''

Lehman's collapse caused the Reserve Primary Fund, the oldest U.S. money-market fund, to write off $785 million of debt issued by the investment bank, forcing the fund to break the buck, meaning its net asset value fell below $1 a share.

The run on money funds, prompted in part by the government's decision to let Lehman fail, caused yet another extension of the safety net by the Treasury and Fed.

On Sept. 19, invoking Depression-era authority, the Fed's Board of Governors authorized its Boston branch to provide emergency loans to commercial banks to purchase asset-backed commercial paper from money mutual funds to help them meet shareholder redemptions.

Paulson's Goal

The Treasury is gambling that the $700 billion plan now being debated in Congress will kick-start capital markets and lending. If the government is a buyer of mortgage securities, they will trade higher, Paulson told Congress. If the banks are cleansed of bad assets, they will find new capital and the cycle of lending will start again.

Investors say once again the government's big-footing in the financial markets could create more problems than it solves.

Officials ``have designed a financial bailout plan that is not only misdirected, but may further exacerbate problems in the housing market,'' says Eric Hovde, chief investment officer at Hovde Capital LLC, which manages $1 billion in financial services stocks. ``Just as foreclosure sales are pressuring housing prices today, government sales will only make matters worse.''

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Eric Martin in New York at emartin21@bloomberg.net.