Connelly on Commerce

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

Who needs a bailout if JP Morgan can buy WaMu? The Federal Reserve, that’s who. The dirty little secret of the bailout debate is that the US taxpasyer is already on the hook for the toxicity in the financial system by virtue of the Fed’s now-abnormal balance sheet, which has been drained away from Treasuries by the less than stellar collateral it holds in exchange for its extraordinary lending facilities to financial institutions (hard to believe JP Morgan would have done the WaMu deal and taken on WaMu’s dirty laundry without access to the Fed “window”).

All the political posturing in the halls of Congress and the media will not change the fact that without Governmental intervention as the “patient buyer” of distressed securities, the US will have no choice but to print money to bail out the Fed, if nothing else. Ironically ‘Helicopter Ben” will be the recipient of this inflationary largesse rather than the dispensory!

Meanwhile, back in the CDO market, it will be dawning on unsecured debt holders of any bank that they are not exactly sitting pretty (think Wachovia) so expect more deals to follow like WaMu (pre- or post- FDIC intervention). Ironically, all these acquisitions in distress are creating a new rank of financial institutions that are again “too big to fail”!

So far as the debate in Washington over the weekend, how ironic that we are approaching the season of the Hebraic “day of atonement”. In what is left of the securitization market (ie, credit default swaps), it is the turkeys, not the chickens, that are coming home to roost. Once every political faction has gotten a piece of the draft legislation to call its own, something big will pass. But the question will remain, is the bailout bill “too big to fail”? The signals of success will first appear in the credit markets. Probably LIBOR. Ironically, the Fed as lender to AIG will for once be hoping that the interest on its “adjustable rate” loan  (8.5% above LIBOR) actually goes down.

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Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

Much is made these days of “systemic risk” — and we clearly have a lot of that on our hands. But some of the problems of Lehman and Bear Stearns and AIG, which have contributed centrally to our current credit seizure, are not simply the fault of the “system”, be it the structure of investment banking firms like Lehman and Bear, or financial conglomerates operating as hedge funds, like AIG. Some of the problem is plain old “pilot error” — those running these businesses made profound errors in judgment, most notably in the case of Lehman and Bear, by failing to bring their firms in for a safe landing in heavy weather through asset sales and outright mergers that they could have done but rejected.

AIG is a little more complicated because its new CEO Bob Willumstad was not given enough time by circumstances to lay out and execute a recovery plan, but there was plenty of pilot error that went before him at the company. And it would be amusing (if it were not so painful) to see the rating agencies that brought AIG low rediscover their spines in terms of downgrading firms on the wrong side of the credit default swaps trade. Those swaps were mispriced in the first place on the basis of the rating agencies’ own egregious pilot errors in terms of their “AAA” imprimatures on the various and sundry subprime mortage bonds.

The only solution to this massive credit seizure is to find a “Yucca Mountain” for the temporarily “nuclear” waste on the books of financial institutions that can no longer calculate their own — let alone their counterparties’ —  balance sheets. The Fed and Treasury must set up a separate, Federally-controlled “Resolution Trust Corporation II” if for no other reason than that the Fed cannot continue to be the holder of so much collateralized debt that it becomes a materially  interested player in the very interest rate game of which it is the chief umpire.

And while we’re at it, let’s not kill off the investment banking business model and culture, which has served us well in many ways over the years, including inventing the securitization market itself which brought us out of the corrupt savings and loan regime of the 80′s for mortgage finance. There is no such thing as a vibrant financial marketplace without risk. Yes, let’s get rid of the casino culture, but lets not replace it with folks whose idea of high risk is buying two cards at Church bingo.

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