The catastrophic turn of events in the financial markets this month were actually exacerbated by the Treasury's "fixes" themselves.
When they "rescued" Fannie and Freddie the geniuses in the Bush administration quit paying dividends on the preferred stock. The only problem with that is that these preferreds were a part of many banks' capital structure. Here's what ensued...
from http://www.thestreet.com/... (subscription only)
The Fannie (FNM) /Freddie (FRE) "bailout" eviscerated the preferred markets.
When Treasury Secretary Henry Paulson put Fannie and Freddie into conservatorship, he also eliminated the dividends on $36 billon of preferred stock, and that move sent formerly AA-rated securities to mere cents on the dollar overnight. Treasury's flawed assumption was that the agencies are special entities and that the treatment of their preferred shares ought not to affect the preferred securities of other financials. How utterly wrong and naive.
In the days following the "rescue" of Fannie and Freddie, the market for financial preferreds was essentially eviscerated, virtually eliminating any hope of recapitalization through public markets.
Why is this relevant? Aside from the direct consequences of many regional banks having to write their agency preferred investments to nearly zero and further eroding already-thin capital ratios,
Let us pause for a moment and understand that this is a drastic direct consequence. Banks are allowed to make loans in proportion to their assets. They carried the Fannie and Freddie preferred as assets on their books. When the dividend stopped the value of these assets disappeared at the worst possible moment - banks can only raise capital in the current market under the most onerous terms, if at all. It is hard to imagine how a sophisticated Treasury Secretary would fail to anticipate this. Was it intentional? And there's more:
the overall market for preferreds is significantly larger than the amount of agency preferred outstanding. In fact, this market was one of the only capital markets that remained open to financial institutions in the last eight to nine months, and it raised nearly $80 billon during this period from straight and convertible preferred issuance.
It's one thing to "punish" common equity holders who arguably have lived off the "fat of the land" when Fannie and Freddie reaped abnormal profits, but it's entirely another thing to pull the rug out from under a class of investors (senior to the common) who stuck their neck out to recapitalize financial firms in need less than one year ago! This has caused preferred holders to hedge their exposure by heavily shorting the underlying stocks, further blowing out their cost of capital for the underlying companies.
Translation: Welching on the Fannie and Freddie issues made holders of other preferreds nervous. To hedge their preferred exposure they sold the common stock of these banks short, driving down their prices. This further impaired the ability of the banks to raise more capital, via issuance of common stock.
Problem No. 2: Lehman's bankruptcy has severely eroded confidence between counterparties.
A counterparty is the party that takes the other side of a financial transaction. For example, if you buy a stock option, someone, usually a market maker, has to "write" the option, and is a counterparty to the transaction.
While it was arguably OK to draw the line and appease the "moral hazard" hawks by letting Lehman go, it was a disastrous mistake to not guarantee Lehman counterparty risk --
... As a result of the bankruptcy, any over-the-counter trades done with Lehman have now been terminated.
To make things immeasurably worse, any associated profits from these trades have to be treated as senior unsecured claims in bankruptcy court. (By the way, Lehman's senior unsecured bonds are now trading at 15 cents on the dollar. This means that if I hypothetically had $1 million of profit in any over-the-counter trade I had on with Lehman, $850,000 of that "profit" just evaporated, and it would remain to be seen when I'd even get the remaining $150,000 back.
This "profit" may merely be insurance against a loss incurred elsewhere (see below). But, if you had losses the bankruptcy court will expect you to pay up in full.
Furthermore, if I had cash collateral against any of these trades, or if I had prime-brokered my portfolio at Lehman (there is supposedly more than $40 billion of prime brokered assets that might be stuck), the cash and positions that are rightfully mine have yet to be returned, and the word is that it could take months. The knock-on effects of this disaster could be huge, and this will be widely felt, not only financially but also psychologically, because it undermines the validity of any and all transactions involving counterparty risk.
Ultimately, our financial system revolves around mutual trust, and not backstopping Lehman's counterparty obligations severely damages that trust.
In other words, if you were a financial institution trading "credit default swaps" (CDS) using a Lehman account, your funds are now tied up indefinitely. If you were holding mortgages and used the CDS to insure against your exposure to bad mortgage paper, your insurance policy just evaporated.
And the Buschco financial geniuses want us to entrust them with a $700 billion blank check?