Turmoil on Wall Street     By A. Raj Kumar            September 23, 2008

             So what has been happening on Wall Street these past several months and what is this $700 billion government bailout all about?  As I write this article (on September 23rd), history is being made on Wall Street and in Washington, D.C.  What has happened and is happening on Wall Street are totally unprecedented.  So let me recap the events, explain what and why they occurred, and finally elaborate on their implications.

 

The current stock market volatility is a reflection of the huge uncertainty surrounding the survivorship of the major investment banks on Wall Street (i.e. Merrill Lynch, Morgan Stanley, Goldman Sachs, Bear Stearns and Lehman Brothers).  Investment banks are essential to our capitalist and free market based economy.  Entrepreneurs with new business ideas utilize investment banks to raise the necessary capital to grow their companies.  We would not have a Wal-Mart or a Microsoft today if investment banks had not brought these premier companies to market.

 

The problems started in the spring when Bear Stearns got into a liquidity problem.  Financial institutions do a lot of transactions with each other.  They make loans to each other and hold securities as collateral.  Basically investors with money at Bear Stearns lost confidence in the firm so they pulled out all their money.  Other financial institutions also lost confidence and called in their loans.  Since Bear Stearns did not have the cash to meet all these redemptions, they started selling their assets which was mostly mortgage backed securities but the market price for these securities was in a free fall because of the sub-prime mess.  Bear Stearns could not raise the necessary cash to meet the redemptions.  As the market price of their assets fell, their equity in the business got wiped out as well and they needed to raise additional equity capital but nobody would invest in their company (i.e. buy their stock).  The Fed, in order to prevent a chain reaction of failure of other financial institutions, forced Bear Stearns in a shotgun (i.e. arranged) marriage with JP Morgan Chase and it also bought $30 billion of mortgage backed assets from Bear Stearns to provide the necessary liquidity.

 

By forcing the failure of Bear Stearns the Fed avoided something called moral hazard.  If the Fed always came to the rescue of a troubled financial institution, then Wall Street would know that and would then take unnecessary risks because they know that the Fed would be there to bail them out.  By letting Bear Stearns fail, they avoided the moral hazard because Wall Street firms now know that they should not take stupid risks because the Fed will let them fail.

 

In July the situation at Fannie Mae and Freddie Mac got really bad.  The market price of mortgage backed securities that they held (5.3 trillion dollars worth!) continued to fall and in fact, the market for these securities froze up because nobody knew the proper value for them and nobody wanted to buy them anymore.  As the price of these assets fell, it wiped out the equity of these companies and again, nobody wanted to take a chance in buying their new stock so they could not recapitalize.  Secretary Treasury Hank Paulson could not allow Fannie Mae and Freddie Mac to fail, so the U.S. government took them over since they were effectively insolvent.  As you know Fannie Mae and Freddie Mac provide an absolutely essential function in our society, which is to buy mortgages from banks with investors’ money so that the banks can make new mortgage loans.  Fannie Mae and Freddie Mac’s mission is to increase home ownership in the United States.

 

Another contributor to the financial meltdown on Wall Street was the SEC when it removed the uptick rule a couple of years ago and in my opinion precipitated a crisis in the stock price of the investment banks.  When short sellers sensed a weakness in a company, they would gang up on its stock which would lead to a sharp drop in the price of the company’s stock (e.g. as much as 40% in a single day!).  Lehman Brothers and AIG were targets of short sellers and their stocks fell from a high of $83 and $71 to 10 cents and $1.25 respectively.  The uptick rule states that a short seller can only sell shares short on an uptick price.  This rule prevents a downward spiral in stock prices.  So when the SEC removed it, it led to sharp and deep declines in the stock price of Lehman Brothers and AIG.  Because their stocks were falling so precipitously, they could not raise additional needed capital which then forced Lehman Brothers into bankruptcy and forced the Treasury to bail out AIG with an $85 billion package.  AIG is a huge company with tentacles in almost all aspects of finance.  If it were allowed to fail, the crisis would have spread far and wide to other financial institutions.  By bailing out AIG, the Treasury prevented a financial meltdown on Wall Street.

 

Up to this point the Fed and the Treasury had been working on a company by company basis.  Just recently both agencies together came up with a comprehensive $700 billion bailout solution.  The idea is to set up a separate company (with $700 billion of taxpayers’ money) that will buy all the distressed and illiquid securities (mostly mortgage backed securities) in order to remove them off the books of the financial companies.  Once these distressed securities are off the companies’ books, then other financial institutions could once again have confidence in the other company and start to conduct normal business.  Currently, there is a crisis of confidence and the solution of restoring it would allow the credit freeze to thaw.  Once the credit markets start to function properly, the U.S. economy will start to grow again.  In my opinion, if this bailout is not allowed to happen, the economy could fall into a long and deep depression because the flow of credit (literally the lifeblood of the economy) has been turned off by the financial institutions.  A depression would cost a lot more in terms of millions of jobs lost and emotional misery to thousands of families than the $700 billion bailout plan.

 

We Americans are extremely fortunate that we have two highly capable and intelligent people running the Fed and the Treasury.  We owe a tremendous amount of gratitude to both Ben Bernanke and Hank Paulson.¨

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                 Stocks mentioned in this article are for illustrative purposes only and are not recommendations for individuals to buy.  Past performance is no guarantee of future performance.

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