The Five Dumbest Things on Wall Street This Week

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The Five Dumbest Things on Wall Street: March 20

Nat Worden

1. Bailout Nation

Few things are more pathetic than watching the titans of Wall Street morph into the world's largest welfare case when good times turn bad.

These are the same characters that routinely sing the praises of the free market and justify their excessive compensation levels by pointing to the big risks they take.

But as we saw when the failed, former leaders of Citigroup (C Quote - Cramer on C - Stock Picks), Merrill Lynch (MER Quote - Cramer on MER - Stock Picks) and Countrywide Financial (CFC Quote - Cramer on CFC - Stock Picks) floated off on golden parachutes, there's no real incentive for finance chiefs to avoid taking dumb risks with their shareholders' money.

That's what former Citi CEO Chuck Prince was talking about at the height of the housing bubble when he told the Financial Times that "as long as the music is playing, you've got to get up and dance-- we're still dancing." Prince lost his job when the music finally stopped, but he still danced away with a $10 million bonus, $28 million in unvested stock and options and $1.5 million in annual perks.

When Wall Street inevitably runs amok, its broken incentive structure gets far more ridiculous as government comes running to the rescue faster than you can say "moral hazard." That was the case in the savings and loan crisis of the 1980s and countless other episodes throughout history, and sure enough, that's the case in the housing and credit crisis of 2008.

Last weekend, the Federal Reserve didn't just take responsibility for $30 billion in hard-to-trade securities from Bear Stearns (BSC Quote - Cramer on BSC - Stock Picks) and force JPMorgan Chase (JPM Quote - Cramer on JPM - Stock Picks) to buy the floundering investment bank with just a cursory exercise in due diligence on highly unusual terms. The central bank also agreed to accept some $436 billion -- more than half its entire balance sheet -- in highly suspect securities from Wall Street, potentially putting U.S. taxpayers on the hook for them.

The Fed has not taken such an interventionist role on Wall Street since the Great Depression. Regulators explained their actions by saying the alternative was a breakdown in the nation's financial system that could have wrought untold misery on us all. Fair enough, they should recognize that it was yesterday's laissez faire hypocrisy on the part of today's welfare recipients that made the financial system as fragile as it is now.

Last week, U.S. Treasury Secretary Hank Paulson proposed a raft of new regulations on the mortgage industry that his administration and its allies in Congress have opposed for years -- like nationwide licensing standards for mortgage brokers. The former Goldman Sachs (GS Quote - Cramer on GS - Stock Picks) CEO happily proclaimed that new legislation wouldn't be necessary to enact them. In other words, these common-sense rules were available to the Bush Administration when the housing bubble was building, but it neglected to enforce them at Wall Street's behest.

Dumb-o-meter score: 95. At this point, better never than late.

2. Bear's Cayne: Up in Smoke

Where was Jimmy Cayne when his firm was collapsing last week? You guessed it: he was playing bridge.

The former CEO and largest shareholder of Bear Stearns was at a bridge tournament in Detroit last week when the bank began to unravel. Cayne owns or controls about 7 million shares of Bear Stearns. His stake was worth over $1 billion in January and is now worth about $14 million at the firm's $2-a-share purchase price.

Let's hope the 74 year-old had a higher time at the card table than he did in the stock market last week.

Bear Stearns -- trading at close to $80 a share at the beginning of this month -- was acquired in a fire sale for a stunning $2 a share by JPMorgan Chase, with $30 billion in emergency funds provided by the Fed. The deal came less than three days after the Fed announced it would attempt to bail out the company, which proudly abstained from the 1998 bailout of Long Term Capital Management out of a sense of high principles.

The shocking disintegration of a major Wall Street investment bank concludes a chapter that began last summer when Cayne made headlines by being incommunicado at a bridge tournament while two hedge funds heavily invested in mortgage securities collapsed. The Wall Street Journal subsequently reported Cayne's affinity for smoking in public bathrooms.

Following that bridge tournament, Bear Stearns attempted to dump its junk mortgage securities onto the public in an initial public offering of a financial company that the firm called Everquest Financial, and Cayne lost his job. But now his successor, a former bridge partner, has made his own contribution to Wall Street lore. When trouble began last week, Alan Schwartz was hosting a Bear Stearns media conference in Palm Beach, according to the Wall Street Journal. He left on Wednesday to do a damage-control interview on CNBC.

"Bear Stearns' balance sheet, liquidity, and capital remain strong," Schwartz declared on the airwaves. "Our liquidity position has not changed at all, our balance sheet has not changed at all."

M'kay. On Friday, the firm said its "liquidity position in the last 24 hours had significantly deteriorated."

Before long, the place was sold to JPMorgan for a mere $236 million--less than the company paid its five highest officers from fiscal 2004 through 2006, according to The Wall Street Journal. Meanwhile, investors that are now celebrating earnings reports from other suspect Wall Street firms like Lehman Brothers (LEH Quote - Cramer on LEH - Stock Picks) would do well to remember that Bear Stearns was preparing to report a first-quarter profit before the run on the bank began.

Eight years ago, Cayne mused that he might consider selling the 85-year-old investment bank for four times what it values itself on its books.

Dumb-o-meter score: 91 What was he smoking?

3. Mass Wealth Destruction

While the media busied itself with the demise of Bear Stearns this week, a nifty little proxy filing from bond insurer MBIA (MBI Quote - Cramer on MBI - Stock Picks) managed to squeeze in under the radar.

Shares of MBIA dropped 78% last year, and they're down another 33% so far in 2008. Nevertheless, the insurance giant disclosed this week that its former CEO, Gary Dunton, who was edged out in late February, will be paid a $1 million bonus for 2007 and another $960,000 for his efforts in raising $2.6 billion in new capital this year.

Dunton will also make off with a $2.55 million cash settlement for a long-term incentive grant that won't be paid out, along with $241,000 in prorated bonus for this year.

Yes, mass wealth destruction is a highly lucrative racket on Wall Street these days. For its part, MBIA needs all the money it can get to shore up its highly questionable Triple-A credit rating so it can continue as a going concern. Doubts have spread that the firm won't have enough capital to pay out claims that are in store on its giant structured finance portfolio.

Major ratings agencies Standard & Poors and Moody's Investors Service have maintained their credit ratings on MBIA, but their ratings are increasingly suspect amid a housing and credit crisis in the U.S. that has led billions of dollars in Triple-A rated securities to suddenly become junk.

MBIA rewards the agencies richly for their generous ratings, and when Fitch Ratings recently went off the script with a downgrade, MBIA ended its relationship with the agency.

Joseph "Jay" W. Brown, who was CEO of MBIA from 1999 to 2004, has returned to the company to take back the reins from Dunton. The company's board concluded that Brown is "singularly qualified" to run it, probably because during his previous tenure, he oversaw MBIA's growth in the mortgage-backed securities market.

"We clearly increased our exposure to residential real estate at the wrong time," said Brown.

Dumb-o-meter score: 85. Quick, somebody give this guy a fat bonus.

4. Nothing but Bull

This week, we learned of the end of an era, as Abby Joseph Cohen stepped down as Wall Street's chief promoter of irrational exuberance.

Her storied career took off when she served as the vice president in charge of investment strategy at Drexel Burnham Lambert, Michael Milken's junk bond empire, as it collapsed amid regulatory scrutiny in 1988.

Having joined Goldman Sachs in 1990, Cohen rose up the ranks at the investment bank to become its senior U.S. investment strategist and one of the foremost predictors of short-term stock moves on Wall Street.

Cohen had a legendary streak of prescient bullish pronouncements on CNBC and elsewhere in the media during the dot-com mania of the late-1990s. She's widely credited for helping to drive the markets up to towering heights.

When the bubble finally burst in 2000, Cohen managed to steer her clients around the setback by advising them to cut back on equities by a hair without predicting any declines in the S&P 500. It dropped 7% that year.

In 2001, Cohen covered herself with even more glory by predicting a modest decline for the year. She would have been right on the nose if not for the terrorist attacks of 9/11, which dragged the index down 13% for the year.

CNBC named Cohen Wall Street's most accurate forecaster in 2003 and 2004, years in which the S&P gained 28% and 6%, respectively.

Her replacement, David Kostin, may not have received the memo yet. He's now predicting that in the short term, the S&P will fall to 1160. It was recently trading at around 1311. Kostin is forecasting that the index will close 2008 at 1380, down 6% for the year.

Cohen had recently called for the S&P to finish 2008 at 1675--a 14% gain. The Wall Street Journal reported that she now agrees with "Nervous Nellie's" forecast.

"One thing I made clear internally was that I wanted to start working on longer-term issues and didn't want to do the day-to-day market analysis," Cohen told the newspaper.

She's staying on at Goldman as president of its Global Markets Institute and senior investment strategist so that she can be a cheerleader for emerging markets.

Dumb-o-meter score: 79. Let the global boom begin!

5. Safety and Soundness

Rest easy, America.

The housing mess is about to turn around because the Feds are lowering capital requirements for government-sponsored mortgage giants Fannie Mae (FNM Quote - Cramer on FNM - Stock Picks) and Freddie Mac (FRE Quote - Cramer on FRE - Stock Picks).

Why in the world did these companies, which have implicit backing by the full faith and credit of U.S. taxpayers, have such strict capital requirements in the first place? After all, neither company could even report audited financials on a timely basis to investors until recently, and boy were those recent reports worth the wait.

Fannie swung to a fourth-quarter loss of $3.6 billion on spiking credit-related costs, including a steep increase in money set aside for loan losses. Freddie reported a record $2.45 billion loss for the period.

Created by Congress to boost homeownership, Fannie and Freddie own or guarantee at least 40% of the $11.5 trillion in U.S. residential-mortgage debt outstanding.

Several years ago, both companies were mired in accounting scandals and forced to make earnings restatements totaling more than $20 billion -- dwarfing those of Enron and WorldCom combined.

Their top executives were replaced, but the federal regulator that oversees the company has maintained that "safety and soundness issues" remain at both companies.

Considering all these accomplishments, the geniuses in Washington D.C. have decided to reduce the 30% capital surplus it requires of both firms to 20%, a move that could provide up to $200 billion in immediate liquidity to the troubled mortgage-backed securities market.

"We believe they can play an even more positive role in providing the stability and liquidity the markets need right now," said James Lockhart, director of the Office of Federal Housing Enterprise Oversight.

The Bush administration appointed Lockhart to replace his predecessor Armando Falcon, after the former regulator published a report detailing the "systemic risks" to the financial system posed by the growth at Fannie and Freddie.

Until recently, President Bush has sought to force the companies to reduce their holdings of mortgages and related securities, arguing that they were taking too many risks. Apparently, he has now decided that Fannie and Freddie haven't taken on enough risk.

Dumb-o-meter score: 95. How about another tax cut?