Our Timid Government Is Killing Us

Each "solution" has been hamstrung by an embedded "anti-solution."

"Bailing out" Fannie Mae and Freddie Mac shut down the entire market for preferred shares once Paulson decided to suspend dividend payments; allowing Lehman to fail without a plan to deal with the counterparty obligations caused an immediate run on AIG (AIG Quote); seizing 80% of AIG's equity in return for providing a bridge loan directly caused runs on Goldman Sachs (GS Quote) and Morgan Stanley (MS Quote); the disallowance of short-selling of equities forced market participants to pressure the debt market of the underlying companies, causing "death spirals" due to consequent ratings agency downgrades and forced selling by long equity holders; the arbitrary seizure of Washington Mutual and the government-assisted pillaging of its capital structure by JPMorgan (JPM Quote) did not assuage investor confidence -- it severely damaged it and directly caused the run on Wachovia (WB Quote); the arbitrary treatment of Wachovia in the FDIC-assisted sale to Citigroup (C Quote) and now the federal meddling in the Wells Fargo (WFC Quote)/Citigroup spat again shows that there are no set rules or templates that investors can follow.

Little wonder that people who are otherwise paid to take risk refuse to do so in this environment.

There is a road map out of this morass, but the Treasury and Fed need to put the moral hazard concerns on the back burner now and find ways to re-incentivize investors to take risk. The two other steps I mentioned in my article are ways of addressing this. First, re-inject liquidity into the preferred markets first by reinstating the dividends on the Freddie and Fannie preferreds.

This would accomplish the twin goals of immediately restoring value to the myriad regional banks and insurance companies that took horrific writedowns on collectively $36 billion of formerly AA-rated agency preferred investments that traded down into single digits (as a percent of par!) upon the Treasury Department's unnecessary evisceration. This would also show the marketplace that the government wants to reinstate liquidity to this essential market.