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The elephantine event in a busy week of economic data and earnings reports is Tuesday's



Most traders expect the Federal Open Market Committee, led by Chairman Ben Bernanke, to cut the overnight borrowing rate at least 25 basis points, to 5% from 5.25%. Many also expect another cut to the rate charged at the Fed's discount window, where banks can go for last-ditch liquidity.

The Fed has left the target fed funds rate stable for over a year, as committee members toed a line of inflation fighting amid high commodity prices and easy lending conditions. But the central bank has had to change its tune since the credit markets seized up earlier this summer.

Since early July, declines in mortgage-backed securities have spread. As investors realized that the esoteric securities tied to many mortgages were of questionable credit quality, prices fell and risk premiums rose on all types of credit investments. Buyers fled paper including leveraged loans, high-yield bonds and short-term debt such as asset-backed commercial paper. Investors pulled their money out of hedge funds, and banks reined in their lending standards.

Two months later, the debt market still looks broken, and there's little confidence in the banking system. Investors hope that a cut in the target fed funds rate will fix both problems.

"Goldilocks would favor a 25 basis point cut," writes Ethan Harris, chief economist at Lehman Brothers.

Surely, traders rely on the Fed to determine the damage of the summer's credit crunch to the broad economy. But the onus falls on Wall Street's brokerage firms to inspire confidence in the banking system. The brokers' third-quarter earnings season starts Tuesday as well, and some analysts suggest we're unlikely to see anything very uplifting.

"Good, bad or indifferent, the banks' numbers are low-confidence numbers," says James Bianco, president of Bianco Research. He says he doubts Wall Street firms can quickly value all the securities they may hold that are tied to subprime or fraudulent mortgages.

Lehman Brothers


is due to report its earnings Tuesday, followed by

Morgan Stanley

(MS) - Get Morgan Stanley Report

on Wednesday and

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Bear Stearns



Goldman Sachs

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on Thursday.

Without liquidity, these firms have to "mark to market," or "mark to model," derivatives or structured products tied to mortgages. This means the firms valuing investments such as collateralized debt obligations make assumptions and guess at how these instruments would be priced if they were sold into the market. These assumptions and inputs include credit ratings by ratings agencies whose evaluation techniques have been largely discredited.

Mark to market is "a sophisticated term for 'they made it up,'" says Bianco.

BNP Paribas


recently reopened the three funds it had closed in August because of lack of liquidity. The firm reportedly claimed it does not have significant exposure to troublesome subprime mortgages.

Bear Stearns didn't get away so easily. The firm acknowledged in late July that two hedge funds that had run into trouble were nearly worthless. The surprising declaration came after a review of asset-backed, mortgage-backed securities and derivatives in those portfolios.

"Let me offer up a parable," says Bianco. He recalls that the bill for

Fannie Mae's


restatement of $9 billion of earnings due to improper accounting for derivatives came to $800 million.

"They took over 2,000 accountants and 18 months to restate their earnings," he says. "They had to go through every security the firm owned and put a value on it, and that was for conforming loans."

Conforming loans are those backed by government-sponsored entities that require extensive documentation. Valuing those loans was a piece of cake compared with the layers of assumptions needed to price a collateralized debt obligation filled with mortgage-backed securities tied to borrowers who got loans with no income verification.

Regulators are looking into how Wall Street valued these instruments, and lawyers are surely champing at the bit. And marking to market CDOs is just one potential minefield in brokers' earnings next week. The brokers are also working to sell

billions worth of bridge loans they've committed to the

private-equity titans for deals hatched in the first part of the year.

Sanford Bernstein analyst Michael Werner says it's unlikely that fraud was at work in marking securities to market, though current estimates may be well short of perfect. He says that if liquidity is good, a firm turns over the securities it holds on its balance sheets at least four times a quarter -- which means Wall Street can still make money in a declining market.

But without liquidity, a decline of 15% in a security that's marked to market will be impossible to hide. Werner adds that the brokers will likely try to get all their bad news out in the open as soon as possible.

"At worst, you can characterize the

U.S. securities industry as a group of exuberant fraternity boys who party too much too hard during the football season and are forced to clean up their act -- and their college fraternity house -- just prior to Mother's Day," write Werner and his colleagues at Bernstein. "Well, Mother's Day has arrived."

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click


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