April 1, 2008 4:08PM

What Congress Must Ask the Federal Clean-Up Crew

By Elizabeth MacDonald

Who knew Liza Minnelli had it in her when she said the following: “Religion is for people who are afraid of hell–spirituality is for people who have been in it.”

That quote came to mind on the news that Jimmy Cayne, chairman of the disgraced Bear Stearns (BSC), was consulting Jewish tradition to learn life lessons about the near-death experience of his firm.

As with most anyone who has endured outsized cataclysms of biblical proportions, I am now hearing from traders down on Wall Street that all they can do now is hold hands and pray.

But as for those who get paid to run the show, who their employees say did little to cauterize the bleeding, by, for example, raising capital for their distressed firms, let’s hope Washington sees through the newfound scruples of any such plaster-saint sentimentality.

That goes for the regulators, too. Soon taking to the microphones once again on Capitol Hill to talk about their repair jobs in the housing crisis are Federal Reserve chairman Ben Bernanke, Treasury Secretary Henry Paulson, and Christopher Cox, chairman of the Securities & Exchange Commission.

May common sense prevail. It’d be a winged bird of hope to think you won’t witness any narcoleptic, after-the-fact posturing, which at this late date ought to make you feel like you are chewing on aluminum foil.

Because what is occurring now is preposterous.

The financial system has been rocked back on its heels by booms and busts every decade or so since the late 19^th century. But the past ten years has seen a plague of them practically every other year.

The Asian flu crisis, the Russian debt crisis, the blow-up of the hedge fund Long Term Capital management, the dotcom implosion, the telecom crash, and now the meta-crisis of them all, the housing and credit meltdown. The US saw that the regulatory system was clearly broken back in 1995. Bureaucratic apathy, the idea that free markets don’t need guardrails, have brought both investors and taxpayers to the brink. Free markets, yes. A free for all, no.

The financial system has been on a drunken leveraging spree for the past decade, which could take longer than ten years to delever and unwind. And like fire up a rope, the debt spree has already roasted Bear Stearns (BSC) and threatens to take out other big players as well.

Such leveraging has created outsized profits and executive pay. Though the financial services industry’s share of total corporate profits stood at just 10% in 1980s, it grew to 40% at its height in 2007 thanks to the borrowing spree. Everyone likes an asset bubble on the way up, but when they blow, watch out.

Banks and investment houses have written off a total of about $215b to date in degraded inventory from the credit crisis, with tens of billions of dollars more in writedowns expected. Goldman Sachs (GS) says the amount will top out at $460b.

By the end of 2007, two-thirds of the subprime writedowns were booked at just ten banks and brokerages. They still have something like 60% of total exposures to bad subprime credit and about half the exposure to leveraged loans as well.

Sovereign wealth funds have lost nearly 40% of the $50b they’ve invested in places like Citigroup (C), Merrill Lynch (MER) and UBS (UBS). UBS has been hit the worst. It just announced $19b more in writedowns, with the total there now at $37.4b. The Swiss bank has already raised funds from Singapore’s SWF, which is why it’s jokingly now called the Union Bank of Singapore. More writedowns are expected at places like Citigroup and Merrill Lynch; Deutschebank says it expects to write down $4b in its first quarter.

But foreign money is balking, so expect more ultra-dilutive new equity offerings like the $4b just announced at Lehman Bros. (LEH), a new $15.1b equity offering at UBS, and the planned $20b total for mortgage finance giants Fannie Mae (FNM) and Freddie Mac (FRE) (a sum that is about a whopping two-thirds of their market caps).

It’s past the midnight hour. Congress ought to ask what regulators are doing to avoid the costly taxpayer-funded clean-up and investor dilution later on. Taxpayers deserve to get answers from the Paulson-Bernanke-Cox regulatory cleanup crew on the following:

*Mr. Paulson, under the new plan from the Treasury, the Federal Reserve will have much more power to regulate investment banks, but the plan says it will only curtail the risks when their actions “pose a threat” to the financial system. Why only when these outfits “pose a threat” to the system? Why not around the clock? What if just one bank or brokerage is engaging in excessive risk? Will the federal sheriffs ride in to Dodge City then?

*Mr. Paulson, under the new plan, how exactly will private equity firms and hedge funds be regulated, if at all? Will you at minimum force them to publish their balance sheets, so Wall Street can truly see how dangerously leveraged some of these shops are that they are lending to? And why aren’t these pools of capital regulated?

*Mr. Paulson and Mr. Cox, subprime loans only began to be securitized earlier in this decade. Does the Treasury plan do anything to stem the risky practice of bundling toxic subprime mortgages and selling them as Frankenstein securities rubberstamped with high credit ratings? The credit rating agencies got paid lots of money by Wall Street to hand out triple A ratings like Kleenex to truly bad securities. What are you doing to stop this dangerous practice? Why not force the credit rating agencies to publish an updated quarterly report card of their prior calls going back fifteen years?

*Mr. Paulson and Mr. Cox, do you plan to require that trading in credit derivatives be hauled out of the shadows and into the sunlight by having such trades brought on to a major exchange?

*Mr. Bernanke, Mr. Paulson and Mr. Cox, please walk us through the rescue of Bear Stearns (BSC). Let’s start with March 14^th, when Bear was essentially given a 28-day loan from the Federal Reserve to fix itself before the Fed-orchestrated JPMorgan Chase (JPM) deal came to pass. This marked an historic break–it was the first time the Fed let 20 unregulated investment banks access to loans from the Fed’s discount window. In effect, the Fed was now running with the wolves on Wall Street. Shouldn’t investment banks be forced to keep the same amount of capital reserves on the balance sheets as do commercial banks if they can now access the discount window?

*At the 11^th hour, the ratings agencies then cut Bear’s rating to junk status, causing counterparties to stop trading with Bear and fueling a run on the bank–counterparty contracts stipulate that any time a firm is downgraded to junk status, any such contract governing a counterparty trade is broken, forcing these outfits to stop doing business with Bear Stearns (BSC). Do you know the answer to why this move at the 11^th hour?

*To complete its shotgun wedding with the severely damaged Bear Stearns (BSC), JPMorgan Chase (JPM) got the New York Federal Reserve to backstop, via a non-recourse loan, $29b of the most illiquid securities on Bear Stearns’ balance sheet. Non-recourse, meaning JP is not on the hook for it.

A sweet deal hammered out by JPMorgan Chase (JPM) head Jamie Dimon, who sits on the board of the New York Federal Reserve. Isn’t this a conflict of interest?

*Mr. Bernanke, a record amount of government funds was used to bail out Bear Stearns (BSC), more than what was put at risk in the bailout of Continental Illinois in 1984, analysts note. The Fed promised to lend $29b to JP Morgan at a dirt cheap 2.5% over 10 years, which is renewable, so as to get JP to digest Bear’s damaged balance sheet. JP then used Bear’s collateralized debt obligations and other damaged assets as collateral.

So, Mr. Bernanke, the central bank now owns $29b in illiquid securities from Bear Stearns–meaning, as some analysts rightfully put it, the government has nationalized Bear’s losses by taking on this credit risk, on top of the credit risk it’s already taken on from Fannie and Freddie Mac (see next bullet point).

Is this a truly dangerous precedent? And what exactly is the nature of the assets JP used as collateral for the loan? Taxpayers only know that most of the investments were mortgage-backed securities and “related” items–does that include commercial real estate or Alt-A mortgages? Why the poor disclosure when the Fed ostensibly says it is now about transparency? Don’t taxpayers have a right to know? What discount to par were these assets marked down to? How much cushion is built into their current valuations? Were these exposures hedged, reducing potential taxpayer losses?

*This is the 75^th anniversary of the New Deal and the creation of the Federal Home Loan Bank board. The socialization of Bear Stearns’ losses and of housing finance has meant taxpayers are bearing credit risk in ways never before seen in the history of this country, through the government’s implicit guarantee of the mortgage finance companies Fannie Mae (FNM) and Freddie Mac (FRE).

Both have had a history of accounting misdeeds, totaling $11b. Both have been reporting record losses. But now the government is loosening their capital reserve standards so they can take on $200b more in mortgage debt as to stop the housing crisis. Already they both have a total of a microscopic $80b in reserves to back an eye-watering $1.7t. Taxpayers will foot the bill for their incompetence, as both have credit pipelines into the US Treasury. Should Fannie and Freddie be completely privatized? Should regulators at minimum stop Fannie and Freddie from paying out any dividends whatsoever?

*Mr. Bernanke, since the late ‘80s the Fed has been cutting off financial crises at the pass by acting pre-emptively, meaning, moving quickly to cut rates before disaster strikes. Since July 2007 the Fed has cut rates to 2.25% from 5.25%. Will you take pre-emptive action in good times to raise rates and reduce the expectation now entrenched on Wall Street that out-of-control bankers and brokers that the Fed will rescue them no matter what? Are you running out of ammunition to deal with the credit crunch?

*Mr. Cox, has the SEC studied whether the fair value rules are overstating losses on Wall Street? Do companies have a point when they say that a big slug of the losses they now post under fair value rules may never materialize since they won’t sell the assets until their value recovers? Or is this 20-20 complaining?

*To all three-shouldn’t you force lenders to keep a slice of the riskiest part of any debt securities they sell, from mortgage-backed bonds to securities backed by leveraged loans, on their balance sheet so they have an incentive to make sure no bad loans are made and that borrowers pay back their risky debt?

*As for investment banks now getting their mitts on Fed money via the discount window. Shouldn’t you force investment banks to pay an insurance-style premium similar to what the Federal Deposit Insurance Corp. charges regular banks to cover the cost of bailing out their deposits?

The way it could work is, those with solid capital and lower risk sluicing through their operations would pay less into the insurance pool. Isn’t it only right that the likes of Bear Stearns (BSC), Lehman Bros. (LEH) and Goldman Sachs (GS) pay a premium into the system if they get to now, risk-free, effectively foist their pathologically risky bets onto the rest of society? Bear didn’t pay a cent for its government bailout, so it’s no surprise to see Wells Fargo (WFC) tossing its hat into the ring hoping to get a merger deal backed by such free money as well.

*To all three, the Environmental Protection Agency set up a superfund to deal with hazard waste cleanup. Is it time for a housing superfund to buy defaulting toxic mortgages now poisoning the system, replacing them with more accommodating loans?

*To all three, given the deficit financing of this bailout, are you not creating another vicious cycle in the bond market that will cause mortgage rates to remain high, as loans are tied to long term bond rates? Are you at all concerned higher inflation is bearing down on the economy at a time when Social Security and Medicare are near bankrupt, when the first baby boomer got to retire this past January 1?

*And to all three–when will this government come out and support a strong dollar?