NEW YORK (Reuters) - Letting Lehman Brothers fail is the lesser of two evils facing U.S. financial regulators trying to stop a textbook trading ploy dead in its tracks -- a private sector raid on the public purse.
U.S. authorities have already been forced to pledge some $230 billion this year to restore calm in the wake of speculative attacks on investment bank Bear Stearns and Federal mortgage agencies Fannie Mae and Freddie Mac.
Market veterans say the classic trade was set to be repeated in the weeks ahead if any form of official assistance had been involved in a deal to save or restructure Lehman, the 158-year old finance house which fell victim to traders aggressively selling its stock in a bid to book a slice of profit supplied, or ultimately guaranteed, by the government.
“It’s the taxpayer versus the speculator,” Paul Markowski, president of New York investment advisory firm Global Research Partners, told Reuters.
“The speculator doesn’t always win, but clearly in this case the speculator has increased the bill of the U.S. taxpayer.”
Speculators have a track record in correctly scenting the willingness of official institutions to commit public funds to try to sustain an ultimately unsustainable situation.
Friday’s 31 percent plunge in the share price of U.S. insurer American International Group, which has been hit by $18 billion in losses over the past three quarters from guarantees it wrote on mortgage derivatives, suggests traders were already on the hunt for their next victim after Lehman.
So too does a rapidly stitched together weekend deal that will see Bank of America Corp buy Merrill Lynch & Co Inc, the world’s largest financial brokerage that has written down the value of its assets by more than $40 billion over the last year.
Hedge fund manager George Soros cemented his reputation by famously “breaking the Bank of England” in 1992, forcing the central bank to spend billions to defend the pound’s place in the European Union’s exchange rate mechanism before the British government withdrew sterling from the scheme.
Currency traders employed similar tactics in Asia in 1997, scenting blood when they realized huge foreign currency borrowings were incompatible with the region’s fixed and quasi-fixed exchange rates.
Their huge bets against the currency pegs saw successive central banks empty their coffers trying to defend the indefensible and forced International Monetary Fund bailouts for the region of more than $100 billion -- money that traders had essentially sucked out of the system.
OLDEST TRADE IN THE BOOK
If a second successive weekend of talks between bankers and officials from the U.S. Treasury, Federal Reserve and Securities and Exchange Commission to keep the U.S. financial system functioning smoothly had resulted in more public funds being committed to a single institution, it could have pushed wide open the door to the oldest trade in the book.
“What is good is that the Fed dug in its heels, refusing to be dragged into a bailout. This was a test for the Fed and the Fed passed it,” said Robert Brusca, chief economist at Fact and Opinion Economics in New York.
While there was no direct money for Lehman, the Fed did unveil several fresh initiatives on Sunday to support markets, broadening the type of collateral financial institutions can use to obtain loans from the central bank and increasing the amount of Treasury securities it auctions on a regular basis to help foster liquid markets.
Edward Grebeck, chief executive officer of Tempus Advisors in Stamford, Connecticut, reckons there is a bill and it’s clear who is paying.
“The Fed is using, one way or another, a printing press to bail out the banks.”
The U.S. government’s seizure and backing of multi-trillion dollar mortgage lenders Fannie Mae and Freddie Mac last weekend essentially added $1.6 trillion to the debt burden, pushing it up to 44 percent of national output or around $6.3 trillion.
Meanwhile the sheer supply and demand dynamics of that shift suggest that the market rates of interest the U.S. government -- and ultimately the taxpayer -- will have to pay to finance the additional debt must rise.
The credit crisis “would be an interesting sporting event if it weren’t so costly,” said Mark Grant, managing director of structured finance at Southwest Securities, based in Dallas.
“We are not just going through deleveraging, but through a castration of capital not seen during my lifetime.”
Our Standards: The Thomson Reuters Trust Principles.