The Federal Reserve Bailout of Wall Street: Not Enough Lifeboats

With this week's announcements of an increase in the Fed's Term Auction Facility to $100 billion, the creation of a $200 billion Term Securities Lending Facility for the Fed primary dealers, and Bear Stearns' individualized line of credit at the Fed discount window, it's clear that the Fed is paving the way for a federal government bailout of Wall Street. But there aren't enough lifeboats on this sinking ship. Although the Fed has almost $900 billion in assets, there are trillions upon trillions of dollars of CDOs, CMOs, and other hinky debt instruments out there. The Fed can't buy or finance it all without creating the mother of all inflations that would turn America into another Argentina (except most Americans can't do the tango).

So who should get priority in the bailouts? First, brokerage and investment advisory customers (e.g., widows, orphans, paraplegics, Mom, Pop, 401(k) plans, and pension funds) should be protected, and beyond SIPC limits if it comes to that. Their money constitutes the investment funds that Wall Street depends on, and if they lose confidence, the current financial crisis will feel like a gentle Spring breeze. Second, counterparties of Wall Street firms (including other Wall Street firms in their capacity as counterparties, as well as non-Wall Street entities) should be protected. Counterparty confidence in the markets is necessary to make the financial system function.

The debt holders and shareholders of Wall Street firms should not receive full protection. The government should receive senior debt and preferred stock in connection with any bailout, so it can profit if and when the firms rebound. If the taxpayers are going to bear some burdens here, they should get some upside potential. (Chrysler paid this price for its 1979 bailout and the taxpayers actually did make a profit.) Debt holders and shareholders that are unhappy about being diluted can (a) take their chances in bankruptcy (which is another way of kissing their investments goodbye) and/or (b) shake the tree until current management decides to pursue other interests. Of course, that's if the government doesn't force a change of management, which it should if there's going to be a federal bailout. Providing taxpayer funds to the same executives who mismanaged these firms so badly they need a federal bailout would be absurd. There's no room on the lifeboats for them. New leadership is needed at the firms if public money is needed at the firms.