Why We're on the Road to a Federal Bailout of Lehman and Others

A federal bailout of Lehman Brothers in the near future is a near certainty. It probably won't be the end. More federal bailouts of large financial institution are likely to be in our future. Here's why.

Real estate and mortgage losses continue to abound. A lot of these losses remain unrealized on the books of major financial institutions and may grow as payments pop on option ARMs written two and three years ago. Foreclosure rates are rising and much of the relief provided by the Bush Administration's mortgage aid package from last year simply defers payments instead of reducing them. A lot of people who can't make the payments now won't be able to do so later, not when we have a slowing economy and rising unemployment. So losses are deferred but remain to be recognized. To make things worse, the commercial real estate market is getting uglier by the day.

Losses in commodities trading are rising rapidly as oil, gold, silver, platinum, corn, wheat, copper and other commodities deflate in value. Since commodities trading is heavily leveraged, the banks that financed these transactions, as well as hedge funds and other speculators, stand to book losses. Thus far, little has been said publicly about these losses, although a large hedge fund, Ospraie Fund, has shut down because of poorly performing commodities-related investments. More commodities losses will surface sooner or later and take their toll.

Credit card, car loan and other credit losses are on the rise, just at a time when investors are increasingly reluctant to buy securitizations of all types of loans. Banks have nowhere to go with an ever stinkier loan portfolio.

The U.S. and worldwide economy are slowing and unemployment is rising, making it more difficult for banks and other financial firms to work their way out of their losses.

Last, but certainly not least, the "too big to fail doctrine" discourages private capital infusions. Having booked monster losses, and with even uglier monsters looming in their financial futures, many large banks desperately need to raise capital. The financial sector's depleted capital is like a weakened immune system, and capital infusions are the way to buck up the patient. But the "too big to fail" doctrine employed by the federal government in the recent Bear Stearns, Fannie Mae and Freddy Mac bailouts includes substantial elimination of the interests of stockholders. That policy makes sense. If stockholders are at risk of total or near total loss from federal intervention, they presumably will hire competent management who will prudently avoid the need for a federal bailout. But this policy also means that a seriously distressed bank large enough to qualify for "too big to fail" treatment won't be able to find private capital. Investors will be concerned that they could pony up their money today only to be squeezed out by the feds three months hence. In effect, the "too big to fail" doctrine means that the federal government is the only salvation for major financial institutions when they become seriously impaired. The smart money will wait for the federal bailout, figuring that a year or two from now, when the feds are reorganizing the bailee and selling off its assets, private investors can buy those assets at a better price than investing in the failing banks today.

So, get used to the idea of more federal bailouts, and a bigger federal deficit to pay for them. The stock market seems to be getting used to them. The 290 point gush in the Dow after the announcement of the Fannie/Freddie bailout dissipated the next day. Another day, another bailout.

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