A Stealth Lehman Bailout?

No. 3 on the Federal Reserve's list of duties, according to its mission statement, is: "Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets."

Step one was salvaging what was left of Bear Stearns. That was unquestionably necessary. Step two was opening up the discount window to investment banks, allowing a cheap source of emergency cash. No qualms there.

Two broader measures implemented more recently have been the crackdown on naked short-selling (imposed by the SEC), and news of a possible Fed intervention last month in the Lehman Brothers saga. More on that below.

First, the short-selling ban. Nineteen financial firms were granted a ban on naked shorting starting July 15 and expiring Aug. 12. The results shouldn't be too surprising. Take a look:

Company

Return During Ban Period

Return Since Ban Ended

Freddie Mac (NYSE: FRE  )

6.46%

(43.57%)

Fannie Mae (NYSE: FNM  )

18.81%

(42.26%)

Bank of America (NYSE: BAC  )

80.24%

(13.00%)

Lehman Brothers (NYSE: LEH  )

39.49%

(25.60%)

JPMorgan Chase (NYSE: JPM  )

35.04%

(13.44%)

Morgan Stanley (NYSE: MS  )

46.42%

(18.35%)

Goldman Sachs (NYSE: GS  )

12.87%

(11.70%)

Source: Google Finance .

Without pulling out my abacus, it looks like the ban alleviated some pain, all else equal. Bravo! Naked short-sellers are probably rascals to begin with. As a rule of thumb, I don't trust anyone who practices nudity in the workplace. But in all seriousness, the ban provided a good example of how government powers can crack down and prevent future wobbles in an appropriate manner. Nobody needs to nakedly short a stock -- it's there for those looking to make a profit. Removing the practice may pinch a bit of liquidity from markets, but ask most investors if they'd trade a sliver of liquidity for a ban on vicious shorts, and the answer would be close to unanimous.

Just don't take it too far, regulators
Another example of Uncle Sam flexing his regulatory muscle came from The Wall Street Journal this week, in news that the Fed may have tried to prevent a major investment bank from cutting ties with Lehman last month. The Fed apparently called Credit Suisse in early July after the bank was rumored to be planning to withdraw a credit line from Lehman -- the same type of action that sent Bear Stearns into a death spiral. Credit Suisse denied the rumor, and nothing further happened. Thank goodness.

But think a little deeper about the severity of this story: The Fed may have tried to encourage a (relatively) healthy bank to keep doing business with a bank that's holding on for dear life. Like I said, desperate times call for desperate measures, but where is the line drawn? Squelching vicious rumors and squashing short-sellers is one thing; preventing a bank from protecting its own welfare is quite another.

Let the good banks be free, Ben
To be sure, I couldn't look at you with a straight face and tell you the Fed's actions were wrong. If Credit Suisse had planned on pulling the plug based on groundless rumors about Lehman Brothers, perhaps the Fed was just there to talk it off the ledge. That would be all well and good.

But -- and it's a big but -- the thought of attempting to prevent firms from ceasing to do business with one another in the future relies on every exodus being rumor-fueled. What happens when a bank truly does run out of cash, and counterparties try to flee? Will the Fed not let them? That itself would probably spread systemic risk, rather than prevent it.

Screaming fire in a crowded theater is a no-no. Seeing a fire and not saying anything about it is irresponsible. Having the Fed nudge you to lay down face-first in the fire is just plain nuts.

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Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. The Fool has a disclosure policy.


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  • Report this Comment On September 03, 2008, at 8:55 AM, ernestjames wrote:

    still wondering why Lehman management don't buy this for themselves? Lehman must have at least $10bn in cash???

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