News	In Paulson We Trust by Ted P. Schmidt

From the minute the Wall Street bailout bill was passed to the following Friday, the Dow Jones Industrial Average fell more than 2,000 points. The stock market has risen again, but many observers expect that it will be a long time before it reaches 14,000 again.

Treasury Secretary Henry Paulson

Supporting the bailout bill was hard for many members of Congress. The main reason they gave for supporting the bailout bill was that something had to be done quickly to restore confidence in financial markets.

So why didn’t the bailout restore some sense of trust or confidence in the markets? Blame should be placed squarely on the shoulders of Treasury Secretary Henry Paulson. The event that caused the financial crisis to spiral out of control was Paulson’s decision to “let Lehman Brothers go.” While the underlying cause of the crisis is attributed to the housing bubble and subprime mortgages, the acceleration of the global meltdown is related to the impact Lehman’s bankruptcy had on money market funds, and its role in the $60 trillion credit default swap market.

Money market funds are where investors store their “cash.” Money market funds purchase short-term treasury bills and commercial paper, the corporate equivalent of treasury bills. Only highly rated companies participate in this market. The “share price” of a money market fund is given as $1, so that the amount of shares one owns is equal to the amount of money invested in a fund. Once Lehman defaulted, its commercial paper was worthless. If a money market fund held 10 percent of Lehman’s commercial paper, then its money market fund’s share price was now $.90—each dollar invested in the fund was now only worth 90 cents. This is known as “breaking the buck.” Several money market funds “broke the buck,” which sent shock waves through all markets. If the money market wasn’t safe, was any investment safe?

A credit default swap is an insurance policy that protects against the possible default (or down-grade) on a company’s bond. The buyer of a credit default swap is purchasing protection from a default and pays an up-front fee as well as periodic premium payments over the life of the bond. The issuer/seller of the credit default swap offers to pay the full value of the bond if the company indeed defaults. The amounts paid for a credit default swap are based upon the current expected risk of default. The issuer and buyer are known as the “counterparties” in the deal, and the corporation whose bonds are being insured is known as the “reference entity.”

Here’s what happens to a credit default swap holder if a default occurs in the underlying bond: The issuer of the bond pays the buyer the full face value of the bond, then attempts to recoup any remaining value the bonds have.

A separate market came into existence over the past several years for these credit default swaps. The major players in this market are the large money-center banks, investment banks (what’s left of them), hedge funds, and insurance companies, and they play both sides of the fence—they both issue and buy credit default swaps.

But here’s the problem. While a credit default swap can be a useful risk-management tool for investors who own bonds, the main use for credit default swaps currently is to make bets on whether a company will default or not, regardless of whether an investor owns the bond for which he or she bought the credit default swap. The credit default swap market essentially created a way for market players to make bets on the survival of a company, no different than how gamblers bet on football games; the better the odds that a company remains in business, the cheaper the cost of the bet. And any amount could be bet.

And here’s where the very, very curious coincidences come in. Lehman Brothers, like most of the players, was both a “book” and bettor: It acted as a dealer lining up bets, and it made bets (was a counterparty); and more importantly, other players made credit default swap bets on Lehman’s bonds. It’s this type of activity that caused the credit default swap market to grow from less than $10 trillion in 2004 to over $60 trillion in 2008—yes, that’s trillion!

In May of this year Moody’s Investor Services, which is the leading independent company that rates bonds, issued a warning: “the potential failure of an investment bank or other large counterparty poses a large systemic risk” (a risk to the entire financial system).

The secretary of the treasury apparently did not take Moody’s warning seriously. Lehman Brothers was the seventh largest player in the credit default swap market, so one would have to believe that the Treasury Secretary Paulson was well aware of this risk.

On Friday, October 10, an auction was held to determine the payout on Lehman Brothers credit default swaps, and the price came in at 8.7 cents per dollar. That means the issuers will have to pay the buyers 91.3 percent of the face value of their contracts. Estimates of the payout on Lehman Brothers credit default swap contracts range from $275 to $365 billion.

That loss was too big for the market to digest. A key reason why the credit markets are still frozen is that the issuers of Lehman Brothers credit default swaps have been hoarding cash in order to meet their obligations, and some participants may not have the wherewithal to make their payments. Over the next several weeks the issuers will have to fulfill their obligations. If they (insurance companies, banks, and hedge funds on the wrong side of the Lehman Brothers bet) don’t have the resources to pay, and if these insurance companies, banks, and hedge funds default, it very well could trigger another credit default swap event. That is, if a loser can’t pay and a winner doesn’t collect, it raises the odds that both counterparties face defaults or downgrades.

The financial crisis has raised the odds on defaults on all outstanding credit default swaps—and has affected all the other bets that Lehman Brothers was counterparty to, not just credit default swaps. In addition, Lehman Brothers managed the brokerage accounts for dozens of hedge funds, providing loans, clearing trades, etc. These accounts were frozen once Lehman Brothers declared bankruptcy—and in the middle of a liquidity squeeze, if you lose your source of short-term borrowing, you will also die.

It’s safe to say that by letting Lehman Brothers go into bankruptcy, Treasury Secretary Paulson sparked a global contagion fire. Why did he allow it?

The argument made was that someone had to pay for the risk-taking on Wall Street. However, many Wall Street bloggers have speculated that Paulson may have been helping his old firm—Goldman Sachs—by eliminating another large competitor. To add fuel to this speculative fire, the billionaire liberal George Soros, who openly supported John Kerry in the 2004 election, purchased 9.5 million shares (1.2 percent) of Lehman Brothers between April and June of this year. In an interview with Bill Moyers this past Friday, Soros blithely stated he “has a negative view of his [Paulson’s] performance,” and that he hopes to see a new treasury secretary regardless of who wins the election.

Lehman Brothers former CEO Richard Fuld, in his testimony to Congress, stated that Lehman had talks with the Federal Reserve Bank about becoming a bank holding company during the summer, but talks “went nowhere.” That would have given Lehman Brothers access to the Fed’s emergency loans and created a source of stable funs through deposits; interestingly both Goldman Sachs and JPMorgan were given permission to convert to bank holding companies shortly after Lehman’s collapse. As to why US regulators judged his company unworthy of a bailout, Fuld concluded, “Until the day they put me in the ground, I will wonder…”

Initially, Treasury Secretary Paulson’s bailout plan was going to use the allocated $700 billion to buy toxic debt from banks, including his old firm Goldman Sachs. However, the majority of economists and world leaders urged Paulson not to buy securities, but rather to pursue the same policy that Sweden used to cure its banking crisis of the early 1990s, and that Great Britain is advocating in today’s crisis: namely, to recapitalize the banks by buying preferred equity shares.

Secretary Paulson has bowed to that pressure: Today, the bailout bill is allowing the US Treasury to purchase $250 billion worth of stock in banks. Meanwhile, however, Paulson has appointed a former Goldman Sachs banker to the most important position in implementing (t)his plan.

More and more people are questioning whether this appointment, and the behavior of Paulson, constitute conflicts of interest. There is considerable sentiment that the world’s financial markets need an injection of trust and confidence, and that maybe the surest way to inject trust is to replace Henry Paulson as soon as possible.

Dr. Ted P. Schmidt is an associate professor and chair of the Department of Economics & Finance at Buffalo State College.