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Bernanke's Bank Bailout


A solution just shy of nationalization.


Yesterday Federal Reserve Chairman Ben Bernanke foretold of a bank bailout in the purest sense.

Much of the commentary on Bernanke's speech is focused on his push for expanding the role of government sponsored mortgage lenders Fannie Mae (FNM) and Freddie Mac (FRE). Professor Depew explains why this paves the way for nationalization of the troubled lenders.

Bernanke also discussed the idea of principal reductions, where banks write down loans if borrowers owe more than the underlying property is worth. Bernanke gave a clue as to his real intentions for these principal reductions toward the end of his address: "This [writedown] might include a feature that allows the original investors to share in any future appreciation, as recently suggested, for example, by the Office of Thrift Supervision."

The plan would allow banks to take losses, while retaining rights to profits from a later sale of a home. A palatable solution for banks if it weren't for the credit crunch. Many just don't have the balance sheet to incur the losses, especially as home values continue to fall and lenders like Countrywide (CFC), Washington Mutual (WM) and Wachovia (WB) see negative amortization on Option ARMs eating into what little equity they have left.

There is, however, a potential solution that would allow the Fed to ease strains on the financial system caused by the housing market crisis. If banks were allowed to finance the principal writedown through a loan from the Fed, they could take the loss without actually taking it – a nice trick for a bank that can't afford more losses. Borrowers stay in the house; banks remain solvent; every body wins.

The Fed is looking for any and all ways to save the banking system without actually nationalizing it, and while in the near term such a bailout may be good for equity investors, borrowers and politicians looking for votes in November, the precedent it would set is a moral hazard in the most extreme sense.

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