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Jeff Saut: No-Confidence Vote for the Fed


Wall Street, Main Street suffering crisis of faith.

Confidence is defined as the "faith or belief that one will act in a right, proper or effective way." But confidence can be short-lived. As Fed Governor Kevin Warsh stated:

"Confidence can be fleeting. Confidence can beget complacency. If, in liquid times,investors in structured products become complacent, they may not understand fully the value of the underlying assets.

"High levels of confidence, perhaps even complacency, were also observable in the behavior of many financial intermediaries. Many hedge funds, growing in size and scope, invested in less-liquid assets in search of higher expected returns. Many commercial banks increased sponsorship of structured investment vehicles to invest in long-term securities, often financing them off-balance-sheet with short-term commercial paper.

"Those financial intermediaries that recognized the risks of extrapolating high levels of liquidity indefinitely were threatened with eroding market share and less impressive profit profiles. They may have hoped that robust trading markets would allow them to exit positions ahead of a crowded trade.

"But, to paraphrase an old Wall Street saw, they don't ring a bell when the markets are at the top or at the bottom."

Since the Ides of March, triggered by the collapse of Bear Stearns, confidence has clearly been waning. In September, we suffered a "confidence crash" when the Treasury Department nationalized Fannie (FNM) and Freddie (FRE). As I've previously stated, it wasn't that the GSEs didn't need to be bailed out - they did. But the structure of said bailout caused a confidence collapse.

Indeed, in previous bailouts, the government has left an equity stub for shareholders, allowing them to participate in the survival, and eventual recovery, of the company (e.g. Chrysler, Lockheed, etc.). This time, however, the equity holders were wiped out after being told by Secretary Paulson that everything would be okay.

Ladies and gentlemen, the structure of this bailout is historic, as well as a game changer. As a result, international investors are asking: "Why would any rational investor commit capital to a situation where, if things didn't go the right way, the government might come in and totally wipe you out?!"

Clearly a valid question, and one we can't answer. A few weeks later, another unanswerable question emerged when the Fed decided to let one of its primary dealers, Lehman, go bankrupt. At the time, the "spin" was that at $80 to $90 billion, the cost of rescuing Lehman was just too great.
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