A New Direction on Wall Street

The feds take unprecedented actions to save the financial system.

Panic and uncertainty have sent markets reeling.

Panic and uncertainty have sent markets reeling.

By SHARE

On Wall Street, they're calling it the Great Unwind. Trillions of dollars of interlaced leverage and debt is now being removed around the globe after years of steady economic growth and record low interest rates encouraged investors and speculators, including scores of American financial institutions, to take unprecedented risk. Today, it's clear that those bets were made on a now collapsed foundation of greed and overly optimistic economic assumptions. And anyone with a dollar at risk is looking at mathematical models or even Ouija boards to figure out what happens next.

The job of keeping the Great Unwind from turning into another Great Depression has now fallen to Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson. In a mere two weeks, Paulson and Bernanke have transformed American capitalism, as they mount a high-stakes commando operation to head off the worst financial crisis since the '30s. After a dizzying fortnight of near-death experiences, the U.S. government now effectively owns the world's biggest insurance company, American International Group, and has approved up to$85 billion in loans from the American taxpayers to prevent a bankruptcy filing and a deeper market meltdown. The feds are now deeply into the mortgage business, too, thanks to a $200 billion commitment to Fannie Mae and Freddie Mac, which fund three quarters of all home mortgages being written today. "Who would have thought that the United States would nationalize its financial assets?" asks economist James Barth of the nonprofit Milken Institute.

Global gloom. And it's not just an American crisis. Central banks worldwide have been forced to pony up a collective $200 billion plus to unplug the clogged drains of the global credit markets. Russia, recently celebrating its newfound oil wealth, suddenly found its stock market dysfunctional. And China, everyone's great financial superpower of tomorrow, moved to buy up shares in its banks. But not everybody is getting a bailout. When Richard Fuld, CEO of Lehman Brothers, came hat in hand, the feds said no, and Lehman declared bankruptcy virtually overnight. The once venerable Merrill Lynch didn't even wait to be turned down: It rushed into the arms of Bank of America, creating a new, if fragile, financial titan.

At the center of these troubles is America's housing boom and now bust. As the Fed poured cheap money into the system in the past decade to prevent a financial shock after the dot-com bust, interest rates plunged and home prices soared. That fired up the market for mortgage-backed securities. Mortgage brokers lent as much money as they could to hopeful homeowners—even if it meant shaky or even fraudulent loans—since they didn't have to hold the loans themselves. They just passed it along to Wall Street through a process called securitization. Most of the world's major financial institutions ended up with a portfolio of mortgage-backed securities that turned out to be much riskier than any of them or their fancy computer models anticipated.

The whole rickety scheme began to unravel in 2006, when overpriced homes began to fall in value and refinancing became a lot tougher. Then, foreclosures skyrocketed, and mortgage-backed securities began to blow up like time bombs. Investing firms hold very little cash (unlike their commercial bank colleagues) and borrow much of the money they invest. Lehman, for instance, had as little as $1 in cash on hand for every $30 it borrowed. As worried creditors started calling in their loans, the whole show looked like a cat with a ball of string. First to fall was Bear Stearns, which was forced into a shotgun marriage with JPMorgan Chase, with the feds providing a $29 billion dowry.

So far, the government (i.e., the taxpaying public) could be on the hook for more than $300 billion in guarantees and loans. The betting in Washington is that's preferable to a full-scale meltdown that could take an already ailing economy with it. But at some point, the bill has to be paid, and already the critics are wondering whether the bailouts are a placebo treatment that's losing effect. Instead of taking comfort from last week's AIG deal, for instance, the markets plummeted, fearing more devastation ahead. "The feds have exhausted a lot of policy initiatives," UBS executive Mike Dion warned clients. "This may be the deepest crisis in 50 or 100 years, but we'll only know a couple of years from now."