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What’s Driving the Wall Street Rout

On Tuesday, Federal Reserve Chairman Ben Bernanke outlined Washington efforts to restore confidence in U.S. financial institutions. Initially, this gave the market a lift. After closer examination by investors, the market continued its downward spiral on Wednesday, led by financial stocks.

Simply, Bernanke’s speech offered little new. The Fed is reforming the practices of mortgage brokers, which should improve the quality of loan applications and transparency about the risk of specific loans, and he further outlined plans to extend bank regulation to securities firms through capital requirements and better Fed access to their financial data. However, these steps fail to address the most fundamental flaws eroding market confidence in both banks and securities companies. These are business models that encourage executives to seek risky arbitrage opportunities–such as through questionable auction rate securities, mortgage finance and hedge funds. By permitting executives to reap annual bonuses in the millions when bets go right and stick stockholders with the losses when things go wrong, banks are inclined to imprudent risks that ultimately victimize shareholders.

Consequently, the banks’ problems are much deeper and far reaching than their losses on subprime securities. Citigroup’s losses on Old Lane hedge fund provide a classic illustration. To attract CEO Vikram Pandit, Citigroup purchased Old Lane for $800 million. Although the fund never made much profit, the transaction netted Pandit $165 million. Subsequently, Citigroup wrote down more than $200 million in losses. Pandit used some of his proceeds to purchase Tony Randall’s Manhattan apartment for $17.9 million, and Citigroup shareholders took the loss. Nothing Bernanke has proposed will stop that kind of reckless behavior, which has nothing to do with the subprime debacle.

The market recognizes Bernanke’s proposals are hollow, and bank stocks continue to fall. Home builders can’t recover without steady banks, and their stocks and the stocks of supplying industries, such appliance makers, head south with them.

Meanwhile, Congress seems little inclined to do much that could quickly address the drag of high priced imported oil on the U.S. economy. Solutions from wind power to free up natural gas for use in vehicles, suggested this week by T. Boone Pickens, to simply accelerating the build out of hybrids through judicious incentives are all being ignored by the Democratic Congress and President Bush. It is no wonder that consumers are pessimistic, auto stocks are skidding and taking the equity values of many supply industries with them.

Until Bernanke gets serious about reforming the business practices of the large New York banks and securities companies and Congress and the President show a pulse on near-term energy solutions, neither the economy nor stocks can recover.

PETER MORICI is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.

 

 

 

 

 

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PETER MORICI is a professor at the Smith School of Business, University of Maryland School, and the former Chief Economist at the U.S. International Trade Commission.

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