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Bailout cost: higher than you think

Intervention buoys the financial sector at a time when consolidation is what the economy needs.

Colin Barr, senior writer
Last Updated: September 19, 2008: 5:32 PM EDT

The Merrill chief did the prudent thing accepting a buyout from Bank of America.

FORTUNE (New York) -- Henry Paulson and Ben Bernanke have saved us, for now, from a market meltdown - but at the cost of allowing the folks who caused the current crisis to keep ducking reality.

In the long run, guess who gets to bear that cost?

The Treasury secretary and Federal Reserve chairman have spent September dashing off blank check after blank check in a bid to quell turbulent markets. Since Sept. 5, the feds have pledged $200 billion to shore up mortgage giants Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500), $85 billion to prop up insurer AIG (AIG, Fortune 500), and $50 billion to guarantee money-market funds.

Then there are the untold sums the U.S. might spend under the plan Paulson unveiled Friday to set up a bad bank to relieve institutions of their troubled mortgage assets. And let's not forget the hundreds of billions the Fed has poured into the markets in the name of maintaining liquidity.

Even in a U.S. economy that produces $14 trillion worth of goods and services a year, that's a lot of cash.

Spending all that money, sooner or later, will intensify long-standing questions about the nation's fiscal health, possibly at the expense of another drop in the value of the dollar.

"We're going to be sorting this out for years," says Howard Simons, a strategist at Bianco Research in Chicago who questions the blitz of taxpayer spending on programs that haven't even been debated in Congress.

Ultimately, what could prove to be the most expensive aspect of the bailout spree is the message the government is sending to firms in which the market has lost confidence. Prudent management, it seems, will be punished, while the status quo - however unhealthy - must be maintained at all costs.

The strong stock-market rally of the past two days aside, intervention that fails to foster a shakeout of weaker firms will only delay the reckoning that must occur before a sustainable economic recovery can take shape.

"We continue to believe that the financial sector is in need of massive consolidation because the sector simply has too much lending capacity left over from the credit bubble," Merrill Lynch investment strategist Rich Bernstein writes Friday. "History shows well that consolidation is the primary driver of post-bubble economies."

The upside to down

Though the free fall in financial shares over recent weeks wasn't pretty to watch, it had the sanguine effect of forcing businesses with questionable fundamentals to confront an uncertain future. Take the case of Merrill Lynch (MER, Fortune 500) chief John Thain.

Thain took over at the struggling broker last November, promising to "continue to grow Merrill's global business and add value to our customers and our shareholders." He then spent 10 months recognizing more than $50 billion in losses, mostly on risky mortgage-related debt gone bad, and raising almost $30 billion in new capital, in a furious fight to keep the 94-year-old firm independent.

But in the meantime, the market was concluding that Merrill and its rivals at Lehman Brothers, Morgan Stanley (MS, Fortune 500) and Goldman Sachs (GS, Fortune 500) were pursuing a business model - the standalone trading firm that borrows heavily in the short-term debt markets - that makes no sense in an era of risk aversion and rising funding costs.

Thain, after a game fight, conceded to the market's view Monday, when Merrill - facing the prospect of a run on its shares after Lehman imploded - agreed to sell itself to Bank of America (BAC, Fortune 500) for $44 billion in stock.

Thain, of course, had seen his peer Dick Fuld run Lehman Brothers into the ground by refusing to accept the low-ball offers of potential partners, a stand that ended up putting thousands of Lehman workers out of work. Thain chose instead to take a deal that likely saved most of Merrill's 60,000-plus workers.

And yet now - with the feds organizing a bailout and banning short-selling, the practice of betting against a company in the stock market - Thain's decisiveness seems misplaced. Rather than acknowledging economic reality and selling his firm, he could have waited for a handout and Merrill could have lived to see another day, it now appears.

Dodging the tough calls

Thain's rivals seem to be reaping the rewards of expanded federal largesse. Morgan Stanley, after plunging as low as $16 a share in panicked trading Wednesday afternoon, has recovered to the low $30s, possibly forestalling the need for the firm to find a merger partner such as Wachovia (WB, Fortune 500). CEO John Mack, who responded to his firm's plunge with a memo to employees blaming short-sellers, surely likes the way this week has turned out.

But for the rest of us, the feds' rush to defend teetering financial firms only defers the tough decisions that will need to be made before this crisis subsides - at the expense, perhaps, of repeating Japan's so-called lost decade of economic stagnance after its property bubble collapsed around 1990.

History shows that setting up bad banks without forcing financial firms' managers to confront their problems won't solve anything.

"This seems to us," Bernstein writes, "to be a very Japanese approach to solving a credit crisis."  To top of page

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