From Bubble to Bubble with Plenty of Fed Puts in Between

In yesterday's post , I explained the origin of the famous "Greenspan Put" option: used to bailout Wall Street from its own speculative excess in 1998 after the collapse of hedge fund Long Term Capital.

That episdode set up the expectation that the Fed would always ride to the rescue of financial markets.

A few years later, after jacking up rates in 1999 and early 2000, which finally triggered the bursting of the internet bubble (a case of too much too late?) the Greenspan Fed once again issued put options in massive quantities from 2001 to 2003 to once again rescue Wall Street.

This time the free and easy money flowed into the housing bubble. And Wall Street was only too happy to supply the hot-air!

The banks and brokers outdid themselves in creativity this time with an alphabet soup of asset backed securities and derivatives.

These things are sliced and diced and packaged in such a way that few on Wall Street really understood or knew how to value them – and they were sold off to investors in the four corners of the investment world.

Just after receiving their MBAs, Wall Street analysts must be required to attend special internal training classes: the “What Me Worry School of Security Analysis.” The first lesson is that there’s really no need to worry after all about this alphabet soup of arcane derivatives blowing-up, because if it did… why the Fed would simply issue more put options!

The New PPT Swings Into Action

The Greenspan Fed started jacking up rates a few years ago (again too late) and the fresh faces at the Bernanke Fed decided to toe-the-line, keeping rates high even as the housing sector's foundations began to crumble.

Now, in full reactionary mode, the Fed last week cut the discount rate (a different kind of put). And it appears to be just a matter of time before more Fed issued puts (vintage Bernanke) come flowing into the hallowed halls of Wall Street!

The new Plunge Protection Team under Helicopter-Ben’s leadership may have to put in some serious overtime to reign in the current subprime mortgage mess. With losses initially estimated at between $150 and $300 billion – and these early estimates always get revised higher – the financial system my face a whole series of ongoing market shocks that will make the LTCM bailout look like a tea-party.

The Subprime Crisis Isn't Over Yet; be Prepared for the Next Market Shock

Mortgage industry bailouts and the related collateral damage in derivatives – many of which can’t even be accurately valued in this credit crunch environment – could easily exceed the inflation adjusted expense of the U.S. Savings & Loan bailout twenty years ago.

That episode of irrational exuberance led to the bankruptcy of thousands of S&Ls, with the Resolution Trust Corp. liquidating assets for just pennies on the dollar, and costing taxpayers nearly a half-trillion dollars adjusted for inflation!

With Federal Budget deficits deeply in the red already, it simply may not be possible to fund such a massive bailout without triggering significant and lasting after-shocks in global financial markets.

These tremors will be felt far and wide, but should create many opportunities for attentive investors to profit.

Now here’s the $64 trillion question: When Wall Street cashes-in the next round of put options courtesy of the Fed… I wonder what speculative bubble they’ll think of inflating next?