Have you heard the one about the French army rifle for sale on eBay? It is advertised as “Never fired, dropped only once”. The reason to think about this item is not to make fun of the French again, but to ruefully consider the metaphorical bazooka that US Treasury Secretary Hank Paulson holds; and wish as a free market agent that it had never been removed from its holster, let alone fired.

For those of you who skipped financial newspapers over all of the summer – admittedly not a bad idea in itself – the reference here is to the infamous July speech when Paulson said, “If you have a squirt gun in your pocket you may have to take it out. If you have a bazooka in your pocket, and people know you have a bazooka, you may never have to take it out.”

The context was the Treasury grabbing power from the US Congress by insisting on greater powers to deal with the crisis cutting across the entire financial sector. Proving the rule that a fool and his money are soon parted, Paulson last weekend had to fire that bazooka after all, in his rescue of failed mortgage giants Freddie Mac and Fannie Mae; which followed the March takeover of Bear Stearns by JP Morgan at the insistence of the Fed and US Treasury.

On the face of it, these events are only loosely related in the bigger framework of the credit crunch. However, that ignores the key aspects of behavioral finance – the application of psychology to financial behavior – a subject that is far more relevant today than at any other time in financial markets. While this subject itself has multiple branches, I am here only looking at the most simplistic framework, ie, how do finance professionals behave in given situations.

The larger framework for studying the interplay of governments with financial markets in crisis situations is defined in the rules of Pareto Optimality. Simply put, a Pareto optimal situation is one in which all players in the game get efficient outcomes. An external agent, like the government, that seeks to influence the outcome can either create a higher chance of such an optimality (a Pareto Improvement) or more likely, not.

Dialing back

First, let us dial back a bit: under “normal” situations, a financial institution such as a commercial bank operates on the basis of trust. Wafer-thin capital is intended to support gargantuan balance sheets on the notion that the incidence of losses through defaults and the like are both miniscule and spread out over a long period; so ongoing earnings can replenish the capital base. As I have written before, banking isn’t exactly rocket science, though – for all the wrong reasons – it does tend to attract the world’s best brains.

Investment banks – like the dear departed Bear Stearns – had a slightly different business model, wherein investors depended on their ability to continuously undersell their positions to investors, or they were paid to distribute risk. This is like the children’s game of passing the parcel, except of course that something a lot more incendiary than a Barbie doll is being passed around. Traditionally, investment banks relied on getting the parcel as far away from themselves as possible, and it would hopefully blow up some distant investor.

However, as of three years ago, investment banks changed their business model. The usual phrase that can describe this is unfortunately a bit too racy for an Asian newspaper; so let us just call it “gun envy”. As the old firm of Goldman Sachs went from strength to strength, other investment banks like Bear Stearns and Lehman took it on themselves to bolster their own standings. This they did by boosting proprietary trading, the business of trading on their own account, and something that Goldman excelled in consistently – providing billions of dollars of income every year.

Now, the thing with proprietary trading is that while conceptually it looks similar to investment banking, it is actually the exact opposite as it involves brokers buying up their own produce. If you have ever come across the sickly pig farmers gorging on their own produce in Italy, you would begin to appreciate where I am going with this. Anyway, to fund the book – remember the wafer thin capital holding up the assets – the brokers increasingly used short-term “cheap” money.

When the first Special Investment Vehicle (SIV) went kaput last summer and was swiftly followed into the breach by the money market funds that lend in the short-term markets, this access to financing quickly disappeared.

This is when all financial institutions turned to “repo financing”, or pledging collateral to each other to get cash. Typically, this works as follows: bank A sells a security to bank B at say 98, and promises to buy it back after a month at 100. The difference of two is the interest cost associated with the financing. For bank A, the process is good because it gets 98 immediately, and for bank B, it gets a security that is worth a 100 for 98, so if bank A doesn’t honor its agreement to purchase the security back, bank B can sell it in the open market for 100.

Dr. House maxim: Everybody lies

By now, astute readers would have guessed the fundamental flaw with the above setup, which is, to use the maxim of television’s Dr. House: “Everybody lies.” The investment banks bought assets that they should have sold on but instead held on their books to eke out marginal gains, all the while funded by short-term markets.

As the price of these financial assets started falling, brokers and their customers soon found an inexorable volume of losses hitting their accounts. This was only in the most liquid assets though, leaving the issues of less liquid assets to be sorted at a future date. Like a man with a limp who hides a serious flatulence problem by pretending that the squeaks emanate from his cane (and I will leave the Dr. House analogies alone after this), brokers and other financial players preferred to conceal the losses they were running up on their illiquid assets like Collateralized Debt Obligations (CDOs).

When you think about CDOs though for a few minutes, the idea of funding long-term assets with short-term liabilities starts looking awfully familiar – it is in fact a mini-version of a bank. And as with bank runs, the idea of suddenly removing the availability of funding for these asset vehicles causes a plunge in the value of the assets they hold.

To complicate matters, all brokers (and their biggest customers including the hedge funds) held the same kind of assets – see my previous comments on the general lack of smarts in the banking world. Thus, whenever the weakest link of the chain cracked, these assets were sold forcibly. Soon, the declines in value were so perceptible across the whole chain that the haircuts being demanded by potential lenders on the repo market soon started creating their own set of headaches.

Even as brokers and others increasingly depended on the repo markets, the volatility of asset prices was also rising dramatically, thereby forcing greater care in lending based on such collateral. Worse, by opening the Fed window (as well as the European Central Bank and Bank of England windows) to brokers, the day of reckoning was essentially postponed.

This is always the problem with imposing moral hazard on the markets: someone eventually calls your bluff.

Paulson is not Pareto

By rescuing Bear Stearns in March and Fannie and Freddie last week, Paulson probably tried to assure holders of long-term debt that the outlook was not all that bad. However, by doing so he scared the holders of equity and those holding short-term debt; because a continuous decline in the value of assets meant that the coverage for short-term borrowing was absent and capital was meanwhile being wiped out.

By creating a misalignment of interests between different types of creditors – long- and short-term – and shareholders, in effect Paulson unleashed an untenable timetable for a turnaround of the financial sector. Effectively, his strategy to save Bear would have worked had US financial markets enjoyed a prolonged upturn.

Instead, all players focused on surviving the immediate short term, thereby pushing more firms to seek securitized financing from the repo market. In turn, this left firms with both a funding and a capital problem whenever asset prices fell – Paulson’s moves effectively made the US financial system a leveraged bet on investor optimism.

Stepping away from the rescue of private firms like Bear Stearns though would have necessitated a quick self-sale of smaller firms like Lehman, even as greater clarity on asset prices would have followed. However, by saving the long-term unsecured creditors of Bear Stearns, Paulson set in motion a precedent that was to cause greater volatility in the financial system.

More pointedly, the interest of long-term unsecured creditors, ie, the people who had the most capital at risk (given the amount of leverage that Wall Street firms, banks and agencies had relative to their capital) were frequently against those of investors in other parts of the capital structure or equity and holders of short-term secured debt. These investors had only one proven way of getting their money back and that was to secure government backing for the debt issued by these private companies.

This was the main “cost” of the rescue of Bear Stearns, it became imperative for holders of long-term debt to actually push large financial firms towards bankruptcy to force the government to rescue them. In effect, the arbitrage so created, that is buying long-term debt for extremely wide spreads that then tightened when the government took over the firms, became the new mantra for such investors. This is the exact opposite of Pareto optimality and the blame for that can be laid straight at the feet of Paulson.

The bigger cost is for the US government. Already, the total debt load has doubled since the absorption of Fannie and Freddie into the government balance sheet last weekend (See Paulson placates China, Russia – for now Asia Times Online, Sep 10, 2008). Now to add the likes of other troubled firms would be to push the overall debt burden well over 100% of gross domestic product, at which level it becomes unthinkable that the US government itself will retain its Triple A rating.

What Paulson may have forgotten though is that for all their mismanagement and so on, the two agencies actually held the best assets in the US mortgage space. If they needed to be rescued by the government, investors could easily work out what the fate of other US institutions holding lower-quality instruments would be. Three in particular entered crisis mode this week: Lehman Brothers, Washington Mutual and AIG (American International Group). All three were being quoted at distressed levels in the credit markets on Thursday.

Market reaction after the Fannie-Freddie rescue is where the behavioral finance aspect that I described in the beginning of the article began to bite. The rally on Monday quickly gave way to circumspection as investors worried about which was the next shoe to drop. The near-term experience of seeing capital wiped out on Fannie and others meant that there was no capital to be had from equity investors, even as the repo market was shut down for the affected firms by lenders afraid of being caught with either counterparty exposure or worse.

All of that meant that capital was pulled out of the affected firms at exactly the time when they needed it the most: a classic instance of herd behavior, and one that has become depressingly familiar in the global financial system of late.

Stung by the market crisis from the beginning of this week and the failure of Korea Development Bank to top up its capital (about the smartest thing that an Asian investor has done of late, in my opinion), Lehman advanced its earnings call to September 10 from September 16. But the announcement proved problematic as while losses of nearly US$4 billion were confirmed, the management could not identify the path of any turnaround, nor could it shed light on future sources of capital.

Lehman’s share price continues to fall, and opened under $5 on Thursday in New York, a quarter of the value on July 1 and just a tenth of the highest price reached after the rescue of Bear Stearns.

Instead of one single rescue – of Lehman – US authorities are going to have to think of at least three institutions. A forced sale such as Bear could well work again, but that still leaves two big institutions in the lurch as of Monday morning. The number of companies which can potentially bail out these firms is fairly limited to start with.

It looks to me like the US government and its agencies will have to make some painful decisions about who to let go by Monday morning. It would be better for them and global investors if they left the decision to the markets instead. Essentially, someone has to take the bazooka of intervention from the trigger-happy US Treasury secretary.