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Small investors may help Wall Street players

The Fed's action softens consequences for banks and traders, but average citizens also benefit.

August 20, 2007|Walter Hamilton | Times Staff Writer

Don Williams doesn't know it, but he may be helping to bail out Wall Street.

Williams, a 64-year-old retired firefighter, lives off a pension and a handful of stock and bond mutual funds. "If the financial markets were to collapse," he said at home in Genoa, Nev., "I have so much tied into it that it would have a strong effect on my standard of living."

Millions of Americans feel it when the market swoons, and the Federal Reserve no doubt had them in mind when it slashed a key short-term interest rate Friday. Despite that supportive move, shareholder angst is sure to be a factor in today's trading.

To some observers, the Fed's unusual action was a sop to the investment bankers, securities traders and hedge fund managers who fanned the sub-prime mortgage boom and other excesses of the easy-money era.

They -- and to a certain extent the homeowners who tapped into the frenzy to spend beyond their means -- are taking the blame for the market mess and, in the eyes of some, should take the hit.

"They have to pay a price for the risks they have taken," said Stanley Nabi, chief strategist at New York-based Silvercrest Asset Management. "They're paying it now."

But because of Williams and other innocent bystanders across the country, the financial industry may be shielded from more severe fallout than what it is grappling with now. Whatever pain Wall Street feels inevitably spreads to Main Street, and regulators and policymakers want to prevent that.

In fact, the lowering of the discount rate, which banks pay to borrow money from the central bank, raised expectations that the Fed soon could cut its primary interest rate, the so-called Fed funds rate. Wall Street has pined for such a move as a way to lubricate the economy -- potentially a boon for masses of Americans, big investors and small -- and alleviate the credit crunch that has stricken the fixed-income market.

But is it the right thing to do? There's a running debate about the wisdom of the central bank's giving Wall Street the financial equivalent of a get-out-of-jail-free card, allowing the industry to curtail losses from its risky bets on sub-prime loans and leveraged corporate buyouts.

That, according to critics, would reward Wall Street for bad behavior. Shouldn't a hedge fund holding too many sub-prime bonds be allowed to fail and an investment bank stuck with unwanted bonds from a leveraged buyout take a hit to earnings?

"The Fed is protecting these guys on the theory that they're protecting the economy," said Richard Bove, an analyst at Punk, Ziegel & Co. But "Wall Street deserves to bear the results of their actions -- and to date, the results of their actions is that they're worth $10 million or $20 million or $30 million and they have multimillion-dollar houses in the Hamptons."

Wall Street jumped aggressively into the sub-prime-mortgage business and played a major role in stoking the industry's explosive growth and questionable practices in the last decade.

Investment banks provided much of the financing that allowed sub-prime companies to lend to home buyers with checkered or skimpy credit histories. The banks then pooled the loans into bonds, lobbied credit-rating agencies for high ratings despite the securities' underlying risk and sold the bonds to investors.

Some banks simply acquired sub-prime lending companies. Investment banks found willing buyers for the bonds in hedge funds and other institutional investors, such as overseas banks, that were hungry for high yields.

The Fed itself is caught in the blame game. Under former Chairman Alan Greenspan, the central bank, anxious to mitigate the effects of the late-1990s Internet-stock bust, created fertile ground for the housing frenzy by keeping interest rates at historic lows. And the rating agencies blessed the risky securities that issued from the boom.

"From the Federal Reserve to Wall Street, which developed new and sundry types of mortgage products, to people who stretched themselves further than they should have, everybody shares responsibility," said Jim Paulsen, chief investment strategist of Wells Capital Management.

There's no question that many Americans bought houses they couldn't have otherwise afforded and drew unwisely on their home equity to buy plasma TVs and take vacations. But there's an argument that people who tapped into the easy-money system shouldn't shoulder too much culpability, because sub-prime loans give a leg up to those who don't qualify for traditional financing -- Americans who need help to fully participate in the economy.

"Conceptually, [sub-prime loans] are not bad ideas," said Brian Hamilton, chief executive of Sageworks Inc., a financial research firm, "but they were blown out too far" by firms on a quest for ever-greater profit.

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