Opening Bell: Bernanke v. Paulson?

A Fed-Treasury split; Wamu pay outrage; a growing bankrupt class; pitiful Fed testimony, etc.

Federal Reserve Chairman Ben Bernanke came down firmly on the side of government action on Tuesday, urging banks to forgive part of the principal on loans they’ve made to borrowers who are now under water on their mortgages, and calling for a bigger government role in backing mortgages.

The New York Times goes above the fold on page one with a story that says the Fed and President Bush, despite his rhetoric, are moving toward a “government rescue” of borrowers and the home industry.

The Financial Times leads its front page with the news, saying:

…shows how policy-makers are considering increasingly drastic measures to tackle the troubles in the housing industry, where Mr Bernanke said “delinquencies and foreclosures will continue to rise for a while longer”.

“This situation calls for a vigorous response,” he said. “Measures to reduce preventable foreclosures could help not only stressed borrowers but also their communities and, indeed, the broader economy.”

The Wall Street Journal on A3 says Bernanke’s move shows the shortfalls of the current rescue plans, which have focused on freezing interest rates to help borrowers keep their homes. But with prices falling sharply, more than 10 percent of homeowners have negative equity on their homes—they owe more than they’re worth—and thus have more incentive to mail the keys back to their mortgage lenders. The WSJ quotes a study that says one in five borrowers could soon owe more than their houses are worth.

The Fed chief called for expanding the government’s role in guaranteeing big mortgages and those that are in trouble, something the NYT says the administration has already done. Even the liberal Barney Frank praised Bernanke’s newfound activism, the papers say. The banking industry frowned on it, though.

Bloomberg says Bernanke’s speech shows he thinks the problems can’t be addressed with fiscal and monetary policy—economic-stimulus plans and interest-rate cuts. It says Treasury Secretary Paulson contradicted Bernanke’s emphasis on helping under-water home borrowers, saying “almost too much” has been made of the issue. It will be interesting to watch how these splits between the Fed and the Bush administration widen or narrow over the coming months. Either way it will be a big story.

The NYT says the moves, of course, would leave taxpayers on the hook to effectively bail out homeowners and the housing and banking industries.

Banker pay under fire

The FT reports on its front page that the investment-banking industry is proposing new pay guidelines for itself in a bid to head off political pressure to reform how compensation gave bankers the incentive to take huge risks that held out the possibility of big payoffs for themselves with little downside for their pay.

The Institute of International Finance is considering proposals to defer bonuses until the long-term impact of bankers’ moves are clear, or to force bankers who lose money in their individual business units to make up the shortfall before they get any more bonuses. You know, like almost everyone else has to do.

The issue of banking pay is becoming particularly controversial because salaries in the financial industry have exploded this decade relative to other sectors of the economy. However, some sectors with the biggest pay-outs in recent years—such as complex credit—are in the storm of the current credit turmoil. Meanwhile, the banks are still paying high bonuses to many employees, in spite of a swath of writedowns.

This is triggering growing criticism of compensation structures among policymakers and some investors. “At present, compensation incentives are asymmetric…This encourages employees to take excessive risks,” says Philipp Hildebrand, vice-chairman of the Swiss National Bank.

The pay issue is an essential one that will be increasingly important and visible as the credit crisis unwinds over the next months and years. The incentive structures are gamed for short-term gains to the long-term detriment of their companies and to the economy.

Wamu to Street: Drop dead

Incredibly, the board of Washington Mutual is going the opposite way on the pay issue, the WSJ says on A3. It will exclude many of the effects of the credit crisis from its bonus calculations, something the paper says “effectively shields the pay of chairman and chief executive of the thrift, Kerry Killinger, and more than 100 other executives from the continuing mortgage fallout.” This from a bank that has been one of the hardest hit by the credit and housing busts, with shares down more than 70 percent from early last year.

Unsurprisingly, WaMu investors are ticked:

“They’ve cost their shareholders a lot of money,” said David Dreman, chairman of Dreman Value Management LLC, which holds 27.9 million WaMu shares. “Bonuses should be given to the executives who enhance shareholder value, not destroy it.”

Apparently it was just too much that poor WaMu execs had their bonuses cut in half last year. That banking-industry plan to make bankers earn back their losses before raking in windfall bonuses looks even better than it did two minutes ago, huh?

Quote of the day

The WSJ says the Fed’s vice chairman issued a mea culpa on behalf of the central bank for not understanding before it was too late how much risk the institutions it’s supposed to regulate had been taking. Donald Kohn said the Fed will become more aggressive in regulating the banks.

“One of the lessons learned is that we need to be more forceful,” Kohn said when pressed by Sen. Richard Shelby, the top Republican on the panel, to explain why bank regulators did not spot subprime mortgage problems earlier.

It was an eye-opening look into the timidity of the Federal Reserve, the country’s dominant financial institution.

Here’s Reuters:

Kohn defended the Fed, saying it was “a very hard sell” for the Fed to get banks to focus on potential risks when the U.S. economy was booming and banks enjoyed record earnings.

“It’s a hard sell for the banks, yes, but you’re the supervisor,” Shelby responded impatiently. “You’re also the central bank, so you have not just a little bit of power, but a lot of power.”

That’s the Quote of the Day.

Another one bites the dust

Another week, another hedge-fund collapse.

New York’s billion-dollar Focus Capital lost about 80 percent of its value and had to liquidate its assets to satisfy its lenders, the FT reports on its Companies & Markets cover. Last week, a Peloton Partners fund collapsed, wiping out nearly $2 billion in holdings.

It’s about to get worse:

Several other funds specialising in credit are close to crisis, according to investors and consultants, while a few smaller funds have had assets seized by banks or required rescues by investors or allies…

Many other hedge funds investing in illiquid assets, mostly in the credit markets, have suspended redemptions by investors to avoid forced sales. But concerns remain that withdrawals by investors from certain sectors could force more to shut.

The bust illustrates the outsize effects hedge funds, which are heavily levered (laden with debt), have on markets. Last week, when Peloton failed, it pushed the prices of the top-quality mortgage securities markets in which it had invested to new records. Focus Capital’s liquidation unloaded big stakes in two companies whose stocks plunged more than 30 percent apiece.

Bid-rigging probe

The WSJ says on its Money & Investing cover that the SEC is considering charging nearly thirty people and several firms with bid-rigging in the management of municipal bond proceeds that haven’t yet been spent by the cities and states on things like roads and schools.

The paper says the feds are investigating whether the companies, including UBS and Bank of America, colluded to rig bids to manage the money, something that may have resulted in higher fees for cities and states.

It looks like the problems come in part from—guess what?—a failure in regulation and oversight.

After a series of scandals in the 1960s, Congress created the Municipal Securities Rulemaking Board.

The MSRB, however, lacks enforcement authority. The SEC and the Financial Industry Regulatory Authority, Wall Street’s self-regulator, instead are charged with inspecting and reviewing the market through brokerage firms.

But the three firms whose offices were raided weren’t subject to federal oversight, inspections or examinations.

Stupid insurance tricks

The Journal has an important page-one feature on a test called the Fake Bad Scale that’s being used to sniff out fakers in personal-injury lawsuits.

Use of the scale surged last year after publishers of one of the world’s most venerable personality tests, the Minnesota Multiphasic Personality Inventory, endorsed the Fake Bad Scale and made it an official subset of the MMPI. According to a survey by St. Louis University, the Fake Bad Scale has been used by 75% of neuropsychologists, who regularly appear in court as expert witnesses.

But now some psychologists say the test is branding as liars too many people who have genuine symptoms. Some say it discriminates against women, too. In May, an American Psychological Association panel said there appeared to be a lack of good research supporting the test…

“Virtually everyone is a malingerer according to this scale,” says a leading critic, James Butcher, a retired University of Minnesota psychologist who has published research faulting the Fake Bad Scale. “This is great for insurance companies, but not great for people.”

Some judges are now barring it from being used as evidence. The psychologist who created the scale, unsurprisingly, defends its efficacy and makes most of his money testifying for defendants in personal-injury lawsuits.

Additional bad news

In economic news, the NYT says bankruptcies surged 28 percent last month from a year ago. It was the busiest month for bankruptcies since Congress overhauled the law three years ago.

“This number of bankruptcies may be under-representative of the true financial distress consumers are feeling because of the steps Congress has taken,” said Jack Williams, a scholar in residence at the American Bankruptcy Institute and a professor at Georgia State University.

Unsurprisingly, home-bust states California and Florida were in the top three for bankruptcy increases.

Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.