mere two weeks ago, the Fannie/Freddie rescue was called "the mother of all bailouts" by some commentators. If the plans of the Administration come to fruition, it will shortly be surpassed by the $700 billion mortgage rescue plan proposed by Hank Paulson late last week.
The increase of the request from the initial $500 billion and the release of the shockingly short, sweeping text of the proposed legislation has lead to reactions of consternation among the knowledgeable, but whether this translates into enough popular ire fast enough to restrain this freight train remains to be seen.
First, let's focus on the aspect that should get the proposal dinged (or renegotiated) regardless of any possible merit, namely, that it gives the Treasury imperial power with respect to a simply huge amount of funds. $700 billion is comparable to the hard cost of the Iraq war, bigger than the annual Pentagon budget. And mind you, $700 billion is not the maximum that the Treasury may spend, it's the ceiling on the outstandings at any one time. It's a balance sheet number, not an expenditure limit.
But here is the truly offensive section of an overreaching piece of legislation:
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.
This puts the Treasury's actions beyond the rule of law. This is a financial coup d'etat, with the only limitation the $700 billion balance sheet figure. The measure already gives the Treasury the authority not simply to buy dud mortgage paper but other assets as it deems fit. There is no accountability beyond a report (contents undefined) to Congress three months into the program and semiannually thereafter. The Treasury could via incompetence or venality grossly overpay for assets and advisory services, and fail to exclude consultants with conflicts of interest, and there would be no recourse. Given the truly appalling track record of this Administration in its outsourcing, this is not an idle worry.
But far worse is the precedent it sets. This Administration has worked hard to escape any constraints on its actions, not to pursue noble causes, but to curtail civil liberties: Guantanamo, rendition, torture, warrantless wiretaps. It has used the threat of unseen terrorists and a seemingly perpetual war on radical Muslim to justify gutting the Constitution. The Supreme Court, which has been supine on many fronts, has finally started to push back, but would it challenge a bill that sweeps aside judicial review? Informed readers are encouraged to speak up.
Nouriel Roubini does not think it passes the smell test:
`He's asking for a huge amount of power,'' said Nouriel Roubini, an economist at New York University. ``He's saying, `Trust me, I'm going to do it right if you give me absolute control.' This is not a monarchy.''
It would be best if this provision were expunged, but failing that, the Treasury should articulate what scenario it is worried about and any shield against legal intervention should be made as narrow as possible.
Now to the substance. The Treasury has been using the formula that it will buy assets at "fair market prices". As we have noted, there is simply huge amounts of cash ready to bottom fish in housing-related assets (we saw an estimate of $400 billion a couple of months ago). The issue is not lack of willing buyers; it's that the prospective sellers are not willing to accept prices that reflect the weak and deteriorating prospects for housing. Meredith Whitney, the Oppenheimer bank analyst who has made the most accurate earnings and writedown calls of her peer group, has noted how the housing market price decline assumptions used by major banks fall short of where the market is likely to bottom, given traditional price to income ratios and expectations reflected in housing futures prices.
In addition to the factors that Whitney (and others) have cited, the duration of the 1988-1992 US housing bear market and major financial crises suggests that that a peak-to-trough decline of 35-40% is realistic (obviously, this average masks substantial variation across markets and housing types). We are thus only a bit more than halfway through, as measured by the fall in prices.
Yet as we discussed, the plan makes no sense unless the Orwellian "fair market prices" means "above market prices." The point is not to free up illiquid assets. Illiquid assets (private equity, even the now derided CDOs were never intended to be traded, but pose no problem if they do not need to be marked at a large loss and/or the institution is not at risk of a run). Confirmation of our view came from a reader by e-mail:
I worked at
, but now I handle financial services for , and I was on the conference call that Paulson, Bernanke and the House Democratic Leadership held for all the members yesterday afternoon. It's supposed to be members only, but there's no way to enforce that if it's a conference call, and you may have already heard from other staff who were listening in.
Anyway, I wanted to let you know that, behind closed doors, Paulson describes the plan differently. He explicitly says that it will buy assets at above market prices (although he still claims that they are undervalued) because the holders won't sell at market prices. Anna Eshoo pressed him on how the government can compel the holders to sell, and he basically dodged the question. I think that's because he didn't want to admit that the government would just keep offering more and more.
I don't think that our leadership has been very good during this negotiation (or really, during any showdowns with this administration) at forcing the administration to own their position. If Paulson wants this plan, then he needs to sell it to the public, and if he sells a different plan to the public (the nonsense buying-at-market-price plan) then we should pass that. I'd rather see the government act as a market maker for the assets to get them transferred over to private equity firms and sovereign wealth funds and other willing holders. And if we need to recapitalize these companies, it seems like the cheapest way for the taxpayer is to go in and buy up the distressed debt and then convert that to equity.
So unlike the Resolution Trust Corporation, which took on dodgy assets which had fallen into the FDIC's lap due to the failure of thrifts, and the Home Owners' Loan Corporation, which was established in 1934 after the housing market had bottomed, this program is going to swing into action with the clear but not honestly disclosed intent of buying assets at above market prices when future markets and the analysts with the best track records on forecasting this decline (you can add Robert Shiller, CR at Calculated Risk, and Nouriel Roubini to the list) believe it has considerably further to fall.
As we said earlier, this is a covert, not particularly well designed, inefficient, and unduly costly recapitalization of the banking system. Why?
Losses on the paper acquired are guaranteed. This is not a bug but a feature. The whole point of this exercise is an equity infusion to banks. The failure to be honest about it upfront will lead to a taxpayer backlash (or will lead to the production of phony financial statements for the rescue entity, which will lead to revolt by our friendly foreign funding sources).
Taxpayers have no upside participation.
There is no regulatory reform as part of the package. This would seem to be a minimum requirement for a donation of this magnitude.
There is no admission that deleveraging is inevitable. This plan seems to be a desperate effort to keep bad debt from being written down. Yet the sorry fact is that a lot of these assets simply will not be repaid.
There appears to be no intention to do triage. The financial services industry, on the back of an explosive growth in debt, has reached an unsustainable size. The industry will have to shrink. Yet the Administration does not address this issue; indeed, it appears it intends to forestall the inevitable. Regulators need to decide who will make it, who won't, and figure out what to do with damaged institutions. Instead, the reaction is ad hoc. The stunner was the contemplation of a possible merger between Morgan Stanley and Wachovia. As far as I can tell, the only thing the two firms had in common was coming into crisis on roughly the same timetable. For all I know, their IT systems are not compatible (many an otherwise promising bank merger has been scuttled over IT integration issues).
Reader Marshall forwarded a note from Jon Hatzius, the Goldman analyst who was an early housing/financial firm bear and has forecast that credit-related losses to the economy will reach $2 trillion. His outline of what the rescue program must do:
Basically, I see three main conditions for resolving the crisis (a slicker marketer would call them "The Three R's"):
a) Recognition. We need to find out what the assets on the balance sheets of banks and other financial institutions are really worth, and what the balance sheets of the most troubled institutions look like under a regime of realistic marks.
b) Recapitalization. The US banking system needs a lot more capital. Credit losses are depleting equity capital, and deleveraging increases the required equity capital per unit of balance sheet capacity. So capital infusions are needed to avert a sharp contraction in lending.
c) Relief. In many cases, we need to restructure the loan terms of homeowners who lack the ability (or economic incentive) to service their mortgage. This isn't just in the interest of the homebuyers, but it's often also in the interest of the lender (given the cost of foreclosure) and certainly in the interest of the macroeconomy (given the feedback effects between foreclosures, home prices, and economic performance)....
In any case, recognition is only a start. In fact, recognition actually increases the need for recapitalization because it brings capital shortfalls out into the open. So it will be important to see how the Treasury proposal addresses this. Do they force banks to seek equity infusions from private investors in a specified time period? Do they simply "pay over the odds" for the assets (this would promote recapitalization but jeopardize recognition)? Is part of the program earmarked for the purchase of preferred stock in banks? Or is there a public/private partnership scheme such as an issuance of publicly financed puts in e xchange for warrants for would-be private investors?
As we read from the Congressional staffer, they simply want to "pay over the odds".
Although I agree broadly with Hatzius, I quibble with his idea that the goal is to avoid a sharp contraction in lending. The US needs to wean itself of unsustainable overconsumption, and since consumption has come to depend on growth in indebtedness, a reversal, however painful, is necessary. Our excesses have been so great that there is no way out of this that does not lead to a general fall in living standards (note that the officialdom in the UK is willing to say that, but since perpetual prosperity is a God-given right in America, admitting we will be getting poorer is verboten). Thus, a sharp contraction in lending seems inevitable; the trick is to prevent it from crossing the tipping point into a vicious, accelerating downward spiral.
But regardless, there has been broad agreement that private capital will not enter the mortgage/housing market until investors have confidence that a bottom is nigh. The Treasury program, by quite deliberately propping up asset prices, will delay finding a market clearing level and thus attenuate the financial crisis.
The unacknowledged dead body in the room is whether our foreign creditors will support this plan. As we have noted before, sentiment in Asia (remember, China, Japan, and Taiwan are among our biggest funding sources) has turned against the US, particularly as AIG, a once-trusted company with a very large client base in the region, both retail and corporate, nearly went bankrupt.
The reason the US economy has not suffered much despite the magnitude of our financial mess is that we have been the beneficiary of what Brad Setser has called "the quiet bailout" as foreign central banks and sovereign wealth funds continued to buy Treasuries (and until recently, agencies) to the tune of $1000 per person. Now consider what we have in store. From the New York Times:
Divided across the population, it would amount to more than $2,000 for every man, woman and child in the United States.
Continued>>>
http://www.nakedcapitalism.com/2008/09/why-you-should-hate-treasury-bailout.html
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