In Response to Joel as “Joe Middle Class”

Joel asks in response to my previous blog, “how does this bad debt affect me if the USA doesn't purchase it?”

The argument is being made that if this bad debt is not removed from bank’s balance sheets, then the banking system will be unable to continue lending. If this happens, then everyone will be hurt, because no one can finance the purchase of a house.

Personally, I think Bush has probably stepped aside in these conversations (thank goodness!), Bernake's role is more advisory, and Paulson is basically running the show as far as the Executive Branch. Despite President Paulson's obvious conflicts of interest (e.g., he formerly ran Goldman Sachs and his Assistant Treasury Secretary recently left to run Wachovia), I honestly believe that he wants to do the right thing here. That is not to say Congress or the American taxpayer should trust his judgment implicitly, as this is a very complex and dynamic crisis, and the optimal solution is far from obvious. I would prefer to characterize his past positions, current stock holdings, and friends in high corporate places as leading to bias in his judgment, not blind self-interest. I think what is driving his self-interest now is mostly that he does not want to become the Don Rumsfeld of the Credit Crunch, and I am OK with this as his primary motivation.

I think the current proposal is inherently flawed in four respects:

1) As it has been described in the press, the bailout does not address Moral Hazard, and most suggestions being offered to exact punishment might trigger the theorized death spiral that Paulson is trying to prevent.

2) The premise that lending will seize up is predicated on all banks being in jeopardy of failure, but I have yet to hear is true. If weak banks fail, why can’t strong banks fill the gap? Is this not Free Market Capitalism, which I thought Paulson and the Republican Party has been espousing for decades?

3) There are vulture funds with billions in cash, impatiently waiting for the banks to finally admit they have been grossly overvaluing their loan portfolios (i.e., lying to regulators) so that these funds can purchase these assets at an appropriate discount. In truth, these banks have been insolvent for months, so instead of buying their toxic waste, why doesn’t the government simply seize all their assets, then move RTC style to raise funds to bail out the insured depositors? I do not know whether this strategy could work, but is there even a debate over alternative solutions?

4) This bailout plan is extraordinarily expensive to the US taxpayer, but still only puts a band-aid on the larger problems facing the financial system. Anyone heard of Credit Default Swaps?

If more people like Joel would start asking questions about whether it makes sense to use taxpayer dollars in truly unprecedented ways to bailout financial institutions that have become corrupt and bloated, we might actually encourage Washington to take a fresh look at the core problems and alternative solutions.

Why this Bailout is not “RTC Part II”

In the early 1990’s, the Resolution Trust Corporation closed or otherwise resolved 747 Thrifts with total assets of over $390 billion. This period played out over several years, and is now referred to as the Savings & Loan Crisis. The RTC created equity partnerships for private sector partners to acquire interests in asset pools of these failed Thrifts. These private sector partners controlled the management and sale of the pooled assets and made distributions to the RTC. Prior to utilizing the equity partnership structure, the RTC had conducted bulk sales of these asset portfolios; however, heavy discounting made this unacceptable. By partnering with the private sector and retaining a stake in the asset portfolios, the RTC was able to realize strong returns like the private investors, and the alignment of incentives was assured. Ultimately, it is estimated that the RTC bailout still cost taxpayers approximately $125 billion, but it was remarkably successful.

So-called market experts have been saying for more than a year “not to worry” this time, because they do not expect so many banks to fail as a result of the sub-prime mortgage mess. Of course, what they failed to acknowledge was that the S&L Crisis involved the failure of small community Thrifts to manage their balance sheets, not the entire financial market’s failure to do so. Now our federal government has requested $700 billion from Congress to buy up distressed assets as part of its plan to halt the worst financial crisis since the 1930’s. The press, in typically ignorant fashion, is describing this as RTC Part II.

The Treasury Department sent Congress a two-and-a-half page outline to suggest legislative language that would create an RTC-like government entity with the authority to buy the toxic assets of U.S. financial institutions. As taxpayers, we need to understand that there are three critically important differences from the days of the RTC:

(1) Treasury is not asking for a government institution to hold the assets of failed banks and then sell them off; they want to purchase this toxic waste from a wide range of financial institutions, hold them until better times, and then try to sell them. Sounds like a pipe dream, I would not invest my money in.

(2) The RTC was charged with raising money from the sale of seized Thrift assets to help fund the shortfall from the government-insured deposits of little people like you and me; the current Treasury proposal calls for an entity to transfer wealth from taxpayers directly to the balance sheets of commercial banks. The former was a private fundraiser to pay for government guarantees to individual checking account holders; the latter is a bailout subsidy for bankers.

(3) The failed Thrifts of the 1990’s were holding mostly commercial mortgages; however, today’s toxic assets consist of mostly residential mortgages, CMOs and other securitized mortgages, which have been cut up into tranches (with the servicing rights sold off). Good luck putting Humpty Dumpty back together again!

The true cost to the taxpayer of this bailout proposal is impossible to calculate today; nevertheless, it will likely make the S&L Crisis and RTC action look like a very minor historical event in financial history. It appears to me that Treasury is asking taxpayers to be the high bidder for this toxic waste. Banks will obviously sell this waste to the highest bidder, so I have to assume that this government entity will only buy up what the private sector won’t touch. Moreover, who can sell to this government entity and by what date must they be holding the assets in question to prevent arbitrage at the expense of the taxpayer?

So many questions loom around such a brief, yet significant, proposal that is now in the hands of a Congress, which is far more skilled at debating the fate of Terry Schiavo than the fate of our economy. They are being pushed by Treasury and Wall Street to act quickly, which is never a harbinger of successful regulatory action. The fact that this is an election year only adds to the uncertainty.

Just look at SEC Chairman Cox’s quick action last week to ban short selling of 799 financial stocks for at least 10 days. Did he simply forget that he removed the uptick rule on writing shorts—which had been in place since 1934 up until last year—and reinstating this rule would have sufficed? Besides, it is not at all clear that the downdraft of trading in the financials last week was really about short writing as much as it was a rush to get out of these stocks, because no one knew who would be the next Lehman or AIG.

I suppose this would not be a good time to request a “bail out” of the 10,000,000 children in the U.S. without health insurance? I guess that Iraq reconstruction, preventing bankruptcy for banks that sustained huge profits by underwriting bad loans, and subsidies to corn producers to produce ethanol are more worthy uses for our tax dollars.

Where in the World to Startup?

I am not a fan of rankings — whether for web pages, business schools, or NCAA football — because any methodology that attempts objectivity is prone to bias and error. Nevertheless, the World Bank has developed an interesting set of rankings of the friendliest countries to startups and small businesses as part of their Doing Business Project, and I think it is worth a look. I am just guessing, but there must not have been a metric for the number of Russian tanks that might blow up your business, otherwise Georgia probably would not be ranked fourth in the world for starting a business.

At least the U.S. is still in the top ten for most of these rankings. Although... did the World Bank include a metric for major financial institutions going bankrupt or needing government bailouts on a weekly basis?