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The latest proposal put out by the Treasury with the Fed's blessing really makes you question whether they understand the real problems plaguing the U.S. financial system: undercapitalization of commercial banks, trillions of loans outstanding and an inability of both households and corporations to afford the debts they have subscribed to. If the government adopts the plan and buys the assets for anything close to current market prices, the banks will still be undercapitalized, people still will not be able to afford their payments, and credit contraction, along with plummeting confidence in the financial system, will continue spreading.

The only way for the plan to have any impact is for the Treasury to buy the assets at enormous premiums. "Hey Citi (C), you know those CDOs that you have marked at 50 cents on the dollar and Merrill (MER) recently sold at 20 cents? Well, we'll buy them for three dollars". I'm sure taxpayers would be thrilled with that strategy.

Why are banks currently unwilling to lend money to people and to each other? Because they have very weak capital positions, believe every other bank is in a weak position, and perceive consumer lending as much more risky than before. Look at Bank of America's (BAC) balance sheet. It has $1.7 trillion of assets, and only $84B in tangible book value (difference between "real" assets and liabilities).

Analysts estimate that the bank may sustain $60B+ in losses on its loan portfolio over the next three years, which will make it fall below its regulatory capital requirement by $5B+ (taking into account profits that the company is expected to generate, which are by no means guaranteed).

Given the thin margin of error on its capital position, Bank of America is unwilling to underwrite any more loans that it perceives as risky. And this is the largest bank in the country! Imagine how much worse the positions of smaller banks are.

How does the current proposal help? Assume that the Secretary is right, and a lot of the illiquid securities are currently trading at prices below their intrinsic value – an assumption that some would argue against. For Bank of America, securities that may be purchased by the Treasury are: $8.4B in residential mortgage securities, $10.2B in leverage loans and $2.2B in monoline securities (insured by financial guarantors). That's a total of $20B.

The bank has taken some marks against those, and let us assume generously, that the Treasury buys those securities at a 10% premium to their current value on the books. But that's only a $2B addition to Bank of America's book value, which will barely do anything to improve its capital!

In addition to $20B of securities, Bank of America also holds one trillion in loans that it has made out to businesses and consumers. This is where analysts expect the $60B+ of losses to occur.

However, the bank will not be willing to sell its non-securitized loans because according to regulation it can keep marking down its loan portfolio gradually, while in case of a sale it will take down an instantaneous hit by marking down the portfolio by the total expected loss. Not to mention that Treasury's $700B will simply be not enough to buy the loans of Bank of America alone.

The impact of the Treasury's proposal is larger if we look at other top banks, but not by much -  Citigroup has ~$80B of similar securities exposure, and JPMorgan Chase (JPM) has ~$30B. So the biggest beneficiary would be Citi, the bank that pursued the most reckless practices. Even then, however, Citigroup's gain is at best under $10B – which is an insufficient improvement to its capital.

So why does purchasing these risky securities help the banks relatively little? Two reasons:
1) Because they are not the ones holding most of them! OECD estimates that there is about $3,000bn invested in collateralized debt obligations (CDOs – the most impaired security type in the current market) of which hedge funds have $1,400bn of exposure, banks $750bn, asset managers $565bn and insurers $300bn. And among the "banks" are included many foreign banks.

FDIC states that U.S. banks hold $1.1TR of mortgage-securities, while the total number outstanding is $5.3TR (according to IMF Financial Stability report). That means that the people who stand to benefit the most from asset purchases are hedge funds, which have little role in improving lending conditions for our economy, while the banks will remain in the dire capital hole they were in before.

2) Because most of the losses that will be incurred are not on the subprime securities of which there are only $1.5-1.8TR outstanding according to the IMF (and assuming 20% losses, that means $300B in losses, most of which have already been written off by the banks), but on $20TR of non-subprime mortgages and corporate loans/debt, which even assuming an optimistic 5% cumulative losses leads to $1TR in credit losses. The Treasury's puny $700B budget can't even put a dent in the market for these assets.

So what is to be done? Two steps that were used very successfully seventy five years ago:

A)  Creation of an institution similar to the Reconstruction Finance Corporation that invested in the preferred stock of financial institutions. A new version would buy preferred shares in U.S. banks, thus improving their capital cushions, increasing confidence in the banking system and allowing lending to resume.

As for the size of the fund, a sufficient investment in our previous example, Bank of America, might be $30B, and given that Bank of America accounts for ~10% of total U.S. deposits, a $300-400B overall investment would be enough to cover the entire U.S. banking system.

That $300-400B will go much further than the $700B Paulson is proposing, and instead of the US taxpayers owning toxic assets of uncertain value, they would own a stake in actual viable institutions. Existing shareholders will be punished through a dilution of their stakes, and the government could exercise direct control over the pay packages of executives that contributed to this dire situation

B) Creation of an institution similar to the Home Owners' Loan Corporation that can purchase individual loans from the banks at a discount and restructure those loans before homeowners file for bankruptcy, by reducing the mortgage payments and overall mortgage value. While some families will still file for bankruptcy, this institution can reduce the number of foreclosures (that is expected to be upwards of 6 million over the next several years), keep the families in their homes and prevent further declines in house prices as millions of foreclosed properties hit the market.

The financial situation is difficult, and we have to act quickly, but we cannot allow the Treasury to scare us into a plan that will only compound this country's troubles in the long run.

Disclosure: None

Source: Do Paulson and Bernanke Really Understand What's Going On?