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"The creatures outside looked from pig to man, and from man to pig, and from pig to man again; but already it was impossible to say which was which."-- George Orwell, Animal Farm

Watching and listening to the Big Media comment Monday on the press release by the Fed's Board of Governors regarding Morgan Stanley (MS) and Goldman Sachs (GS) becoming bank holding companies, it struck us that very few people outside the risk community really understand the corporate structure of financial firms.

Even Dick Bove, the dean of the sell side bank analyst community, got it wrong, in our view, when he said on CNBC Monday morning that the decision by MS and GS to submit to federal bank regulation would result in "no change" to the business models of these monoline dealers. To give you a hint about why we say this, let us remind you of comment we published last December ("Outlook 2008: Valuation, Attestation, and Litigation" ):

Last summer, around the time that Countrywide Financial CEO Angelo Mozillo was on CNBC telling the Money Honey about going back 'in the bank,' the music stopped in the game of musical chairs that was the market for complex structured assets. Bids evaporated and, now six months later, value is likewise disappearing from balance sheets public and private.

The reason that investors were fleeing firms like Bear Stearns, Lehman (OTC:LEHMQ), MS and GS, is not because they don't already own banks - each, in fact, either owned small FDIC-insured industrial loan companies or private trust companies. But rather the Street was turning away from these firms because they were unwilling to take risk on the entire organization.

When Mozillo proclaimed his intention last summer to go back "in the bank," what he was really saying to Maria Bartiromo is that nobody wanted to do business with his publicly traded parent holding company, the firm now known as Countrywide Financial that is a direct subsidiary of Bank of America (BAC). Countrywide Financial, in turn, is the parent of Countrywide Bank FSB.

Subscribers to The IRA Bank Monitor click here to see the profile for Countrywide Bank FSB. Notice that at the end of Q2 2008, Countrywide Bank sported a rating on The IRA Banking Stress Index of 21.5 vs. the industry average of 1.4, driven largely by the bank's negative ROE. The 275bp of defaults (annualized) puts the bank 2x the industry index for loan defaults of 2.1.

Unlike commercial banks such as BAC, JPMorgan Chase (JPM) and Citigroup (C), broker dealers and even insurance companies such as AIG (AIG) tended to book principal trades and other risk positions in the publicly traded parent and/or other non-bank units. Since the subsidiary banks of GS and MS are very small and the broker-dealer units were, until recently, much more highly leveraged than banks, when the Street began to back away from both firms last week, the only alternative was to get "in the bank" or die a la Bear and Lehman.

Last week, when neither GS nor MS could cut a merger deal with a commercial bank, the only choice was mutation. Thus the expedited application to the Fed's board for conversion of the publicly traded parent holding companies to regulated BHCs. But it is the transformation of the industrial loan companies of MS and GS into national banks that holds the key to understand why such a change was necessary.

In the institutional money markets, counterparties of BHCs always insist on doing business with the lead bank rather than the publicly-listed parent company. The reason for this is very simple as demonstrated by the bankruptcy of Lehman Brothers. Publicly listed shell holding companies can and do die, but the operating units generally are either acquired or resolved via a government receivership. Thus counterparties always prefer - indeed insist - on dealing with the regulated bank, not the thinly capitalized shell holding company, and by so doing are effectively senior to all of the debt holders of the parent company!

If you are trading say interest rate swaps, when you do a deal with C or JPM, the contract specifies the subsidiary bank as counterparty, Citibank NA and JPMorgan Chase Bank NA. By becoming BHCs and, more important, converting their existing non-bank subs into full fledged national bank charters, MS and GS finally have achieved equal footing with the large universal banks - almost a decade after the passage of the Gramm-Leach-Bliley legislation repealing most of the Depression-era Glass Steagall legislation.

As the press reports indicate, GS intends to move several hundred billion dollars worth of business activities and assets into its Goldman Sachs Bank USA bank unit, effectively creating a business model configuration comparable to a money center bank. It is not merely that the age of the independent investment bank is at an end, but further than the banksters are being forced to hide what remains of their principal trading business behind a regulated national bank regulated not by the Fed, but by the Comptroller of the Currency. Today, GS actually owns three FDIC-insured banks:

  • CERT 57485-Goldman Sachs Bank USA SALT LAKE CITY, UT
  • CERT 33124-GOLDMAN SACHS TRUST CO NEW YORK CITY, NY
  • CERT 57337-GOLDMAN SACHS TRUST CO NA NEW YORK, NY

Subscribers to The IRA Bank Monitor may view these institutions by searching for either the names or FDIC certificate numbers shown above.

To get some perspective on the evolution of the last remaining large investment banks into commercial banks, we now turn to Bert Ely, one of the leading experts on banking and finance in the Washington policy community. An accountant by training, Ely has specialized in deposit insurance and banking structure issues since 1981. In 1986, he became an early predictor of the S&L crisis and a taxpayer bailout of the FSLIC. In 1991, he was the first person to correctly predict the non crisis in commercial banking. In 1992, he predicted an eventual taxpayer bailout of the Japanese banking system.

While Ely is registered on his own behalf as a lobbyist with respect to financial issues, most of his activities in Washington involve consulting for industry groups and financial institutions of all types on topics ranging from highly specialized regulatory issues to broad economic and financial policy.

The IRA: Bert, you said earlier that you did not care for John Kenneth Galbraith and his description of the causation of the Great Depression. Why?

Ely: While Galbraith was a facile writer, I (and many others) have never considered him to be much of an economist or a particularly perceptive analyst of the causes of the Great Depression or of its banking problems. He never drilled down through visible symptoms and consequences to underlying causes of that economic calamity, the rules of the game, so to speak, such as the gold standard and the bank-branching restrictions and prohibitions of that era.

The IRA: True. Like many of the revisionist writers of the post-Depression era, he focused on the greed and stupidity of the personalities rather than the economic factors that made them behave so badly. People are more fun to write about than issues and Galbraith admits this in his book, The Great Crash. But speaking as someone who writes, Galbraith was far more than merely a facile writer or people would not still be attacking him. He is also one of the few two-time winners of the Presidential Medal of Freedom. We confess to being biased in favor of The Great Crash because The IRA editor Chris Whalen owns most of the classic revisionist books in the bibliography. But speaking of great depressions, what is your reaction to the latest "emergency" plan from Treasury Secretary Hank Paulson?

Ely: I am highly skeptical of the workability of the Paulson plan, largely because I worry that the hooks and conditions Congress will plug into it, such as limits on executive compensation and equity participation in the institutions which participate in the program, will discourage many institutions from participating in it. It will be too expensive to play, particularly if Treasury tries to low-ball its pricing for the assets it is willing to buy. Merely offering low prices also will have serious mark-to-market impacts on all balance sheets, which could be a major negative of this program.

The IRA: Agreed, the crisis is almost over, but now Paulson is riding belatedly to the rescue. [Readers click here to see the comment by William Grieder in The Nation FYI.] But isn't it right for the government to at least support commercial banks? Aren't all commercial banks just competitive GSEs, as Alex Pollock said in our interview earlier this year ['Conflicted Agents and Platonic Guardians: Interview with Alex Pollock', May 13, 2008]?

Ely: While it pains me to say this, I differ with my good friend Alex Pollock's assertion that commercial banks are GSEs. The key reason why banks are not GSEs is that banks are on the hook, though deposit-insurance premium assessments, for insolvency losses in failed banks while taxpayers are directly on the hook for any insolvency losses the GSEs incur. Consequently, GSEs have been the beneficiary of a direct taxpayer subsidy (including explicit tax breaks the banks do not get) while badly run banks are subsidized by well-run banks through mispriced deposit insurance premiums.

The IRA: Agreed on the subsidy by the good of the bad, much like the rest of the US economy. So no role for the government in protecting bank deposits? Many of our over-protected citizens would not be ready to deal with such a strict regime. And if our internal estimates at IRA are correct about the magnitude of the losses facing the industry, then the banks may not have the resources to deal with the problems alone. What then?

Ely: That is of course the trillion dollar question. I have run the numbers looking at the capacity of the industry to pay the tab. Assuming that bank insolvency losses don't get way out of line, which I don't think they will, then the industry can handle it. It's not going to be cheap, but the banks can handle it and clean up their own mess. The losses will feed back through the industry to depositors and borrowers in the form of lower rates on deposits and higher cost of loans.

The IRA: A few months ago, we published a summary of a bank RAROC study we did for one of the big four accounting firms. We looked at real returns for the top 100 banks by assets over 20 years. The results suggest that the banking industry got less and less profitable in real, risk-adjusted terms even as "innovation" was embraced ['Talking About RAROC: Is "Financial Innovation" Good for Bank Profitability?', June 10, 2008]. This suggests to us, at least, that the twenty-plus percent equity returns of the past half decade were an anomaly and that the industry is really collapsing onto a utility type model. How can the banks afford to self-insure with above normal loss rates and sub-normal returns, nominal or otherwise?

Ely: I am going to disagree with you on that. They may become a utility-type model - I don't buy that argument today, but I will concede that it could happen - but that just means that the self-insurance becomes part of the cost structure. What may then happen is that competitive pressures will affect bank market share. I don't see trending towards a utility-type model as a justification to let the banks off the hook to support the deposit insurance fund. Higher premiums may result in lower growth, but I don't believe in subsidies.

The IRA: Nor do we, but if the profits are not there then self-insurance is not viable. To that point, how is your analysis affected if the Treasury starts to guarantee money market mutual funds? That seems to us to be an open declaration of war against the banks by Wall Street. Do you agree?

Ely: I can't speak for the banking industry, but once the Reserve Primary Fund "broke the buck," a rescue of the money-market mutual funds (MMMFs) became a systemic necessity. However, I am extremely concerned about the longer term implications of this rescue. I have long viewed the MMMFs as an arbitrage of bank regulatory capital standards once Regulation Q was no longer a justification of the MMMFs. The banking industry is right to be extremely concerned about the competitive implications of MMMFs operating with a government guarantee, no capital requirements, and no upper limit on the amount of "shares " protected by this new scheme. Also, I doubt if this protection for the MMMFs will end a year from now. What to do about the MMMFs competing against banks funded by insured bank deposits is a major, and as yet unarticulated, challenge facing Congress next year.

The IRA: Indeed, today's money market funds look an awful lot like the unregulated investment trusts like Shenandoah and Blue Ridge floated by GS in the summer of 1929 that Galbraith describes so beautifully in The Great Crash. So how do you feel about the proposal by Paulson to bail out money market funds that bought toxic waste? Aren't the investors in these funds supposed to read the prospectus? After all, money market funds are unregulated and are supposed to be riskier and offer better returns that bank deposits. Don't you think investors should be responsible for their asset allocation choices?

Ely: Yes, for the reasons already stated.

The IRA: But doesn't the reaction to this crisis by a nominally Republican administration suggest that America is not the democratic, free market society we all pretend? The Paulson plan would leave the US government as the largest owner of banks and illiquid assets in the country. Does no one in the Bush administration and the Congress care about what happens beyond the next five minutes? Caps on executive compensation will be only the beginning of a process that will lead to wage and price controls as inflation rises. If this idiocy by the Democrats in Congress continues, we're going to start referring to House Financial Services Committee Chairman Barney Frank (D-MA) as "Napoleon" after the pig in Animal Farm.

Ely: While it is true that we live in a largely socialized economy, the answer to that problem is not to move towards even greater socialization, but to begin de-socializing the banking sector by getting rid of the GSEs while utilizing the cross-guarantee concept to privatize bank safety-and-soundness regulation, which will function much better than the present arrangement -- a government regulatory monopoly whose product-warranty costs (bank insolvency losses paid for through deposit insurance premiums) are paid for by well-run banks. To put this another way, well-run banks are at the mercy of the government bureaucrats at the bank regulatory agencies.

The IRA: True, but how do we move the country away from a statist, explicitly socialist model a la the EU if Americans are unwilling to take any pain as a result of poor investment decisions by banks, dealers and funds? Neither party seems willing to see even a mild economic recession for fear of the backlash by the public.

Ely: That is a problem. While it is false that bank deposits are insured by the federal government -- they are insured by the banking industry through the deposit insurance premiums the banks pay, which have no upper limit. Depositor discipline is a farce, for even banking experts, such as you, me, and supposedly the bank regulators, are limited in our ability to judge the condition of a bank by the quality of the call report data to which we have access. Even though the regulators have access to non-public data with which to judge a bank's condition (such as who the bank has lent to and the geographical distribution of its construction lending), they are slow, at best, to properly judge the condition of a bank. Even worse, it increasingly has become a game of FDIC roulette as to whether or not uninsured depositors in a failed bank will be fully protected against loss when a bank fails. The cross-guarantee concept eliminates the need for depositor discipline by fully protecting all deposits against loss, no matter how large the deposit.

The IRA: So like the joint and several liability of the clearing members of an exchange, for example, all banks would cross guarantee each other? Do you think this type of arrangement would address the crisis of confidence visible in the markets?

Ely: Yes, if the cross-guarantee system is properly designed and legislated as design. Rep. Tom Petri (R-WI) introduced cross-guarantee legislation several times in the 1990s. It can readily be reintroduced. Additionally, the FDIC does not need $500 billion of Treasury borrowing authority for the simple reason that in 1991 Congress gave the FDIC the authority to tax banks, without limit, to pay deposit insurance losses. Despite the magnitude of existing regulatory ineptitude, the banking industry has the earnings power to pay the foreseeable cost of bank regulatory failures, specifically the losses arising from the delayed seizure of insolvent and close-to-insolvent banks. Until bank regulation is privatized under the cross-guarantee concept, Congress needs to insist that government-employed bank regulators enforce Prompt Corrective Action, specifically by making banks reserve adequately and timely for expected losses on their bad loans and then to sell those banks which in fact are insolvent or whose owners refuse to adequately capitalize them.

The IRA: So you oppose the idea of the government putting preferred equity into solvent but troubled banks that cannot raise capital on reasonable terms?

Ely: Yes, it is not necessary, even now. There is absolutely no need for the Treasury to have the authority, as you suggested, to "inject capital into solvent banks that are temporarily unable to raise new capital." If a bank truly is solvent, it can raise additional capital or sell itself, if its present owners are realistic about what their bank is worth. The reason solvent banks have a problem raising capital, or selling themselves to a stronger bank, is that they set their price too high, as did AIG. As an aside, I am glad to see AIG's shareholders getting whacked by the warrants associated with the Fed's taxpayer's loan to AIG. There is absolutely no need for the taxpayer to subsidize banks so they can stay independent, provided no barriers are erected to prevent new entrants into bank or specific banking markets.

The IRA: Agreed. We were referring to banks that could not be recapitalized or sold. A sale is obviously the first, best choice. So you would let the banks resolve their problems privately. Would you agree with Ernie Patrikis ['A Change in Bank Control: Interview With Ernest Patrikis', July 9, 2008'] that the Fed needs to loosen the restrictions on bank ownership in order to facilitate this process?

Ely: I fully agree that restrictions limiting investors from taking significant positions in banks should be lifted. Not only is the belief in separating banking from commerce invalid in an open, competitive economy, but we need to get ruthless investors inside troubled banks to get these banks and their bad assets cleaned up and/or sold. That is what should have happened at AIG, but unfortunately did not.

The IRA: Precisely. We want to see the bad assets remain in private hands, not in a government warehouse for toxic waste. But why then should anyone support Paulson's proposal to place these toxic assets in the hands of the government? Chairman Frank seems to want to declare the jubilee and engage in mass loan forgiveness in order to ensure his permanent re-election. Maybe we can just all stay home instead of going to work and Barney Frank will just mail everyone a check.

Ely: Look, all of the fallout we are seeing in the markets today is part of clearing the detritus from the last speculative bubble. The housing bubble has to be allowed to collapse in order to clear the markets. We have a very necessary correction process underway. But this process creates a lot of pain and loss. I don't like that, but we have to clean up the mess and take the pain in order to get the economy back into balance. In collapsing bubbles you have collapsing companies. Japan tried to muddle through and they had a lost decade. I hope we are not going to do that.

The IRA: What about Washington Mutual (WM)? You saw our analysis. Do you agree that something needs to happen in terms of recapitalizing WM?

Ely: I arrive at the same conclusion as you, but with a different methodology. WM is not IndyMac and there is huge franchise value in WM, but that value is eroding rapidly. The WM situation is like a fresh caught fish, not a fine wine. It does not improve with age. Something needs to happen soon.

The IRA: But how does a bank like WM or any other survive when they are being pursued by hordes of rabid hedge funds and credulous journalists? The use of gaming instruments such as credit default swaps has enabled hedge funds to drive banks to the verge of failure, even when there is virtually no trading. The media simply takes the indicative spreads reported by the CDS dealers and treats them as a true indication of probability of default. Paulson has recommended prohibiting short selling of banks, but without limiting such short sales using credit default swaps. How does a bank anywhere in the world survive when credulous, inexperienced members of the media breathlessly report credit default swap spreads as though they actually suggest anything about probability of default?

Ely: Like you, I view short selling as an extension of free speech. This is the world in which we live. There is television and real-time data. There are outlets such as CNBC, Fox and CNN who have air time to fill. I will grant that this is difficult environment for troubled banks but you know, that's the world in which we live and it ain't going away.

The IRA: So what changes should a bank make in its business model to survive in this marketplace?

Ely: That is a very good question. This is one aspect of the information age. It is not just Fox or CNBC at work here. It's the internet. What I can do today in terms of grabbing information, had it been available in the 1980s, might have helped me and other critics get quicker action in resolving the S&L crisis. The technology has changed and we cannot turn back that clock. Ultimately for the industry it will mean much more conservative financing structures.

The IRA: Let me give you another example. We've consulted for some of the Icelandic banks during the past year. During the bear raids on Iceland, which are focused on the banks since the country has no sovereign foreign debt, the depositories in that country have seen huge volatility in their deposits. This has forced them to carefully match assets and liabilities, and maintain far higher cash balances. Today they are essentially impervious to bear raids by hedge funds, but the CDS for these names is still indicated over 1,000bp for some names - and with virtually no risk be written.

Ely: In the information age, with CNBC and so forth, liquidity has become relatively more important.

The IRA: Exactly. Banks, dealers are all being attacked on the liability side of the balance sheet. The losses on assets hurt, but it is the inability to fund themselves in a reliable and stable fashion that is forcing banks like WM to shrink $10 billion per quarter. The peak assets for WM was $350 billion in 2005, but by the end of Q3 2008 the bank will probably drop below $300 billion.

Ely: This also gets to another point that's important, namely maturity mismatches. That is one reason that I am a big proponent of covered bonds. What I see in covered bonds is the potential for a significant on-balance sheet maturity matching. In the case of Fannie (FNM) and Freddie (FRE) they both mismatched horribly and we now see the result of those decisions. [Click here to see the comments by Ely and others at the recent AEI conference on covered bonds.]

The IRA: So what happens going forward for the banks and the independent dealers? Is the "monoline" broker dealer going the way of the dodo bird?

Ely: When you think about it, what the market is doing this year in terms of restructuring the relationship between investment banks and commercial banks is what many people thought Gramm-Leach-Bliley would do but did not, namely bring investment and commercial banking back together. Let me put it this way, let us say that Glass-Steagall had never been enacted or it was repealed in 1935, as Senator Carter Glass (D-VA) proposed. We would not have seen in this country the emergence of large, independent investment banks. You would have always had boutiques out there as we will have in the future, but a Merrill Lynch would have morphed into a deposit taking entity, Morgan Stanley would never have split from JP Morgan Chase and even Goldman Sachs would have probably needed to be affiliated with a bank or gotten into the deposit-taking business. So what is happening this year with amazing rapidity is that an industry with very large balance sheets is being re-absorbed back into the mainstream banking industry.

The IRA: Yes, especially since some of those investment banks like Bear and Lehman decided rather stupidly to get into the real estate business as principal. Isn't that the main point of the Paulson plan, to use taxpayer credit and funds to subsidize this process?

Ely: That appears to be one rationale for the Paulson plan, but we can't escape the fact that a fundamental correction is needed in housing prices, to bring them back in line with personal income, and that that correction unavoidably entails substantial credit losses due to the great extent to which home purchases are financed with debt. That is making this correction so painful is the much greater leverage many homebuyers took on earlier this decade. To put this another way - the increased borrowing to finance home purchases and to tap into home-equity buildups has caused a double-whammy - the bubble inflated further than it would have had more conservative mortgage-lending standards been in place and the credit losses caused by the deflating bubble are much worse as a result. Obviously Bear and Lehman and their ilk fed this very unhealthy credit expansion through their mortgage-securitization activities.

The IRA: But that is precisely the point. Why should Washington use taxpayer funds to rescue people who deliberately made bad business decisions?

Ely: This is the question that comes up frequently about Dick Fuld at Lehman and Kerry Killinger at WM. When these guys were contemplating life, did they have any second thoughts, any doubts about these decisions? Did hushed discussions among the top folks in their organizations, with the senior managers and directors, include deliberations such as these or were they too arrogant, too isolated from reality?

The IRA: Well, our research suggests a large number of factors were involved. But we have always believed that the decline in profitability in the cash securities markets pushed all of the non-banks into more risky and opaque asset glasses and derivatives. When they saw the opportunity in structured finance or CDS, the Street lunged headlong for the money. And the sell side dealers orchestrated this activity by lobbying in Washington and at the state level to make the world safe for complex structured assets and OTC derivatives. We can recall our first conversation with Chuck Muckenfuss at Gibson Dunn in 2004 regarding the regulatory efforts to place even modest "guidelines" on the very complex structured assets that Paulson now wants to subsidize with tax dollars ['Complex Structured Assets: Feds Propose New House Rules', May 24, 2004].

Ely: That was part of the lobbying for Glass-Steagall repeal. The joke in Congress was that let's finally repeal Glass-Steagall so that the lobbyists will not be educating their grandchildren on the fruits of lobbying over Glass-Steagall after having educated their kids on Glass-Steagall lobbying. It's all part of the same process. Going back to the piece I wrote for the May 31, 2008 Wall Street Journal, "Let's Try Market-Oriented Market Reform," in which I discussed underlying causes, a lot of what is going on here is in effect a regulatory arbitrage. I first talked about this at a Chicago Fed bank conference in 1991. I put up a chart in which I contrasted the complexity of a structured finance model with a bank. And I asked the question of the audience: which is more efficient? A number of people have called me in recent weeks reminding me of that discussion we had in Chicago The bottom line is that I never bought into the arguments regarding the efficiency of structured finance. It was always an arbitrage of bank capital standards and a poor one at that.

The IRA: Yes and the dealers never bothered to truly perfect the model, in either a business or legal sense of the term. The documentation, diligence and other aspects of securitization deals was often very sloppy - as people trying to restructure this crap are now discovering first hand. The issuer banks did not want to spend the money to make these deals truly credible.

Ely: But even then, even cutting corners on costs, these structures were far less efficient than banks. The one thing I did not see was the huge moral hazard in asset securitization. Most financial specialists I have spoken with did not see it either. This past year has been a real wake up call for this moral hazard angle. The other issue that Alex Pollock and others focus on is the role of the rating agencies in enabling all of this securitization. I still haven't figured out how to fix this problem. No one has figured out how to make the rating agency piece work better. One solution would be to take away their First Amendment protection.

The IRA: Agreed. Joe Mason and IRA's Chris Whalen have an article coming out in GARP Risk Review next month that addresses these issues. There have been some evidentiary rulings in the Southern District of New York that have gone against the ratings firms on the question of journalist vs. investment banker, but no actual rulings on the law or findings of fact.

Ely: If the First Amendment protection is ever stripped away, then the rating agencies will be just as vulnerable to litigation as the accounting firms.

The IRA: That day may have already arrived. Ratings firms are not members of the NASD. They don't have the relative shelter of arbitration and confidential settlement agreements behind which to conceal their dirty laundry. But when a rating agency operates in the primary market they are clearly acting as an adviser. If you are in the room providing advice to an issuer in the context of a primary offering of securities and you are sharing commissions of that offering, then how can a judge make any finding other than that you are an adviser and not journalistically following an issue in the secondary market? The actions of the ratings firms in the primary market are those of an investment adviser, not a journalist. As our friend Sylvain Raines reminds us, you are creating a new corporation and helping the issuer structure that firm's liabilities.

Ely: That is a very important distinction. I had never thought of it that way.

The IRA: Another enabler in creating this mess was the SEC and the Financial Accounting Standards Board. We have been very critical of the FASB and the role they played in bending accounting rules to allow for the expansion of leverage via off-balance sheet financing vehicles and ignoring the inefficiencies you referred to in securitization. But it occurred to us the other day that the FASB actually played an important role in pricking the structured asset bubble by implementing fair value accounting last year. I doubt anyone on the FASB planned this. The politicians and the banksters were unwilling to recognize the risks in Wall Street's securitization model, but the FASB's actions in implementing a fair value rule had the effect of deflating the speculative bubble. Maybe we should thank them!

Ely: They did the right thing for entirely the wrong reasons!

The IRA: So how do you see the regulatory agenda post-November. How does the choice of Barack Obama or John McCain affect the regulatory agenda, especially with Paulson now planning to nationalize much of what remains of the non-bank financial world?

Ely: That is a very important question. November 4 is a major fork in the road and one that I find kind of scary. If there is a Barack Obama (D-IL) presidency, then it is time to bar the door. The Democrats in Congress will be leading the agenda, not the White House. Barney Frank will be running the House Financial Services Committee and Senator Tim Johnson (D-SD) will be heading Senate Banking when Christopher Dodd (D-CT) moves over to Foreign Relations. Barney has a very definite agenda as do many folks on Senate Banking. So you would see a head-strong Congress pulling the Obama Administration in the direction of greater and greater government intervention in the US economy. The leadership on financial services issues would, at least initially, come from Congress.

The IRA: Obama had some good comments about the financial crisis, especially when he said that the Fed should not be given greater regulatory responsibility. But the idea of a self-important little Marxist like Barney Frank setting the regulatory agenda in this country is truly frightening. We know a number of disaffected Republicans who are helping Obama but we wonder if they understand that a vote for Barack Obama gives complete control of US financial regulatory policy to the likes of Barney Frank?

Ely: Yes indeed. On the other hand, if there is a John McCain (R-AZ) Administration, then we would see a lot of push-back from the White House. The Congress will still be hell-bent for re-regulation and putting the GSEs back together again, but at least there would be resistance to some of the more radical tendencies of folks like Barney Frank.

The IRA: How do you see the Paulson plan unfolding? What should the markets expect in the next couple of weeks and months?

Ely: It is likely that Congress will not pass the Paulson bailout legislation this week. However, whenever it is passed, it will be much more complex, and incorporate unwise punitive terms and conditions that will seriously impede the intent of the Paulson plan. Further, I believe the process of pricing the assets purchased under the legislation will be much more complex and contentious than many appreciate at this time, which means that this program will get off to a much slower start than many anticipate, just as the RTC started quite slowly. If the Paulson plan starts slowly, market forces may sweep past the plan. It will be extremely interesting to see how this plan evolves over the next year, particularly given that a new Administration will come to power on January 20.

The IRA: Thanks Bert, we'll leave it there till next time.

Stock position: None.

Source: What is to be Done? An Interview with Bert Ely