What's Wrong with the Trickle-Down Bailout?

Federal Reserve Chairman Bernanke and Treasury Secretary Paulson have proposed what they say is a comprehensive bailout plan that promises to restore the US financial system to health.

A key component of their plan is to overpay for US banking assets with hopes that down the road, time will bail us out when the crisis passes and the assets again re-appreciate to their "true value."

Unfortunately time is not likely to bail out the taxpayer as numerous facts make taxpayer losses almost certain:

1. Some of the debt to be purchased comes due in the short term and absent a US government guarantee for full repayment, no rational investors will roll their debt for another term. They will demand immediate and full repayment. If the Government provides the demanded guarantee in exchange for loan renewals then they will book a certain loss on those loans thereby insuring a taxpayer loss.
2. The financial system is leveraged-up on excess liabilities consisting of inflated home loans to be repaid by compromised final payers. The Treasury's proposal does not backstop the consumer; it instead burdens them further with socialized losses to be paid in taxes.
3. The Treasury plan requires overpayment by the government to limit losses at the banks. The debt will require debt service along the way including insurance premiums payments for the toxic credit default swap derivative contracts. Moreover, according to the Treasury plan, private firms will be compensated for managing the bad debt and these fees will additionally reduce the final proceeds recovered.
4. This $1.1 trillion bailout ($400 billion for the FDIC and $700 billion for debt purchase bailout) pushes the Federal Deficit to more than $11 trillion and does not include the cost of Fannie Mae (FNM) and Freddie Mac (FRE) who reportedly have $5 trillion in guaranteed mortgages on the books. This bailout plan additionally does not include any losses festering at sister Ginnie Mae that solely guaranteed sub-prime and low income mortgages.
5. Sovereign governments like China and Russia, as well as Japan and the UK, finance the US government's burgeoning deficit spending. No doubt they are demanding to be made whole from the sidelines. How will China and Russia without a US banking presence offload their loans? Is there a covert plan to have Goldman Sachs (GS) and Morgan Stanley (MS) handle their accounts? At risk in not complying to make them whole are our trade agreements and foreign policy initiatives from some less than friendly nations who undoubtedly will want to be paid back without losing a dime.
6. Democrats, rightfully so, have demanded changes to protect the US taxpayer. Among these is a plan, according to House Financial Service Chairman Barney Frank, to either amend the bankruptcy court's power to reduce mortgage principal values or to do so later, once the government has purchased the debt. Either way the $700 billion bailout is unlikely to make a profit.

The point is that this plan is not comprehensive in that it does not address the inevitable current problems nor does it appropriate enough money.

One gets the impression that the Administration is pursuing a policy of gradualism both secretly hoping things get better on their own while desiring not to make their legacy any worse. But this is not being pro-active and it is certainly no way to run the country let alone to re-instill faith in the US financial system. The problem is that Congress seems likewise content playing along to get past the elections rather than offering a comprehensive solution. The irony here is that in a warped and twisted sort of way, this must be their idea of a bi-partisanship effort. Pay lip service to the public and tell them only what they need to know.

Stock position: Long XLF.

Comments

[Lex Luz:]

A well-written article that points to some of the flaws with the current plan, which is clearly tailor-made to punish taxpayers to the greatest extent possible. Frank's demands for bankruptcy cramdowns and for CEO pay reductions are idiotic window dressing designed expressly to distract taxpayers from the theft that is this bailout package.

The fact that the bailout is designed expressly to grossly overpay for the weakest of the toxic bonds cannot be stressed enough. Taxpayers have a hard time understanding that this program won't cost $700 Billion, it will cost well into the trillions, and it is positively guaranteed to enrich the very banks who have made this mess. There are no provisions in this bailout to increase transparency or to facilitate the creation of a marketplace for these assets that would force some meaningful price discovery.

The bailout as constructed is theft, pure and simple. You can bet that Dodd, Frank, and the rest of the Congresspiggies who vote for this trash will profit handsomely from it.

2008 Sep 25 09:05 AM

[pochovilla:]

It depends on the magnitude of the trickle (or drip). Normally I would say give the government a dollar and get 30 cents back. In this case "fella, can you spare a dime" might be optimistic.

2008 Sep 25 10:25 AM

[venividivici:]

Lex there is not hope in this Sodom and Gomorrah market. The market is soaring today in the face of a lot of shocking news and on the expectation that the already hopelessly indebted American governent will take on as much as another $700 billion dollars in debt for these parasitic bankers. Look after yourself mate.

2008 Sep 25 11:18 AM

[wcrxlp edit...:]

There are three thousand community banks that are capital starved or near capital starved.

When Wall Street absorbs the $700 billion, Main Street banks will pay dearly to maintain their capital ratios.

It makes more sense to distribute the $700 billion to American community banks so they can lend for local transactions or use it to recapitalize Wall Street.

2008 Sep 26 04:06 PM

[Diegojames:]

Give half the money(bailout) to California so the federal reserve can buy the soon to be 1 million foreclosed homes. Then we can fix them up and sell them to refugees from Darfur, hurricane victims, tornado victims, flood victims, slum residents in New York.
There is no need to rebuild after Katrina or the recent Texas hurricane.

Use the other half to build new nuclear generators, high speed train systems, new hybrid car factories , off shore drilling and solar power stations etc for the new economy and we will have the housing ready for them to buy.
DIEGOjames
Northridge, California

2008 Oct 03 12:58 AM

[Okmrbill:]

Follow the dollar...we will be giving foreign investors their money back...that stinks. Think about it...their loss will be our gain! The leveling effect will help US prosper. I'll gladly take a hit to my 401 if rocks the foreign markets---hadn't they made enough off the US. But this country wants a microwave fix...and they'll pass this wasted bill. Who's going to bail the average "Joe" out.

2008 Oct 03 10:49 AM