Time to End Government Dickering Before It's Too Late

The past few weeks have yielded some very strange behaviors, some of which reflect a lack of understanding of what needs to be accomplished while others display the sheer fear and panic felt by many in the financial markets. This will make for good entertainment at some point in the future, though right now there is nothing funny about the recent turn of events. 

Here are just a few items that raised eyebrows, though why they happened is perfectly understandable in light of the current financial crisis.

1. Treasury Secretary Paulson argues for the need to pay above-market prices for illiquid assets
2. The SEC proposes relaxing FAS 157 (mark-to-market accounting rules)
3. The SEC's selective ban on short selling
4. GE sells $3 billion in 10% preferred stock plus warrants to Berkshire Hathaway
5. 2-year swap spreads exceed 160 bps

Paulson and mark-to-market: I understand the arguments for why Secretary Paulson, and many others in Congress, think the only way to save the banks is to buy their illiquid inventories and carrying value: there is no true "market" for their asset portfolios. Dramatic write-downs arising from sales at "market" relative to carrying value would render them insolvent.

This gives the U.S. Government the ability to pay arbitrary prices for the illiquid assets as they are the only game in town, etc. I understand the arguments: I just find them specious.

As I've stated previously, it has to be a two-part plan:

Step 1: Buy busted asset portfolios at market. The U.S. Government is only one bidder. If they come up with prices that are too low, private equity firms, distressed hedge funds with long lock-ups and sovereign wealth funds will come in and bid.

There is over a trillion dollars of liquidity on the sidelines, easy, plenty to create a rich market in illiquid assets with intrinsic value if they can be held for an extended period. The U.S. Government is only one potential bidder; the others keep them honest and create a true market.

Step 2: Determine what the seller's capital gap is, after the asset sale. Here the U.S. Government will buy either debt + warrants or a variant that provides the regulatory capital necessary to bring the bank into compliance, and provides the U.S. taxpayer with a senior claim and equity upside when the market stabilizes.

I really don't get why Paulson and his buddies are at odds with me on this. I think what I am proposing is pretty straightforward and fair. Then again, this is why the issue made my top 5 list of eyebrow-raisers.

SEC and FAS 157: This is related to the points above. What is to be gained by more hiding-the-ball and providing other avenues for obfuscating reality? Have we not yet learned that transparency has to be the guiding principle of all aspects of the recovery?

The fact that this is still up for debate is why the market craters even after the Senate resoundingly passed the bill. There is such a profound lack of trust in the markets that nobody believes any company's numbers any more, particularly those that are either in or related to financial services.

A market can't function this way, and the SEC's step to provide even more latitude for financial reporting is an incomprehensibly stupid move when financial service companies, mutual funds, money market funds and the markets overall are on trial.

Transparency and clarity has to be Job #1 -- let investors make their own determinations as to what is short-term impairment and what is permanent. But when you guard access to this information, investors will vote with their feet, and the vote will invariably be to run away. Fast.

Short selling is evil?: The notion that short-sellers are at the root of the decline in financial services share prices is a bunch of bull. Those in the market who aren't also media personalities or have an axe to grind know that.

For politicians, however, it is a great photo op: "Damn those hedge funds and short-sellers; they are screwing the American people." This could not be further from the truth. In fact, by virtue of the SEC changing the rules of the game in the middle, they have essentially screwed, yes, the American people.

Let's think about this... Who dominates the investment in hedge funds? Wealthy individuals? Nope, not any more; it's pension funds and endowments. And who are these funds and endowments? They invest money on behalf of lots of ordinary people and institutions that are important to such people, like those who depend on their companies' pension plans to provide for their retirement and resources for the colleges to which they might want to send their children.

Bashing hedge funds, even if justified (which it is not in this case), really hurts the average American first and foremost, not the rich people for whom a sharp drop in value is annoying but not life-changing. So pandering politicians, short-sighted members of the SEC and Congressional idiots, WAKE UP! Because once your constituencies do, they are going to be really, really pi%&ed off.

GE's stock sale: So this is what it has come to -- General Electric (GE), a AAA-rated corporate, sells $3 billion of preferred stock yielding 10% , plus receives a $3 billion notional, 5-year warrant struck at today's preferred sale price. Oh, and this is in conjunction with a $12 billion common stock sale which further bolsters the security of Berkshire's (BRK.A) investment.

The IRR of Mr. Buffett's piece of paper is mind-boggling. It is almost as if he got shares in a AAA-rated company for a BB price. What this purchase says to me is less about Mr. Buffett's confidence in GE, or that the market is turning, but more about the unvarnished fear and panic GE is feeling to have agreed to such a transaction.

Does GE really perceive themselves to be AAA if they are motivated to raise money on the terms proposed by Mr. Buffett? Something is grossly wrong with this picture.

Either GE is stupid (doubtful), they think having Mr. Buffett associated with GE will be helpful for market perception (sure, but how much is this really worth?), or they are scared out of their minds by the uncertainty of today's and tomorrow's financial landscape (ding ding ding ding!).

This is one of the most disturbing deals I've seen announced in a long time, because it shows just how scared one of the best and most diversified global corporations feels right now. And they are feeling pretty, pretty bad.

2-year swap spreads: I remember the days when these were in the 20s. Now they are in the 160s. From an implied AA-rated bank credit to probably an implied BB/BBB.

The fear and paranoia evidenced by GE is clearly resident among those in the dealer community. Nobody wants to lend to anybody. Everybody is suspicious of everybody else. Nobody is truly safe.

This does not bode well for commerce, because if the banking system lacks the basic elements of trust it is hard to get business done. Money flows grind to a halt. Lending ceases. Banks hoard cash like they are protecting against a bank run. This is the point we are rapidly approaching.

The 2-year swap rate is generally a good indicator of two things: Fed Funds policy or bank stability. Clearly the Fed isn't in a tightening mode, so virtually all of the aberration in the swap rate is due to the spread, a sad comment on how banks perceive each other right now. And as I am writing this, I don't see a clear path to the spread coming in any time soon.

I find it hard to believe that things have reached this point but they have. A generation's worth of restructuring an industry in two weeks.

Bulge bracket investment banking is dead. Thousands of other banks are on death watch. Lending has come to a screeching halt.

But as it was in the 1930s, the U.S. Government is making some very, very poor decisions, and the market is speaking out. We need to get a deal done - now - but we absolutely need transparency, we need a clear and unwavering set of rules for financial market participants that don't change at the whim of the SEC, we need to create a competitive market for distressed assets and we need to address those who are creditworthy with badly structured mortgages.

This is a big job but a doable job, and it requires bipartisan support with a minimum of BS. And if our current leaders can't do it, let's get some people who can. Because we, the GLOBAL WE, can't take much more dickering around before it is too late.

Comments

[apppro:]

And let's add the following - paying SPECIAL attention to #4:
1. Reinstating the Up-tick rule,

2. Cracking down on naked shorting,

3. Instituting some rules on what should be said on National TV,

4. Pass a Wind-Fall Capital Gains Tax of 65% on ALL short sales retroactive to 01/01/08.

5. Aid to the banks during the transition back to normality,

6. Refinance the monoline insurers with funds, so that roads can get built.. schools can be funded.. bridges will be repaired.. Etc.

7. Give money to municipalities to build.. build.. build.

8. Hold oil under $100.00 while building a natural gas infrastructure for autos. Drill.. Drill.. Drill.

9. Put back rules and regulations on short selling that have been around since the 1930’s.

10. Eliminate 'mark to market', and

11. Have the rating agencies come up with ONE set of rules and stick to them.

12. Increase the FDIC insurance for banks to give people confidence that their money is safe.

13. Set up a separate fund to lend directly to people and companies with urgent requirements, so things will get bought at the retail level - NOW and not 12 months down the road.

14. Time to heal with some reasonable behavior by market participants during this process. It’s not going to happen overnight.

2008 Oct 03 07:13 AM

[Smarty_Pants:]

Best article I have read in quite some time. Your comments and suggestions make sense, which is why, sadly, they will never happen.

Your plan for buying at market then purchasing ownership to re-liquidate is the only economically sensible one I've heard. I would still be against it for the sole reason that it is subsidizing amoral behavior on the part of those who used insane leverage, kept any short term profits, and then lost the store when everything went bad, who now seek the taxpayer's aid to bail them out. They deserve to fail spectacularly and provide a shining example for future decision makers on how NOT to run a bank. Yes, this will cause widespread pain but we are past the point where that can be avoided. At this point we are simply trying to decide who will feel the pain most sharply or trying to spread the pain around as far as possible so it only hurts a little for everyone for a long time.

The reason why "Paulson and his buddies are at odds with me" is that they don't wish to be held accountable for their mistakes. They robbed their shareholders with the 'leverage and gamble' strategy to the tune of mega-millions in salaries, stock options, and bonuses. Now they wish to dump the problems they have created on the taxpayer and walk away, keeping their bonuses for themselves. What they deserve is a raft of civil and criminal lawsuits leaving them destitute and wearing orange jumpsuits for the destruction they have wrought with their actions.

Comment #1 by apppro (above) apparently believes that you can 'force' things back to normal by taking money from those prudent enough to keep it and/or preventing the "bad" outcomes by forbidding free market activities. Maybe he wishes to revisit the 1930s because that's where those kind of policies will take us, as we shall see soon enough.

2008 Oct 03 10:00 AM

[Jackson Cash:]

appro, I wish I could take you seriously. Though your points address many investing particulars, it says nothing about the roots of the problem to our economy.

All your illegal aliens will be building your municipalities. Not closing the borders will continue to put downward pressure on wages (and continue to promote the lack of transparency).

Drill, drill, drill speaks for itself - though I am a Republican, this is nothing but absurd rhetoric, that does nothing for the next five years... WE NEED REFINERIES!!

Separate fund for "urgent requirements"?? What the hell is that, another game to be played?? The problem is regulation (or lack of) with banks. Here's why:

If I am a bank and I make money the "old fashioned way", I lend. If I want to drive the price up I manipulate lending. In other words, I simply don't lend, which restricts liquidity to an economy addicted out of it's means. No transparency, no accountability. There is no mention of saving in your points, and sadly, that is the easiest means to combat liquidity problems associated with our addiction to banks.

... I can keep going.

2008 Oct 03 10:07 AM

[Pent up demand:]

apppro, you cannot do most of the things you listed by simple fiat. A "windfall" tax on short-sellers? So when traders are wrong they get to eat the loss, but when they're right, the government takes the proceeds? I don't care to live in that country, thank you very much.

Your program amounts to fixing the rules of the game, massive government spending "stimulus", confiscatory taxes, restrictions on speech, and more government agencies. News flash: none of those ideas are new.

2008 Oct 03 10:07 AM

[John Pseudonym:]

4. Pass a Wind-Fall Capital Gains Tax of 65% on ALL short sales retroactive to 01/01/08.

I'll vote for that IF you also institute a 65% Wind-Fall Capital Loss rebate.

If I go short and lose money, then I want 65% of my money back.

Now that's a plan I can support!

2008 Oct 03 10:48 AM

[asteroids:]

Prediction: The "shorts" go back to work. The market
has a very very bad day. Then, it gets worse....

2008 Oct 03 11:18 AM

[bobomite:]

Our economy is based on debt, we have chosen to create moeny this way since 1913. The money to pay the interest on the debt is not created.

This "rescue" bill is nothing more than another step downwards into a debt spiral.

Until money is created at source without debt, there will be no way out of this cycle.

2008 Oct 03 11:26 AM

[kashirin:]

Let's see...

1. Reinstating the Up-tick rule,

uptick rule was in order when Nasdaq tumbled 80%. How will it help now? the answer it won't help. only idiots think uptick rule can change anything

4. Pass a Wind-Fall Capital Gains Tax of 65% on ALL short sales retroactive to 01/01/08.

Very interesting, retroactive rules to kill this already manipulated market and remove remaining liquidity?
You want Dow under 1000? Or you want only insiders trade?

6. Refinance the monoline insurers with funds, so that roads can get built.. schools can be funded.. bridges will be repaired.. Etc.

yeah, print money

7. Give money to municipalities to build.. build.. build.

yeah, print even more money, hello hyperinflation

8. Hold oil under $100.00 while building a natural gas infrastructure for autos. Drill.. Drill.. Drill.

yeah, close nymex and declare 100 oil, price control - so new
in the mean time sell 5 gallon per person per month

9. Put back rules and regulations on short selling that have been around since the 1930’s.

yeah, and let markets go down 90% as it happened in 1930s

10. Eliminate 'mark to market', and

yeah, why do we need any transparency, let just wait for next outcry how they need 5 trillion this time. till that time let's pretend all is good

2008 Oct 03 11:43 AM

[muley101:]

Plan B: The Mortgage Investment Bill
for Reviving the Economy

by Stan Muse

The Federal Reserve is out of Federal Funds rate options and now the Congress is about to pass legislation which will be the largest bailout bill in the history of the world. Fannie Mae and Freddie Mac are now penny stocks with perhaps over 1000 bank failures yet to come. The American taxpayer will be told that they and their children will be writing big checks to rescue the Wall Street crooks and congressmen that caused all the problems, while receiving nothing in return.

Anyone who has been following recent congressional hearings knows by now that this is unacceptable to Main Street, the voters who will be firing their congressmen for turning the USA into a socialist country. It is also widely believed that this bailout bill may not be embraced by Wall Street because of its onerous terms even if passed. Finally, it will not provide sufficient liquidity for improving the rest of the economy.

A much more effective and fairer way to end our economic crisis is easily attainable. To state it simply, all Congress has to do is to pass a Mortgage Investment bill which allows individuals a one-time option to use some of the funds in their IRAs to pay off their mortgage balance in full, without any penalty, interest, or taxes for doing so. In return, individuals choosing to exercise this option give up their mortgage interest tax deduction for life. This bill could be passed quickly and independently of any other economy-related legislation currently being debated, or included in the current bill. Individuals choosing this option would need sufficient IRA funds to pay mortgage balance in full. The actual payment to the individual’s mortgage company would be done by the IRA managing institution to avoid fraud.

As one senator recently stated, ‘for most people their home is their IRA’. For many others, their 401-K plans hold many trillions of dollars, much of which by now is parked in money market funds or T-bills as mine is. If these IRA funds could be released to pay off mortgages, we could possibly avert, or at least significantly shorten, the economic recession we now find ourselves in. In fact, no other bailout legislation may even be necessary, although more regulatory legislation is certainly needed.

I asked Allan Meltzer, Arthur Segel, and Ellen Zentner to review this proposal and received some positive responses. Ellen said it seemed to be fool-proof and better than a reverse mortgage. In fact, it is a no-brainer for the homeowner with a large 401-K balance, and for the government. The only people who might object, as Ellen stated, are the bankers who want to keep homeowners dependant on them, especially those in the upper-income group. But even the bankers can not want the government to own a large stake in their business for a multitude of reasons.

It makes sense to allow people to use their IRA money, which they earned, to invest in the best and safest investment they could ever make, their home. Presumably they will need a place to live in retirement on a fixed income. It makes no sense for someone with more than enough IRA funds to cover their mortgage balance to loose their home because they lost their job and can not pay their mortgage. It also makes sense because it is not some form of government bailout which rewards the bad behavior of mortgage companies and unqualified borrowers. Instead, it rewards the good behavior of those who have saved and invested in the economy

If only 5 million people chose this option, for an average of only $200,000 each, the result would be $1 Trillion in paid-off mortgages, providing liquidity to the mortgage industry. By executing the option, an individual’s annual mortgage payment would become disposable income to put back into the economy or back into IRA accounts. To the individual, the effect is the same as lowering taxes. If only 5 Million people were able to put back $20,000 per year into the economy, the result would be a $100 Billion per year stimulus package for many years to come.

In my case, with $800K in IRAs and a secure pension, I would increase disposable income by $1600 per month while reducing the IRA balance by only $160K, but saving over $120K in future interest payments. I could retire, which I can not afford to now, and leave my six figure job to someone else. I could also quickly replenish the IRA money used to pay off my mortgage with the extra income.

Adding a further provision to delay receiving Social Security payments for a year in order to exercise the option would be a baby step towards privatization of Social Security. Anyone financially able to exercise the option should be able to delay the payments. For every 5 million people choosing the option, approximately $100 Billion would remain in the Social Security fund. This could fix our problems with Social Security for good.

Some of the benefits of this plan would be to:

• Immediately increase an individual’s or married couple’s disposable income by tens of thousands of dollars each year while enabling them to become debt free, helping families to stay together
• Save homeowners hundreds of thousands of dollars in mortgage interest payments
• Encourage individual IRA savings by many who have never saved
• Allow many people to retire earlier than they otherwise could
• Create demand for housing, reducing inventory, and stopping the decline in home prices
• Stimulate the overall economy, creating and saving jobs
• Not cost the government anything, and actually Increase federal, state, and local tax revenues by eliminating individual mortgage interest tax deductions, without raising tax rates
• Force the banks to sell their good loan assets to cover their bad loan losses, instead of forcing the taxpayer to buy their worst loans, and increase liquidity for new loans to those who need them
• Allow the free market economy to work through the crisis rather than resorting to socialism
• Not increase the national debt nor the money supply as a bailout would do and contribute to inflation
• Allow the individual home owner to the freedom to become their own banker with the money they earn, reducing America’s dependence on bankers, and changing America from renters and borrowers to homeowners and savers


The merits of this simple plan, the Mortgage Investment bill, for saving the economy, instead of trillions of dollars for a Wall Street bailout which will socialize the finance industry, are obvious and would benefit everyone involved. The individual gets more disposable income and a chance to live debt free, the capital markets get needed liquidity, the government collects more taxes and collects them sooner at the expense of the bankers, the housing market gets more demand, and the general economy gets a much needed boost for the next few years.

Democrats should like this plan because they can claim that it lets the wealthy pay for this mess. Republicans should like it because it increases disposable income, which has the same effect the same lowering taxes. The average voter should like it because it addresses all segments of the economy with a huge economic stimulus package, not just Wall Street, and costs nothing while helping to pay off the national debt and potentially fixing Social Security.

2008 Oct 03 12:21 PM

[carey_jim:]

To the Speaker of the House of Representatives and the President pro tempore of the Senate:

As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:

1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.

2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.

3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, America's dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.

2008 Oct 04 05:53 PM

[carey_jim:]

For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come.


Signed (updated at 9/27/2008 6:00PM CT)

Acemoglu Daron (Massachussets Institute of Technology)
Ackerberg Daniel (UCLA)
Adler Michael (Columbia University)
Admati Anat R. (Stanford University)
Ales Laurence (Carnegie Mellon University)
Alexis Marcus (Northwestern University)
Alvarez Fernando (University of Chicago)
Andersen Torben (Northwestern University)
Baliga Sandeep (Northwestern University)
Banerjee Abhijit V. (Massachussets Institute of Technology)
Barankay Iwan (University of Pennsylvania)
Barry Brian (University of Chicago)
Bartkus James R. (Xavier University of Louisiana)
Becker Charles M. (Duke University)
Becker Robert A. (Indiana University)
Beim David (Columbia University)
Berk Jonathan (Stanford University)
Bisin Alberto (New York University)
Bittlingmayer George (University of Kansas)
Blank Emily (Howard University)
Boldrin Michele (Washington University)
Bollinger, Christopher R. (University of Kentucky)
Bossi, Luca (University of Miami)
Brooks Taggert J. (University of Wisconsin)
Brynjolfsson Erik (Massachusetts Institute of Technology)
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Cabral Luis (New York University)
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Carmel Jonathan (University of Michigan)
Carroll Christopher (Johns Hopkins University)
Cassar Gavin (University of Pennsylvania)
Chaney Thomas (University of Chicago)
Chari Varadarajan V. (University of Minnesota)
Chauvin Keith W. (University of Kansas)
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Christiano Lawrence J. (Northwestern University)
Clementi, Gian Luca (New York University)
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Fox Jeremy T. (University of Chicago)
Frank Murray Z.(University of Minnesota)
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Hart Oliver (Harvard University)
Hazlett Thomas W. (George Mason University)
Heaton John (University of Chicago)
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Jaffee Dwight M. (UC Berkeley)
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Jones Charles M. (Columbia Business School)
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Keim Donald B (University of Pennsylvania)
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Levine David I.(UC Berkeley)
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Levy David M. (George Mason University)
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Lucas Robert (University of Chicago - Nobel Laureate)
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Martin Ian (Stanford University)
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Walker Douglas O. (Regent University)
Walker, Todd (Indiana University)
Weill Pierre-Olivier (UCLA)
Williamson Samuel H. (Miami University)
Witte Mark (Northwestern University)
Wolfenzon, Daniel (Columbia University)
Wolfers Justin (University of Pennsylvania)
Woutersen Tiemen (Johns Hopkins University)
Wu Yangru (Rutgers University)
Yue Vivian Z. (New York University)
Zingales Luigi (University of Chicago)
Zitzewitz Eric (Dartmouth College)

2008 Oct 04 05:53 PM