Markets to Congress: Bailout -- or blowout
Posted
Sep 29 2008, 04:09 PM
by
Jon Markman
Rating:
Members of Congress shocked the world today by voting down legislation aimed at resolving the U.S. credit crisis, evidently determining that it was far from the comprehensive rescue plan that its promoters claimed and instead was just a handout to fatcats. Investors responded by throwing a fit, punching the Dow Jones Industrials Average down 778 points.
The House move was one part nihilism, one part bluff-calling and one part an expression of total constituent outrage, and only history will be able to judge if representatives' snub of their political leadership will rank among the greatest blunders of all time or a brave move of principle. Both views will have their day in court, for dispassionate analysis of the $700-billion bailout plan reveals that it was in fact deeply flawed -- failing to provide a solution to the big problems that plague the banks while at the same time affronting the deep sense of exasperation among ordinary Americans that they were being asked to pay for the sins of the wealthy. One bank analyst said taxpayer sentiment was not 9-1 against, or 70-1, but rather, "there is no 1."
Putting aside the moral issues, here was the problem with the proposed law:
For the past 15 months, the Federal Reserve has been trying to turn banks' bad mortgage loans into cash by allowing them to turn them in as collateral for Federal loans. With each new program with names like "term auction facility," the Fed has lowered its requirements for the quality of the loans it would take, widened the number of financial institutions eligible for the program, and stretched out the amount of time the institutions could keep the laundered money.
The only change in the new plan -- called the "troubled asset recovery program," or TARP -- is that the Fed will accept almost any kind of loan, from virtually any financial institution, and now it is just giving the money away rather than making a loan. That's why this one costs so much more. But it still doesn't get at the two root problems in the banking system.
Here are the real issues:
-- If banks were to get the new money, they would still be fearful of lending it out, and who can blame them, considering there's a recession on, and considering that loans even to major institutions like Lehman Brothers have blown up?
-- If banks were to sell the loans to the government, they would be forced to recognize sizeable write-downs, or losses. That decreases their shareholders equity, also known as bank capital. And since the amount that banks can lend is based on their amount of bank capital -- typically at a ratio of around 8.5 to 1 -- the markdown of loans results in a smaller base from which they can make new loans. That's a double whammy, again reducing their willingness to lend.
As a result, banks that would get new funds under the program were likely to stash it in Treasury bills and hoard it -- just as they have done with every other infusion of funds so far. Figure they were going to huddle under the TARP rather than use it as a springboard to get the economy rolling again.
What most banking experts would have like to see in a new federal program is for the government to simply inject new capital into the banks rather than buying the bad loans. That would mean essentially nationalizing the entire U.S. banking system, and was deemed unpalatable politically. So now instead we are applying an expensive, cynical solution that is likely doomed to failure. Legislators spent more time figuring out how to put their own little curlicues on the bill, such as salary caps for executives and how to pad their own pockets in the unlikely event of profits, than on what really matters.
Why is this happening? Legislators appear to be have been confused between the issues of liquidity and capital, which is admittedly a tough issue to understand. The first is a matter having money to lend, and is the easiest to resolve. The second is a first a matter of having a strong enough base from which to lend it, which is entirely different. A third is the reversal of the mood of fear -- which is something President Bush actually made worse with his doom-and-gloom speech last week, using rhetoric that was 180 degrees different than Franklin Delano Roosevelt's observation in a similar situation in 1933 that all Americans had to fear "was fear itself."
Moreover, while $700 billion sounds like a lot -- and it is -- the hole in the banking system is measured in the trillions. It seems hard to believe, but that is the result of a massive number of derivative contracts coming unwound and falling with a splat on balance sheets. There are something like $600 trillion derivative contracts in the world right now, many of them created by disgraced math whizzes at defunct busineses Lehman Brothers and AIG, that were spun virtually out of thin air, or a very slim base of capital.
You see, derivatives are "fake money" on the way up when created with 30-1 leverage, but they are real money on the way down. Think of it this way:
For years it was real easy to go to a bank and get a home equity line of credit to remodel. If you had a $500,000 house you could get $100,000. That is 20% leverage, and you figure you'll pay it back out of cash flow as your income rises. But what if your pay gets cut by a third, or worse? Suddenly that "fake money" -- the borrowed $100,000 -- starts to feel very real, very heavy as you struggle to pay it back, especially since the thing you bought doesn't provide any cash flow of its own.
Now consider what it would be like if instead of creating $100,000, you were allowed to leverage up by 30-1, so you got $15 million. Now you're an investment bank! And if you can't pay the money back, well, that's show biz. The bank to whom you owe the money is even in more of a crisis than you are, and that is where we find the world banking system today. The bottom line: Deleveraging kills.
Naturally since this is a nightmare, it gets worse. Remember all those off-balance sheet financing vehicles that banks and brokerages created over the past few years to get liabilities off their books so that their lending capacities weren't impaired? Those are now all still coming back on balance sheets, so much of the money that Congress will dispense will go to shore up the capital base just to keep those positions from sinking our remaining banks and brokers.
The end game now is that banks absolutely must get new capital. Yet that is pretty hard to do. To give you an idea, look at the deal that the great Goldman Sachs did with Warren Buffett last week. To get $5 billion out of him, Goldman had to agree to a truly draconian deal in which it issued new shares -- diluting current holders -- and then had to offer both a 10% dividend and options to buy more of the company at a lower price. So Goldman got more capital for its base, but had to do so in a way that was terrible for current shareholders.
If Goldman had to do a deal like that to get capital, imagine how hard it will be for small regional banks. The answer is that they won't be able to get that capital from Buffet, China or Singapore, and will be forced to sell out to bigger national banks like Wachovia. Whoops, I mean like Washington Mutual. Whoops, I mean, um, well -- you get the picture. Pretty soon, Bank of America will be almost a literal statement, as the big banks get huge and everyone else disappears.
Satyajit Das, the derivatives expert who forecast the great deleveraging perfectly exactly one year ago in my column -- "Are we headed for an epic bear market?" -- told me over the weekend in a phone conversation from Australia that the new TARP deal now puts the U.S. balance sheet at risk, because "it is now looking like a hedge fund -- highly leveraged." He figures the U.S. dollar will fall as U.S. Treasury yields go up to attract more foreign money to finance the debt, and that eventually down the road creditor nations like China and Japn will be forced to do an Argentina-style intervention in which they force the country to raise taxes to pay for its debts.
Das continues to believe the only real solution is time. Leverage levels must come down, and will do so smoothly at times and in spurts at other times. The banking crisis is like a massive forest fire, in other words: It has to burn itself out, and will only do so when there is no more fuel.
To see more of my comments on the banking crisis as it unfolds, visit the free social networking site Twitter.com and follow my posts as "jdmarkman."
