Main St.+Wall St.+Politicians=Disaster

Good Afternoon Everyone!

The DC bailout drama continues to unfold as the economy hangs in the balance. It appears like we have another cluster **** on our hands folks. As you can see by my equation headline, this is what you end up with when you throw three giant elephants into a room.

I want to focus on an article in the Economist today that explains why finding a solution to this plan is so difficult to find. It also concludes that Paulson's plan isn't enough.

As you can see, foreclosures are and delinquencies are soaring as of 2008. The problem the Fed has, is its balance sheet is now pretty much tapped out:

So as a result, something needs to be done here. Now lets get to some highlights of the piece from the Economist. I added the bold headlines as a summary.

Why the Fed Balance Sheet couldn't be used

"Conceivably, the Fed could have contained the damage by supplying lots of cash. But that would have meant ever greater and more creative use of its balance sheet. By September 17th it had grown to $1 trillion, up by 10% in a fortnight, with most of it tied up in loans to banks, investment banks, foreign central banks, AIG and Bear Stearns (see chart 2). It was becoming the lender of first resort, not last.

Such steps were also courting political risk. After the rescue of AIG, Nancy Pelosi, speaker of the House of Representatives, demanded, “Why does one person have the right to grant $85 billion in a bail-out [to AIG] without the scrutiny and transparency the American people deserve?” Mr Bernanke later acknowledged that the Fed wanted to get out of crisis management, for which it lacked authority and broad support. “We prefer to get back to monetary policy, which is our function, our key mission,” he told Congress this week."

Why did Congress balk at the plan?

"The Fed chairman told Mr Paulson on September 17th that the time had come to call for a big injection of public money. By the next day Mr Paulson was in agreement and the two men, after getting Mr Bush’s approval, approached Capitol Hill.

Mr Paulson’s first proposal left Democrats cold: it would give the Treasury virtually unchecked authority for two years to spend up to $700 billion on mortgage assets or anything else necessary to stabilise the system. It looked like a power-grab. Democrats countered with several conditions: troubled mortgages would be modified where possible to keep homeowners in their homes; an oversight board would watch over the programme; taxpayers would share any gains for participating companies via shares or warrants; and executives’ compensation would be capped. By September 24th, Mr Paulson seemed to be bending to all these conditions. For its part, the finance industry is ready to yield to all of these conditions in order to get something done. “It was a gargantuan abyss that we faced last week,” says Steve Bartlett, chairman of the Financial Services Roundtable, which represents about 100 big financial firms"

Why The Plan Won't work and isn't enough

"Assuming it comes into existence, there are still numerous risks surrounding the TARP. The first is that it does too much. At $700 billion, the amount allocated to it easily exceeds the Federal Deposit Insurance Corporation’s (FDIC) estimate of roughly $500 billion of residential mortgages seriously delinquent in June, out of a total of $10.6 trillion, though that figure will rise. The Treasury has sought broad authority to buy not just mortgage securities but anything related to them, such as credit derivatives, and if necessary equity in companies weakened by their bad loans.

It is more likely that the programme will not go far enough. Conscious of the public’s deep antipathy to anything that smacks of favours for Wall Street, politicians from both parties have insisted that the protection of the taxpayer be paramount. Yet the point of bail-outs is to socialise losses that are clogging the financial system. If taxpayers are completely insulated from losses, the bail-out will probably be ineffective. “The ultimate taxpayer protection will be the market stability provided,” Mr Paulson argues.

This is especially critical in deciding how the government will set the price for the assets it purchases. An impaired mortgage security might yield 65 cents on the dollar if held to maturity. But because the market is so illiquid and suspicion about mortgage values so high, it might fetch just 35 cents in the market today. Recapitalising banks would mean paying as close to 65 cents as possible. Those that valued them at less on their books could mark them up, boosting their capital. On the other hand, minimising taxpayer losses would dictate that the government seek to pay only 35 cents. But this would provide little benefit to the selling banks, and those that carried them at higher values on their books could see their capital further impaired.

To some, that would be fine. “If they choose to fail rather than sell their debt at its real market value and record the loss on the books, they should be free to take that option,” said Michael Enzi, a Republican senator from Wyoming. The failure of smaller regional banks may be tolerable. The FDIC offers a proven system for coping with failed entities (although it too may need a loan from the taxpayer) and other banks are keen to snap up their deposits. But the final result of big-bank failures would be a deeper crisis and a bigger cost in lost economic output.

Similarly, requiring participating banks to give the government warrants or cap their executives’ salaries might make them less willing to take part. Veterans of the emerging-markets crises of the 1990s say their effectiveness would have been crippled had their ability instantly to deploy cash as they saw fit been compromised. “There is far more risk that the authorities will have too little flexibility…than there is risk that they will have too much authority,” says Lawrence Summers, a former treasury secretary.

A more serious criticism is that buying assets is an inefficient way to recapitalise the banking system.

There have been several false dawns since the crisis began in August of last year. This could be another. The TARP may address the root cause, namely house prices and mortgage defaults, but the crisis has long since mutated. “The same underlying phenomenon that we saw in housing we’re seeing in auto loans, in credit-card loans and student loans,” says Eric Mindich, head of Eton Park Capital Management, a hedge fund. The crisis could claim another institution before the TARP’s effect is felt.

The TARP could conceivably slow the resolution of the crisis by stopping property prices and home ownership falling to sustainable levels. Some homeowners who are up-to-date with payments but whose home is worth less than their mortgage may stop paying, betting the federal government will be a more forgiving creditor. The Treasury is considering using the TARP to write down mortgages to levels that squeezed homeowners can afford. But in the meantime, buyers might be reluctant to step in while a big inventory of government-owned property hangs over the market. That’s one reason Japan’s many efforts to bail out its banks failed to revitalise its economy: the institutions that took over the loans were hesitant to dispose of them for fear of pushing insolvent borrowers into bankruptcy, says Takeo Hoshi of the University of California at San Diego."

My Take:

This obviously went to print before all of the dramatic developments in Washington took place last night. I thought it was a great article explaining why the bailout in its current form doesn't work. It essentially does too much for the housing market, but at the same time doesn't do enough to address the other areas of the economy that have been sucked down by this mess.

There is also a severe risk that the Treasury will end up paying .65 on the dollar for assets that are worth .35 on the buck. This is nothing but a gigantic waste of US taxdollars because we will wind up paying the bill if the Treasury is forced to buy at .65 and then sell at .35. This does nothing but bailout the bankers. It does nothing for Main St!

As you can also see above, throwing the politicians into the mix makes it even more difficult to come up with a solution. DC wants to help fix the financial crisis but is afraid to because the solutions go completely against what their constituents are demanding.

America wants Wall St. to pay for this or fail and suffer the consequences like they have been forced to do. Wall St. wants their piggish pockets filled so they can get back to making billions. The politicians hands are tied because the public hates the proposals that are on the table, and there seems to be no consensus as to how to fix this. At the same time, they know they need to fix the economy, and Wall St. is crying the blues and threating finacial armageddon if they don't pass the bailout.

What a mess. I am glad I am not in Congress!

Bottom Line:

Pay close attention to the debates and developments over the weekend. I think some of the hardcore Republicans believe the only answer to this is to stay out of it and let capitalism run its course. They are beginning to come to the same conclusion that I have: There is no answer to this dilemma. Throwing money at an overlevaraged economy is the same as throwing money out the window.

I think that more and more Republicans are coming to the sad conclusion that its the only answer. Any true conservative would take this stance. Wall St. created this disaster via capitalism, and the only answer is to let the house of cards come tumbling down from the same capitalistic forces.

You can't rebuild an economy until the foundation of it is solid. Trying to fix the problem now as the walls are tumbling down isn't the solution. We need to start from scratch with a solid foundation and only then can we begin to work on making this country great once again.

The fat cats on Wall St. would also learn a nice hard lesson and we all will begin to realize that greed and fraud is not what this country was founded on.

Now do I think that Congress will allow this to happen? Nope

However, the Republicans look like they are ready to brawl over the weekend. I expect them to demand that the taxpayer is protected and for Wall St. to pay for their own mistakes.

What we will end up with from a legislative standpoint is something that sits somewhere in between both parties "solution".

In the end it doesn't matter who wins because neither piece of legislation will work.

The end result of this financial catastrophe will put this country in the most severe recession since WWII. It cannot be avoided. Unfortunately, it looks like Wall St. and DC still aren't ready to accept the inevitable.