Monday, September 29, 2008

Blow It All Up; Go Back to the Drawing Board

That would be my advice to Congress after the House repudiated the $700 billion bailout plan, 228-205. I've read enough online comments to realize that Wall Street is stunned, perplexed, and not a little bit irritated. But I think that reaction just underscores a growing gulf between the two streets, Wall and Main. Joe Sixpack hated this bill with a fury, and that's what Congress has been hearing.

Now I think legislators have two choices (short of nudging 12 members into changing their votes):

Incrementalism (if you like sports metaphors, call this “going short”): Scale back the size and scope of the rescue. One suggestion floating around would provide for $150 billion in low-cost loans to companies weighted down with too many bad assets backed by U.S. home mortgages.
Advantages: Easier to marshal political support on both sides of the aisle. Sidesteps knotty questions of what to pay for hard-to-value toxic financial waste. Minimizes government involvement.
Disadvantages: May be too little to restore confidence and fix ailing firms. Could leave the Treasury Department and Fed injecting funds into the U.S. financial system and stamping out fires for years to come as the economy muddles along.

The “Bear Hug” (or, “going long”): Have the government aggressively take ownership stakes in financial firms in return for buying bad assets and pumping in capital. Try to weed out weaker companies that are insolvent and so badly run they don't deserve to survive.
Advantages: If we can get our arms around the whole problem at once, that could reduce the chances of a drawn-out resolution where good money is thrown after bad. Protects taxpayers better from losses. Also, a government that drives hard bargains (as Sweden did with such a program) will motivate financial firms not to seek Treasury help and to find private funds on their own to recapitalize.
Disadvantages: Wall Street won't like this one, after the tantalizing mirage of being able to dump their toxic waste at above-market prices under the original Paulson plan. And politicians too may balk at the size of the effort and the ideological implications.

Time to get a dialogue going. Two places to start: what Chile and Sweden did during their financial crises, with good outcomes.

And Poof! There Goes $700 Billion

My working title for this blog entry was “Now Serving: a $700 Billion EntrĂ©e Garnished With Political Fig Leafs.” But that was a little too long.

The storyline of the Wall Street bailout: King Henry triumphed, while politicians harumphed and bloviated and found tiny fig leafs to cover their exposure before an irate electorate (voters go to the polls in a few weeks). Paulson essentially won what he wanted, as legislators skirmished in the margins of relevance. Some highlights of what we got:

1. The Democrats can crow that they clamped down on executive pay excesses for anyone receiving bailout funds. In truth, the provisions are pretty limited in scope and meek – and don’t always make sense. Example: the CEO of a company getting rescued gets to keep his existing golden parachute, but any new CEO hired won’t be entitled to one. Come again? So the CEO who presided over a financial firm that acquired a lethal amount of toxic waste gets off scot free, while a fresh leader who works to right the ship gets punished?

2. Not to be outdone, the Republicans inserted their own piece of idiocy. Seeking a free-market fix, they came up with an “insurance” idea. Financial firms could opt to keep their bad assets and guarantee their value by buying special insurance through the government. Sounds like someone was drinking the Wall Street Kool-Aid. The Street, if you recall, protested vigorously that their toxic waste has a “fair value” much higher than what they could get in today’s troubled markets. Taking out insurance only makes sense if you really, really believe that and think you won’t get a sweet price from the government. Move on, nothing to see here.

3. Anyone who gets more than $100 million of bailout funds MUST give the government preferred bonds or rights (known as warrants) to buy stock. That’s promising, as it allows the Treasury to claw back some profits. That will be especially critical if investments bought with the $700 billion turn out to be duds. The caveat: the language in this section is vague and if Paulson doesn’t support the concept (and I don’t think he does), he might not push too hard to get a good deal.

Sunday, September 28, 2008

Why a Reverse Auction Won’t Work

Exhausted Congressional leaders, after hours of testy negotiating, reached a deal on the great Wall Street bailout. The devil, of course, is in the details. But from what I gather, the central feature of the plan was preserved: the Treasury will buy up to $700 billion of bad assets backed by U.S. home mortgages.

The latest version of the plan also requires financial firms to give the Treasury warrants in return for getting rescued. A warrant allows you to buy shares in a company at a fixed price. So if, say, Invest-orama receives a bailout, and then its shares soar from $20 to $40, the government can profit. That’s something at least.

From where I sit though, the troubling problem remains how much to pay for this toxic waste (see my previous blog entry). Warrants don’t eliminate that issue; they just add a complicating dimension to it. A financial firm that might’ve sold a deteriorating bond at 55 cents on the dollar might revise the price upward to 60 cents to account for the warrants.

But how to arrive at that original price, whether it’s 55, 40 or 30 cents on the dollar? There’s a huge spread between what owners of these assets think their investments are worth and what a buyer in the current jittery markets will pay. Fed Chairman Ben Bernanke has floated the idea of a reverse auction. Whereas a normal auction has one seller and many buyers, a reverse auction has one buyer and many sellers.

Reverse auctions make sense for buyer-designed products (a buyer might issue, say, detailed specifications on a car door latch that it wants manufacturers to bid on the right to make) and commodities. If you want to buy 100 barrels of road salt, in a reverse auction there could be 18 sellers that submit continuous bids, each lower than the one before, until reaching the best price.

The problem is that Wall Street isn’t trying to unload barrels of road salt. On the contrary, the toxic financial products held by these firms are complex, hard to value, and often unique. Each mortgage-backed bond is yoked to a specific batch of U.S. homes, and each home in turn has its own history of timely or late payments, its own odds of foreclosure. So Bond A, offered at 40 cents on the dollar, may turn out to be a much riskier (and worse) deal than Bond B at 60 cents.

Also a reverse auction is too scattershot, spraying money through the system without regard to who receives it or how much they get. In a financial crisis, we need a more sophisticated and aggressive approach. Some companies will die; they deserve to. The government should review balance sheets, let insolvent firms perish and pump funds into those that can be rehabilitated (or need to be, for the stability of the system).

I would NOT vote for this bailout plan. A better idea waits in the wings. Check out what the economist Nouriel Roubini proposes; it’s a much smarter way to go and better protects taxpayer funds.

The financial system won’t suddenly implode on Monday without a bailout package. It’s under stress, but we still have some time. Why not do this right?

Saturday, September 27, 2008

Four Reasons to Punt on Paulson’s Bailout Plan

This weekend Congress will try to thrash out an agreement on a Wall Street bailout. Treasury Secretary Hank Paulson wants to spend $700 billion to buy distressed bonds and other assets that are backed by soured U.S. home mortgages. Okay, let’s pause and take a deep breath and look at four big reasons why NOT to.

1. There is no way to know the right price for this stuff, leaving it likely the government will overpay. The seller of a bad mortgage-backed bond may claim its “fair value” is 60 cents on the dollar. Right now, amid jitters over tightening credit and a still-deflating housing bubble, the best offer on the open market may be 20 cents. So do we trust government accountants – toiling under time pressure, analyzing thousands of different (and complex) securities, probably using vague guidelines – to arrive at the proper price?

2. The U.S. taxpayers will pick up the lousiest of the lousy, probably at the worst prices too. There’s estimated to be more than $2 trillion worth of bad mortgage-related assets out there. So, shocking as it may seem, a $700 billion check doesn’t come close to doing the trick. Financial firms will surely cherry pick the wormiest fruit to offload while pretending it’s better than it is. Their knowing more about the individual investments boosts the chances of the government getting hoodwinked on some of these deals.

3. This is a horribly inefficient use of resources in a free market system. The bailout program could become a full employment act for the investment banking industry. For starters, the government would need consultants and specially trained employees to help it process the deluge of applications from financial firms seeking to shed their toxic waste. Then the decisions: what to buy, how much to pay (the research on that alone should keep a platoon of analysts busy around the clock). Then someone has to manage the assets, decide when to sell them, execute the sales.

4. Letting financial firms off the hook sends the wrong signal and sows the seeds for the next crisis. The message: Go ahead and take huge risks, make bad bets, overextend your capital – the taxpayers will be waiting in the wings to pick up the pieces. It encourages the bad actors to keep behaving the same risk-crazy way they have been, and the good ones to follow suit in order not to fall behind.

Thursday, September 25, 2008

The Sly Sage of Omaha

Sometimes, to know what a man really thinks, you need to watch his feet, not his lips. Words are the units of an often-cheap currency that’s easily manipulated and debased. And so when Warren Buffett, finance’s plain-spoken wise man, voices support of a $700 billion plan to bail out Wall Street, one might reasonably glance down to see what his feet are doing. After all, Mr. Buffett’s company Berkshire Hathaway is pretty well cashed up right now, having patiently waited on the sidelines recently while more reckless rivals dabbled in risky ventures.

Buffett’s latest bit of deft footwork: buying a $5 billion stake in Goldman Sachs. While calling any investment bank “blue chip” during this period of financial turbulence is a bit of a stretch, Goldman merits the stamp of quality if anyone does. Goldman is highly profitable, employs many of Wall Street’s smartest bankers, and – perhaps not coincidentally – was rare among peers for foreseeing troubles developing in bonds backed by U.S. home mortgages. So Buffett walks away with ownership in a well-run, top-tier (arguably the top-tier) investment bank on Wall Street. All for $5 billion. Sweet.

If you think, however, he supports such a smart deal for the U.S. taxpayer, you’d be dead wrong. Treasury Secretary Paulson’s plan seeks a towering pile of money to buy Wall Street investments that have gone sour largely because of the U.S. housing crisis. Even after getting a discount, the government would probably pay well above market value. If the investments turn out to be worth only $600 billion, $500 billion, or even $50, tough luck. For all his troubles, the U.S. taxpayer will own nothing of anything. Not even a third-rate boutique investment house or a paperweight bull.

Buffett has a lot of money under his thumb but little apparent appetite for acquiring, even at a deep discount, any of the risky mortgage-backed investments being offered to the American taxpayer. The same appears true of another high-profile cheerleader of Paulson’s plan. Bill Gross, a Master of the Bond Universe and the chief investment officer of Pimco, argues for the bailout on the pages of the Washington Post, even guesstimating how much the government could profit. So why isn’t he eyeballing any of this toxic waste for his portfolio? (Note: Gross is, however, eyeballing a well-paid role in managing the $700 billion pool of bad assets, should Paulson succeed in buying them.)

So as we seek advice from high-finance sages while trying to resolve the financial crisis, the advice bears repeating: Watch their feet. Not their lips.

Wednesday, September 24, 2008

Hands off the Ferrari

One of my favorite Hank Paulson quotes, as he tries to drum up support for a $700 billion rescue of Wall Street, was this one. (U.S. taxpayers are preparing to buy a bunch of bad mortgage-backed bonds to clean up the balance sheets of financial firms.) Paulson was responding to a proposal by those grumpy Democrats to cap executive pay packages at companies that receive bailout money.

“If we design it so it's punitive and so institutions aren't going to participate, this won't work the way we need it to work."

Restrict CEO compensation? L’audace! Haven't the red-faced chieftains of Wall Street been humiliated enough just by virtue of having to step forward and ask for help? In all seriousness, the Democrats' pay slap-down isn't one of the better ideas to attach to this bill. Either firms will find loopholes to ladle out compensation in new, innovative ways or they’ll face a talent drain. Reforming executive pay excesses on Wall Street should be hived off from the urgent matter at hand, fixing a financial crisis.

What's galling though is how Paulson’s quote shows him to be out of touch with reality. In truth, financial firms of all stripes are queuing eagerly to get a chunk of this $700 billion. Will a few gracefully demur, saying “no thanks, we’ll keep our toxic waste ” if they find out that aid comes at the cost of no longer being able to so richly compensate their top executives? Maybe. But somehow I doubt it.

Monday, September 22, 2008

The Big Lie Behind the Great Wall Street Bailout

At the heart of Treasury Secretary Hank Paulson's bailout plan is a Big Lie. The $700 billion plan is predicated on this Big Lie, concocted by financial firms holding a bunch of stinky investments. In brief, Wall Street claims they can't sell the investments (securities backed by deteriorating U.S. mortgages) because of the current upheaval in credit markets and nervousness about the U.S. housing market.

That's a lie. The truth is, the firms can’t sell the securities for nearly as much as they would like. So in other words, let's say they think they're holding investments worth 60 cents on the dollar, when a buyer right now might give them only 20 cents. Their argument: once the fear and panic abates in the financial markets, they'll be able to recoup the "fair value,” or the 60 cents on the dollar. But they need money now. So they're looking for a chump with deep pockets.

Enter the U.S. taxpayer, stage right. Paulson's plan would have the government snapping up armloads of lousy investments in order to bail out Wall Street. If you wonder, how do we figure out how much to pay, go to the head of the class. That’s the $700 billion question. Paulson's line is essentially, “Trust me, I'll take care of it.” In private, he has essentially conceded that the government will pay too much for what are bad assets. (See this excellent blog entry by naked capitalism for the inside scoop.)

With Lehman Brothers recently going bankrupt and mammoth insurer AIG getting $85 billion of cash, the U.S. government is rightly resolved to do something about the financial crisis, and sooner rather than later. That's commendable. But the Big Lie makes this Paulson plan rotten at its core, especially considering the irresponsible behavior of Wall Street's financial firms over the last few years.

When your drunken uncle Hal staggers in from a two-week bender, should you write him a blank check to cover his expenses, buy him a jug of moonshine, and send him back out the door?