Opinion: The US$1 trln bailout is a bad idea that will fail

As a New Zealand taxpayer I shouldn't really care too much about US taxpayers being asked to fork out over US$3,000 each (US$1 trillion) to bail out Wall St. But it matters for New Zealand because continued instability on financial markets will eventually express itself in our interest rates remaining higher for longer. It also creates the potential for a global financial catastrophe that would drive house prices and economic output much lower. So what's wrong with Americans stumping up US$1 trillion in a collection of bailout packages to save the financial system? The immediate answer was simple. No problem at all. Get it done fast and clean was my initial thought. But on reflection, the long answer in brief is that throwing good money after bad in a reckess way (which is what the current plan does) will simply encourage more bad lending behaviour. It will eventually lead to rampant inflation and another crisis within a few months as investors completely lose faith in the moral and economic compass of the global banking system.   The US government should pay fire sale prices to the banks for toxic assets and demand very high ownership stakes in banks in return. It should use these stakes to stop dividend payments, stop massive bonuses for risky behaviour and then eventually sell these stakes when sanity has prevailed. Here's the long answer in more length and depth... Just as American politicians and taxpayers are now asking some tough questions about this plan, I think we should too. The result will have a direct impact on our mortgage rates, our currency and ultimately our economic growth. Two questions need to be asked. Will it work in the long term and is it fair? Firstly, it may not work in either the short or long term. Congress will probably reject it in its current form and a good thing too. Some analysts are saying even US$1 trillion is not enough to make a difference. The scale of the leverage injected into derivative markets, global housing markets, hedge funds and private equity funds in the last 10 years was so great that it will not be enough to stop a meltdown. That's serious risk, but not one that can be contemplated. Something has to be done. The US government simply can't throw its hands in the air. It has to do something. But what? The US Treasury and the US Federal Reserve are proposing the creation of a US$700 billion Troubled Asset Relief Programme (TARP) to buy 'toxic' or damaged mortgage bonds and other assets from US and other banks to avoid a complete seizure of global credit markets that could damage the economy. About US$300 billion has already been spent or approved to insure money market funds and to bail out or guarantee the rescues of Bear Stearns, Fannie Mae, Freddie Mac and AIG. The TARP sounds sensible, but how will it be done? This is important because the 'how' will determine whether it's successful and how fair it might be. The basic problem right now is that US and other banks (but luckily not Australasian banks) have damaged goods sitting on their balance sheets. They're worth a lot less than they used to be because of the rolling collapse of US and other housing markets, as well as other assets such a private equity funds and various derivatives. The underlying assets behind all this mortgage debt are damaged and the ability of borrowers to pay is impaired. Value has been destroyed. But currently illiquid markets are unable to 'price' how much value has been destroyed. "Mark to market" accounting systems mean that fire sale prices for some assets are forcing all the banks with those assets on their books to mark down their values. Banks are then being forced to raise fresh capital to ensure their capital adequacy is strong enough and that they can maintain the great confidence trick of banking, which is to convince depositers and short term lenders not to withdraw all their money at once because most of it has been lent on to someone else and can't easily be recovered quickly. Banking relies on not everyone turning up on the same day to withdraw their money. Banks need capital reserves to convince depositers that there will be enough money in reserve when they turn up to withdraw money.  So banks need cash in their hot hands now. There's a couple of ways to achieve that. They can sell assets, which can include loans, be they damaged or not. Or they can sell shares to raise equity. Sometimes the two merge together. In some situations where the seller is stressed the buyer can demand that they receive shares in the bank as well as the asset being sold, particularly if the fundamental value of the asset is unclear and the buyer wants to ensure they get extra compensation in case the assets turn out to be worth less than was paid for them. This is essentially what the US Treasury did when it lent US$85 billion to AIG and demanded warrants that would give it a 79.9% ownership stake in AIG with the right to veto dividend payouts and interest payments to preferred shareholders. But last night Treasury Secretary Henry Paulson, the former head of investment bank Goldman Sachs, and US Federal Reserve Chairman Ben Bernanke, a former academic, indicated to Congress they wanted to use the TARP to pay high prices to the banks for these toxic assets, rather than fire sale prices. This from the Wall St Journal:

Mr. Bernanke, early in the hearing, distinguished between what he called fire-sale prices -- which he defined as "the price a security would fetch today if sold quickly into an illiquid market" -- and a hold-to-maturity price, or the value of a loan if the borrower eventually pays it off. "If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price," he said, "there will be substantial benefits." That produced speculation that Mr. Bernanke was advocating the purchase of assets at prices other than market-determined values, a development that could benefit banks at the expense of taxpayers. In answering subsequent questions, however, Messrs. Bernanke and Paulson appeared to indicate otherwise, arguing -- in effect -- that a well-designed auction process would lift the market prices of the assets above today's fire-sale values by restoring liquidity.  

Paulson rejected proposals by congressional leaders to limit executive pay or take ownership stakes in banks, saying the role of the TARP was to restore markets to normality, not to punish banks. He wants full authority to spend the money as he sees fit, when he sees fit, buy assets at prices he sees fit, from whichever banks he sees fit and to not take ownership stakes if he wants. He wants to employ fund managers from the very Wall St firms he wants to buy assets from to do this for him. This is a recipe for the biggest conflict of interest and transference of shareholder wealth from public hands to private hands in the history of the world.  No wonder both Democrats and Republicans are balking at the TARP plan. They are proposing amendments to spend the money in chunks, to take ownership stakes and to limit executive pay. The politicians are in tune with the US public on this.  This from a Reuters report:

At the New York Federal Reserve bank, 40 people protested with banners reading "Bail out Main Street, not just Wall Street" and "$700 billion for banks, $0 for homeowners." An angry venture capitalist took a full-page ad in the New York Times, dubbing Bush, Paulson and Bernanke the "new Communists" in a cartoon where the trio planted a flag with a Communist hammer and sickle.

During the congressional hearings members of the public yelled out "Don't put the fox in charge of the henhouse", referring to Paulson's former position as head of Goldman Sachs. It's possible the politicians, less than two months from an election, will simply reject the plan outright because it is politically poisonous. It's more likely they will demand, rightly, that the US Treasury spends the money in chunks and only pays fire sale prices for toxic assets. It will demand that the Treasury takes ownership stakes and blocks excessive executive pay. If Paulson gets his way he will have done the most morally hazardous thing global financial markets have ever seen. Few will be able to trust the banking cultures that created so much bad debt in such a short time unless those responsible for that lack of care and recklessness are wiped out. Confidence has to be restored. It will require shareholders and many holders of bonds in these banks to be wiped out. They made poor decisions and they should pay. That all sounds a bit eye for an eye but that's how confidence works. Taxpayers should not allow them off the hook. After his performance overnight, Paulson's credibility is shot too. The US public will never allow such a 'fox' to spend US$700 billion to protect his mates in investment banks, even if it might stabilise markets for a few days.