The ActiveRain Addiction

I got off my flight down to Los Angeles a few hours ago and was pleased to see that Congress had rejected the bailout bill, woops I mean Financial Stability Act.  I would not be surprised though to see it come back from the dead, given the fear today's large stock market drop will put into many politicians.

In many previous posts I've talked about how this proposed bill simply was throwing money into a fire and would do nothing to solve the fundamental economic problems or even unfreeze the credit markets.  I've referenced many alternative plans by various economists and financial experts to address the root causes of this crisis, but I wanted to take my time to articulate a plan in my own words.

First Define the Problem

One of the things I noticed in talking to offices of dozens of Senators and Congressmen over the past several days is very few of them knew what problem they were trying to solve.  The only common theme was, they were afraid of something really bad happening and felt like they had to act now to prevent it or be blamed later.  Just remember, panicked people often do stupid stuff. 

So, lets define the problem.  It is no exaggeration that the situation in the credit markets and financial system is dire, bordering on a collapse.  There are a number of ticking time bombs in the financial world, some commonly known and some still below the surface.  The fear and uncertainty has caused the credit markets to lock tight, banks won't lend to each other and credit is quickly being cut off to consumers.  These problems in the credit markets spread throughout our entire economy.  Without a healthy credit market you can't have a recovery in the housing markets.

Most critically we've got to defuse these bombs that haven't exploded yet to keep the situation from getting MUCH worse, and we've got to solve the fundamental trust problems so the credit markets can start recovering that will lay the ground work for a broader economic recovery.  Too many politicians, are doing what is akin to trying to rebuild a house while it's still on fire.

Acceptance

Just like a recovering alcoholic needs to accept that they've got a drinking problem, we need to reach acceptance of our financial problems.  We've been binging on credit the last ten years and this country at almost every level is deeply in debt.  This credit bubble fueled what we now call the housing bubble as well as similar bubbles in several other asset classes. Our whole system is over-leveraged and way out of equilibrium.  A common principal in many physical sciences as well as economics is systems, that are out of equilibrium will snap back, no matter how hard we try to prevent it.  The harder we resist the more violent this correction ultimately is.  For example many of today's problems can be linked to steps we took in trying to prevent a recession after the dot com collapse.

We've got accept that to return to a healthy financial system, economy, and housing market is going to require a deleveraging of the system and that implies a vast amount of "wealth" will evaporate.  Just accept it, it's going to happen no matter what we do.  What we do have control over how orderly or unorderly this process is and thus how hard it is for the average American.  Do we have a hard recession, depression or worse?  That's the choice we're making, right now.

The Plan

Below is my articulation of a plan to move down the path of solving this problem and minimizing economic damage.  This is not intended to outline economic stimulus steps, or some specific housing related problems which I do believe also need to be addressed once the big problem has been dealt with.  Almost all the points in it are common themes in plans from various financial experts and economists and ALL of them are missing from the current plan being discussed by the government. 

1. Introduce regulations to defuse the bombs threatening to make things much worse and restore the trust needed to unfreeze intrabank lending.

Right now everybody is afraid to lend.  It's not that no one has any money, they just don't think they'll get it back because they don't know who's solvent.  These three critical pieces of legislation will help restore trust and expose the insolvent institutions so they can be dealt with.

       a. Get rid of the accounting loopholes, no more level 3 assets, no more off-balance sheet crap.  When an investor looks at a balance sheet they need to be able to trust it.  It's gotten to the point everybody is now assumed to be lying about their financials and nobody will invest.

       b. Restoring sane leverage requirements on in banking system.  Prior to deregulation about 5 or 6 years ago leverage, for financial institutions was capped at maximum of 12:1.   Many of the companies that are failing (Bear Stearns, AIG, Lehman, Fannie, Freddie, etc) are ultimately failing because they over levered themselves over the last several years.  They were running leverage ratios of 30:1 or worse.  When you are running 30:1 leverage that means, if you loose about 3% on you investments you are wiped out.

       c. Regulate the derivatives market by forcing all derivatives onto an exchange where margin requirements can be monitored.  People are fixated on the mortgage problems, that could just be the blasting cap that sets off the derivative bomb.

2. Recapitalize the financial system

Simply buying assets from banks is possibly the most inefficient way to recapitalize these institutions.  The most successful recapitilzation strategy in past financial crisis' has been debt to equity swaps. Basically companies proven to be insolvent (see point 1 above) are brought into conservatorship, stock holders get wiped, bond holders become equity holders, and new bond holders can now come in and recapitalize an essentially debt free company.  For institutions where they are still insolvent after a debt to equity swap they go through an expedited Chapter 11 process, where assets are liquidated.  This recapitilization would require almost no tax payer funds, investors who made bad investments will take the losses, while at the same time the financial system will remain operational.

3. Immediately recapitalize the FDIC

If people loose trust to store their money in a bank and everything breaks down.  The FDIC is severely under capitalized to handle the coming bank failures and people are starting to catch on.  If banks start failing in mass and the FDIC is disorganized and can't efficiently make good on insurance, you will have REAL "in the street" panic.  Congress needs to move now to shore up the FDIC, and this is going to require a lot of capital which politicians are trying to hand to Wall Street firms right now.  If needed to restore trust, temporarily raise FDIC insurance limits on existing deposits.  Trust in the banking system is critical right now, and it's quickly evaporating.

The last remaining significant resistance in Congress and the Senate has appears to have crumbled tonight and party leaders announced that they believe that the bailout is a done deal with voting in the house starting tomorrow.  At 9:00 EST the Treasury department held a conference call with primary dealers to fill them in on the details and discuss implementation of the plan.  According to reports from someone present on the call the treasury was very pleased with the final bill in that they got their money, with no real checks on their control and only token oversight.  It was admitted it would take two to three weeks to start implementing the plan and start buying assets once voted on.  I think is a flat out admission that the urgency they portrayed to Congress and Senate to ram the bill through was not in fact real.

The bill that will go up for vote tomorrow expanded from it's original 3 pages to 106 pages.  Of course is the usual porkly earmarks that politicians can't help but add to these urgent bills that nobody wants to block, but there were also some very disturbing additions too.

Section 132:  Allows the SEC to exempt selected firms from mark-to-market accounting rules.  Simply the fact these rules are being thrown away is bad enough, the bigger problem is it can be done at only to chosen firms at the SEC's discretion without transparency.  This allows the continuation of cronyism where these government agencies can pick favorites and makes it impossible to read a balance sheet and no what is going on.

Section 128: Fast tracks a that was set to take effect in 2011, that effectively eliminates reserve requirements on banks.  What?!?!  This allows banks to lever up even more when the one of the core problems in this crisis is that banks levered up TOO MUCH. 

There are many other hidden "treats" in this bill but plain and simple if passed this bill will be one of the disastrous pieces of legislation ever passed in this country.

Outside of the bailout bill currently under debate probably the biggest news last week was the failure of the largest thrift in our nation, Seattle based Washington Mutual.  On Thursday, the FDIC took the step of seizing WaMu due to them being vastly under-capitalized.  The deposits and some other assets were firesaled to JP Morgan for $1.9B, depositors were protected while both stock and bond holders were declared wiped out. This represents a marked difference from how previous bank failures have been handled by the FDIC, a change to the game plan if you will.  Not withstanding he potential sweet deal JP Morgan got, there is a disastrous unintended consequence to the rest of the under-capitalized financial system.

Unintended consequences on capital structures

All companies has a capital structure that includes different types of securities.  Lowest in this capital structure is common stock, followed by preferred stock, followed by different levels of debt (bonds).  When a company is liquidated (for example in a bankruptcy or a typical FDIC seizure) the investors highest on this capital structure get paid first.  This means that common stock bears the most risk for the holders, but these holders typically receive the highest risk adjusted returns to compensate.  Usually in the event of a bankruptcy you'll see the common shareholders wiped out, preferred is often wiped out but usually the bond holders at least get something.

When the FDIC came in, waved their magic wand and simply declared the bond holders got zero, they totally changed the rules to the game and set a damaging precedent. Had the Washington Mutual failure happened through more traditional methods it's very conceivable bond holders would have at least gotten something back. How do you spell lawsuits?

So, now we have all these other undercapitalized financial institutions out there that are desparately trying to raise capital.  Do you think big investors are more or less willing to recapitalize a financial institution if there is now a precident set that their investment can be zeroed without any judicial review?  While the regulators keep talking about how critical it is for these institutions to raise more capital, they may have just shot themselves in the foot with this action.

Similar impacts of another regulator change

Another recent regulatory change has the same impact of discouraging recapitalization of the banking system.  The banning if short selling the stocks of financial companies.  Often when a major fund comes in and purchases bonds in a company, particularly one that has known problems they will "hedge" this investment by shorting the common stock of the company.  If the company totally collapses they make money on their short position to compensate for any principal losses they would take on the bonds.  Undoubtedly, many of the big investments you've seen in troubled financial institutions in the last year have included this type of hedging.  Now that these investors don't have this mechanism available to hedge against the company completely imploding, they are even more skittish of making capital investments in financial firms.

The problems in the capital markets today are in fact being made worse by the panic'd game changes by regulators and officials.  Who wants to play in a high stakes game where the rules may change next week?

See Also: Anti-Bailout video that includes discussion of this.

Probably the most vocal and influential critic of the bailout plan being debated this weekend has been Rep. McCotter of Michigan. Great interview/rant...

"Let me put this in the simplistic terms for people like me to understand. Now the Wall-Street crony capitalist have put a 700-pound billion dollar bag of dung on taxpayers doorsteps, rung the bell, and expect you to thank them when you answer it. I think the American people will think otherwise. "

One of the most troubling aspects of the debate going on through the weekend over the proposed bailout bill is not a single independent economist or financial expert has been brought into testify in front of Congress or The Senate.  True, they brought in Warren Buffet to testify the financial system was going to collapse without it to their closed door meeting last night.  I would argue he's far from independent given he just invested $5B in Goldman Sachs last week (why would he do this is the system was in threat of imminent collapse?), has written nearly $5B in credit default swaps and another $5B in long term put options against the S&P 500.

So what do economists think

Well it's pretty much in synch with what I've been writing here.  Almost unanimously they don't believe the bill solves any of the issues either in the credit markets or the broader economy, and in fact believe it will make things worse.  The link below is a plea from nearly 200 of the top economists in the US to stop and think about the plan.

http://faculty.chicagogsb.edu/john.cochrane/research/Papers/mortgage_protest.htm

Economist Nouriel Roubini, who's one of the few economists that has correctly predicted these events years ago, offered up this scathing response today.

Is Purchasing $700 billion of Toxic Assets the Best Way to Recapitalize the Financial System? No! It is Rather a Disgrace and Rip-Off Benefitting only the Shareholders and Unsecured Creditors of Banks

In it he broke down various government responses to 42 past systematic financial crisis and came to the conclusion

"Thus, the Treasury plan is a disgrace: a bailout of reckless bankers, lenders and investors that provides little direct debt relief to borrowers and financially stressed households and that will come at a very high cost to the US taxpayer. And the plan does nothing to resolve the severe stress in money markets and interbank markets that are now close to a systemic meltdown. It is pathetic that Congress did not consult any of the many professional economists that have presented - many on the RGE Monitor Finance blog forum - alternative plans that were more fair and efficient and less costly ways to resolve this crisis. This is again a case of privatizing the gains and socializing the losses; a bailout and socialism for the rich, the well-connected and Wall Street. And it is a scandal that even Congressional Democrats have fallen for this Treasury scam that does little to resolve the debt burden of millions of distressed home owners."

While the main stream media seems to be portraying this bailout as a done deal this morning, from discussions I've been having this seems to be far from the truth and simply pressure mainly by the administration and democratic leadership (strange bedfellows) to push a bill through before Monday with no time for debate.  Thanks to a lot of tireless work by many individual it appears there are several factions in Congress that are now getting a hold of documents and are now actively in contact with some of the independent experts who have been sounding dire warnings about this bill. 

No one will debate how dire the situation is for our economy and capital markets right now, but taking the wrong action for the sake of taking action can produce a much worse result.  While I've stayed out of any types of politics in the past, I've become very involved with this issue because I truly believe taking the wrong path right now could lead to a destruction of our financial markets for decades.

Today there are reports coming out of three massive banks currently on the brink of financial meltdowns.  The situation at Belgium's Fortis bank with total assets of about $780 Billion appears most dire with Belgium's central bank trying to craft a rescue plan before Monday.  Over in England talks to save one of the countries largest independent banks Bradford & Bingley are taking place throughout the night. More than likely B&B will end up being nationalized by the British government by the end of the weekend.

Back in the US the situation at our sixth largest bank Wachovia with assets of $800B (or a little more than twice the size of Washington Mutual) has deteriorated significantly in the past week.  Wachovia's problem is nearly identical to that of Washington Mutual, they are holding huge amounts of option ARM's on their balance sheet, that have been defaulting at insane rates.  Their option ARM portfolio alone totaled around $140B with the majority of these being made in California who's housing market has been one of the worst hit.  While they've reserved only a couple billion to cover losses on this portfolio, it's a pretty good assumption the true losses are in the tens of billions.  They've been hit hard the last several days as concern has caused massive withdrawals of deposits and greatly increased their borrowing costs.  They officially put themselves up for sale on Friday and many suitors including Morgan Stanley, Goldman Sachs, UBS and Citigroup have been rumored to be sniffing around.  Given the demise of Washington Mutual these suitors will probably step back, play the role of the vulture and wait for a forced merger by the FDIC.

Right now the lack of trust and the total freezup of intrabank lending are putting a lot of large financial institutions are risk.  Unfortunately, the current bailout bills being debated in Congress will do next to nothing to restore confidence and unfreeze the credit markets.  The true combined losses on balance sheets of these firms are well into the trillions, so throwing $700B at the problem will simply amount to tossing cash into a hurricane.  Once the dominoes start to fall and people wise up to the fact the balance sheets of many of these financials are a fairy tale, nobody is willing to lend, even if they have the money because they are afraid they won't get it back.

If you can't guess from my previous dozen posts in the last week, I'm referencing what's going on in our financial system right now and the bailout bill.  One of my biggest arguments with much of the government intervention in the past year and in particular the bailout in front of Congress is it attempts to artificially prop up companies who would otherwise have failed.  There are many pundits that will talk about how it's in our interest to support these companies because it's needed to help the economy recover, keep us from loosing jobs, etc.  No, No, No, let me explain why failure is not just important, it's critical for a healthy, long-term recover.

To use an analogy, for several decades our forest service took on the policy of trying to prevent ALL forest fires, both big and small.  Forest fires are bad, right?  What they didn't consider in this policy is forest fires are part of the natural cycle.  They cleared out underbrush making space for regrowth in the forest, and in fact several species of trees actually require fire as part of their natural reproduction process (seed cones open in a fire).  As this policy continued for decades it was discovered the forest fires got much larger, more damaging and the general health of many of our forests began to decrease.  Within the last decade or two this policy by the forest service has been reversed and it is now policy in many cases to proactively set fires in some forested areas.

Recessions and tough economic times serve the exact same purpose in the corporate space.  The weak companies with failed models are cleared out and smaller more nimble competitors move in to fill the void, recreating jobs and helping the recovery.  Yes it's painful for a short time, especially if you're one of those people that works for a failed company but without this process you never get a true economic recovery. 

Look no further than our current auto and airline industries for proof of how critical this process is.  We propped up large, slow moving automakers and airlines who's business plans simply don't work under the guise, of it being good for the nation.  We've done this for decades and it has created two entirely dysfunctional industries.  Had Chrysler years decades ago, we almost certainly would have seen smaller US competitors move in to fill the void, who would have been more nimble and forward thinking and able to compete with the foreign companies who instead blew past "The Big 3".

This is extremely relevant to the financial, lending and real estate industries of today.  No one will deny they are in a state of disarray right now, but do we want to attempt to avoid the pain and keep them in a perpetual state of disarray or do we want to take our medicine and have a true recovery and a return to a healthy market?

See also: Why I am so Livid About the Bailout

Peter DeFazio - D-Oregon

Thaddeus McCotter - R-Michigan

"Before I was elected to Congress we used to hear that when faced with a crisis, members of Congress would invariably soil themselves, throw money at the problem and hope that it went away.

Unfortunately, in these dysfunctional economic times, we find that this process has continued...."

Jim McDermott - D-Washington

Jim Bunning - R-Kentucky

Anybody who's read my blog in the last week can probably tell what side of the fence I sit on as far as the bailout bill currently before Congress and the Senate.  I'm not just flatly against it, I'm angry and pissed off.  Angry, enough that I've probably made at least 100 phone calls, and faxes to various Congressmen, Senators, and other government officials in the past several days.  Come to think of it, that's about the same number I made in the weeks following the Bear Stearns bailout.

Now here is why

I'm one of the many people that saw this disaster coming, not three months ago, not a year ago, but I first started to put the pieces together way back in 2003.  The more I learned about not just mortgages but derivatives and the leverage occurring in our financial system for more it bothered me, but at the same time I said to myself, "it can't really be that bad".  The people on Wall Street are smart, they wouldn't create something this utterly idiotic. Of course later I realized this monster was not accidental either, just as Enron wasn't an "accident", it was a scam on a gigantic proportion.

Then when the first ripples of the sub-prime crisis hit in early 2007 with the failures of companies like New Century, I popped my head up again and said, this is really happening.  At this point I began spending A LOT of time following the credit markets very closely, watching as one domino after another fell exactly as predicted.

As totally terrifying as it sounds the events leading up to this are almost identical to the events that lead to many of the worlds great financial crisis, The Great Depression being the most notable, but also Japan's "lost decade" as another example.  As these events have played out government officials and regulators have practically followed the exact same playbook on how to make the crisis 10x worse.  Instead of forcing leverage out system and rapidly putting the firewall regulations in place to prevent a systematic event, they've instead allowed the system to further leverage up, and reduced regulation. This has been happening at a frightening pace over the last year, in a desperate attempt to paper over the problems facing us, and hope that they go away. Can we not learn from history?

You can not solve a problem by applying more of the cause.  It's akin to giving a continuing to give a heroin addict another hit to make him feel better, when in reality he needs to go into detox or will eventually die of his addiction.  It's as simple as that.  Yet on more than a dozen occasions in the past year the Treasury and Federal Reserve have attempted to solve the crisis du jour by administering this extra hit of heroin, and proclaimed the problem was on it's way to being fixed.  

The bailout in front of us is just another hit of heroin, a massive one.  It will do NOTHING to solve the underlying problem.  While it may provide a short term high, it won't help the long term situation.  We need to go into detox now, before the ticking bombs in our financial system blow up.  This detox will be really, really painful, many more Wall Street firms will go under, our economy will go through a deep recession, huge amounts wealth will evaporate.  But you know what, the bailout won't prevent this either, it will just add on yet another layer of misery to main street.

What this bailout will do?

Face it the financial train is off the tracks, and no matter how hard we want it to we can't simply throw money at it and put it back on.  What we can do is focus our effort on moving things out of the way and minimize the collateral damage.  Instead this bill is a method by the pig men of Wall Street to throw as many taxpayers in front of the train as possible, hoping to slow it down before it hits them.  It is a looting operation by the banks of the US taxpayer plain and simple.  It is being sold by fear and frankly the finance industry is trying to hold the American people hostage.  Sorry I'm angry, I see through the smokescreen and I'm not going to sit by and take it.

Here's a sample of what I'm hearing about the state of the current $700B bailout proposal.  I've been hearing similar things in phone calls I've had with various officers for Congressmen and Senators.  I thought I'd pass it along...

Subject: Ed Hill: Washington Update/Passage of Bill This Week Unlikely in
His View..

Good Morning,

We had Ed Hill (BofA's Washington Rep) on the Equity Hoot this morning regarding the political situation in D.C. Key headlines:

Bill unlikely to pass this week or next: 128 votes short now Administration "spectacularly unsuccessful" in making their case to large groups Congressional offices getting calls from constituents 10-1 AGAINST the bill

Some more details:

Likelihood of passage this week has dimmed since yesterday. After speaking to leadership on both sides (they need 218 votes to pass), they want 120 votes on each side. if the vote were today, 50 dems, 40 reps (218-90 = 128 short), FAR from having enough votes to pass
When he canvassed 30 congressional offices yesterday the overall response was uniform: For every 1 constituent who phone in for support of the bill there were 10 against it. Remember the election is only 5 weeks away and this weighs heavily on their minds.
If they extend the session (which is likely) Thursday is the earliest they could come back (after holidays), then it takes some time to pass the senate where rules require more debate, don't expect it passes this week or next week.
also talking about strong oversight, both congressional & governmental. bankruptcy provisions still in play, but less likely,
tough to get 120 Republicans
Paulson makes a compelling case 1-1, but not in large groups. The Administration has been unsuccessful getting their own party behind it.