UPDATE: 10-03-08 SPECIAL INTEREST LEGISLATION CONTINUES TO BE BI-PARTISAN: PORK LOADED BAILOUT BILL PASSES, BUSH SIGNS INTO LAW
The final vote in the House of Representatives was 263 to 171, with 58 more people voting aye than in the previous version which was defeated. This bill added at least $115 BILLION in spending to the $700 BILLION which is sure to rise past the TRILLION dollar mark when the actual deals are consumated. (Remember: the bill says $700 BILLION at any one time -- which does not account for the proceeds of any prior asset sales, does not cover the $300 BILLION authorized by Congress for other housing initiatives and does not cover additional spending in additional single-purpose legislation. This may turn out to be the largest special interest theft of taxpayer's money in the history of the United States. It has been rumored that much of the Wall Street turmoil was deliberately engineered by the Wall Street Wizards to force the passage of this bill. Considering that most of the public, as well as the weaker, risk-adverse players, had left the market, it stands to reason that only the professional players were left -- and they were massively bearish.
Original blog entry ...
The so-called bailout bill, more formally known as the Emergency Economic Stabilization Act of 2008, in my humble opinion, is a bit of smoke and mirrors designed to make the American public believe that our hyper-partisan government, such as it is, understands the problem in the financial markets and has created an effective tool to resolve the issues that are creating economic chaos.
It’s a matter of trust …
The basic problem affecting the liquidity of the marketplace – the ability of counterparties to confidently trade with each other, knowing that the trade will be consummated, has been severely compromised.
Both parties are unsure of their own balance sheets and whether or not their counterparty has the financial strength to complete the deal before being declared insolvent or unsound. In addition, both parties want to conserve cash to cover any anticipated and unanticipated losses in order to survive in this fragile economic environment. So we seem to have an unprecedented situation where banks will not even loan other banks money and trading partners will not clear their trades through a firm which they believe lacks soundness. In this environment, rumors, innuendo and even innocent remarks can result in a silent run on the institution’s ongoing business.
Accounting: the core problem …
The core problem behind this economic meltdown is the failure of the accounting profession. To satisfy their well-paying clients, accounting firms not only rationalize poor business decisions with an opinion letter backed by computer-generated trivia, but the accounting profession itself has failed their primary mission: to bring transparency and trust into financial transactions.
Off-balance sheet transactions …
It is the accounting profession that created rules which permitted companies such as ENRON to place non-performing assets and debt instruments into special purpose vehicles. The special purpose being to keep the transaction off the parent institution’s balance sheet and only record notional gains or losses as appropriate. This single rule resulted in companies hiding highly leveraged debt instruments from the shareholders, the investing public and the regulators.
Derivative pricing by computer models …
Add to that the accounting profession’s rules for pricing derivatives which were based on cash flows arising from the underlying collateral. Many derivatives were so complex as to require mathematicians to develop pricing and trading programs to manipulate derivatives in the marketplace. Of course, this was all done without standards. And, in the final analysis, the derivative being worth only as much as a counterparty was willing to pay for the financial instrument. If no one was buying, the value of the derivative was essential zero!
Mark-to-market …
Now comes a genius idea: mark-to-market which requires companies and financial institutions to value their investments at the fair market price. Who in the accounting profession noticed that, in a declining market or with an absence of counterparties, the investment was worthless and needed to be counterbalanced by loan loss reserves equal to the booked purchase price of the derivative?
Excessive leverage …
One may question why the accounting profession did not blow the whistle when companies borrowed excessive amounts of money to purchase artificially and speculatively priced derivatives. In many cases at ratios exceeding a 30-times leverage ratio.
My favorite example is a small company with $1,000 of equity capital being allowed to purchase $30,000 worth of derivatives. If the market drops 30%, the resulting $9,000 loss places the firm $8,000 underwater – resulting in an insolvency. Had the company not used leverage, the loss would have been $300 leaving the company with $700 of equity capital: uncomfortable, but survivable.
All-in-all, these are systemic problem which must be addressed before there is stability in the financial marketplace. Unfortunately, while the problems of off-balance sheet transactions using special purpose vehicles can be solved (eliminated), standardized rules for the development and pricing of Ponzi-like derivatives developed, mark-to-market valuations curtailed or eliminated – I know of no way to unwind the problem presented by excessive leverage other than to make a correspondingly large amount of money to cover any potential loss – or book the loss with a corresponding chance of becoming insolvent.
Why the bailout might not work …
Up until know the operative solution was to buy time – delay booking losses by use accounting techniques (tricks) which artificially inflated the value of the firm as a going concern – hence the crisis in counterparty trust.
When that failed, liquidity injections from the Federal Reserve or the Treasury were made that allowed firms to borrow good funds, collateralized by assets including (apparently) unpricable toxic paper. Under this plan, institutions did not have to book losses as long as they could continue to roll-over these loans. Of course, everyone noted that the Emperor had no clothes and counterparty trust was not restored.
Next, the government plans to purchase the toxic securities, ostensibly to be held for re-securitization or marketing in better times. This makes the fiction of rolling over loans a reality as the government will pay cash for the toxic paper.
But here is the conundrum: how much money is the government willing to pay for essentially valueless financial instruments? If these instruments had any recognizable value, they probably would have been sold to bottom-fishing hedge funds and sovereign wealth funds who do not need to impress Wall Street with ever increasing earnings.
The answer is unpalatable: the government cannot purchase this toxic paper at fire sale prices as they are forced to pay an artificially high amount necessary to prevent the institution from being judged insolvent plus an amount which represents some form of recapitalization effort which insures the institution has sufficient working capital to engage in continued counterparty trading. It is for this reason, I believe that Treasury Secretary Paulson sought unprecedented – and unreviewable – unilateral powers to make deals and set prices.
The real answer …
Even though I am not smart enough to figure out a way to unwind transactional leverage, I am aware that the true solution to the financial crisis requires that a floor be established for the value of the underlying assets used to collateralize toxic paper. That means that house prices can no longer be allowed to freefall and the tide of foreclosures must be stemmed.
To stem the tide of foreclosures, we do not require a government investment or legislation that allows judges to modify mortgage rates and/or reduce the principal balance of the amount owed. There is a simple mathematical fix: we reduce the loan’s interest rate and correspondingly increase the loan’s maturity. This will keep the majority of homeowners in their homes and thus prevent the foreclosed homes from being placed on the open market – further increasing the velocity of downward pricing pressure. In some cases, using programs like HUD’s “buck a house,” foreclosed homes which are not sold to the general public within six months are eligible to be transferred to local and state governments for rehabilitation and resale – perhaps as subsidized affordable housing.
Those who could not afford their houses in the first place, were involved in fraud (application fraud, occupancy fraud, straw buyers, inflated appraisals, etc.) will lose their homes as an unavoidable consequence of their actions. These houses can be re-priced to sell to another generation of homebuyers who will appreciate a bargain price. Of course, this requires losses to be booked by the lenders and those who speculated in derivatives associated with these homes. In this case, the loss will be spread among the many people holding a slice of the sliced-and-diced primary, secondary or tertiary derivative.
For those who has subordinate liens, seconds, thirds or HELOCs (Home Equity Lines of Credit), you risked your money and lost. Sorry, Charlie. If the government wanted to assist the financial institutions holding this paper, they could provide capital appreciation participations which could be redeemed if the home was sold at a decent price within a specified period of time. Knowing Wall Street, these certificates could be sold as speculative securities to those with a high tolerance of risk – or to those with a known gambling addiction.
Fixing this abomination …
Let’s start with the legislative dishonesty of adding enough special interest pork to the bill to convince legislators to vote in their own self-interest rather than protect their constituents.
Eliminate special interest spending and tax items like:
- Sec. 502. Provisions related to film and television productions;
- Sec. 503. Exemption from excise tax for certain wooden arrows designed for use by children; and
- Sec. 504. Income averaging for amounts received in connection with the Exxon Valdez litigation.
Fix the underlying accounting problems associated with:
- Derivative creation and marketing;
- Off-balance sheet debt;
- Mark-to-market valuations; and
- Rules for unwinding or accounting for highly-leveraged transactions.
Provide guarantees rather than actual funds:
- Guarantee payment streams for a actuarially sound premium like FDIC operations which would reassure investors holding toxic paper;
- Adjust accounting rules to allow notional gains or losses to be booked as incurred. In essence freezing the value of the toxic securities on the balance sheet for all to see;
- Allow the failed collateral to be foreclosed and the sale amounts remitted to investors on a pro-rata basis after suitable transaction fees; and
- Do not include non-asset toxic paper in the transactions such as derivatives used to collateralized auto loans or credit card debt. These people are on their own.
There are many good solutions floating around the financial community which do not involve ceding unprecedented unilateral control over hundred of billions of dollars to politicians and their appointees who failed us miserably or rewarding those who participated in these financial schemes which resulted in outrageous multi-million dollar bonuses to people who did little more than engage in selling the financial equivalent of the Brooklyn Bridge.
Unless the bailout bill is reviewed, debated and restructured, the people should be willing to exert a measure of political retribution by not re-electing those who permitted this to happen on their watch.
-- steve
Quote of the day: “You cannot make a man by standing a sheep on its hind legs. But by standing a flock of sheep in that position you can make a crowd of men.” - Max Beerbohm
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Reference Links:
DID THE SENATE SNEAK A GLOBAL WARMING--TYPE ENERGY BILL PAST THE PEOPLE IN THE 451-PAGE BAILOUT BILL JUST PASSED BY THE SENATE? (Updated)|OneCitizenSpeaking
BAILOUT: THE DEMOCRATS ARE PLAYING POLITICS (Updated)|OneCitizenSpeaking
Bailout: Waste, Fraud and Taxpayer Abuse Act of 2008 (Updated)|OneCitizenSpeaking
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