Thinking the unimaginable: that the immediate financial problem may be unsolvable by legislation alone, we now examine what is being proposed by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke.
Understanding the current financial crisis …
The current financial crisis is fairly easy to explain and may be impossible for the government to resolve with their proposed bailout.
The assumption which sunk the ship was that real estate values would keep rising indefinitely and that any foreclosure sale would return a significant percentage of the amount loaned on the property. No one believed that property values would decline to the point of significantly impairing the underlying collateral.
The second assumption which added to the current financial crisis is that insurance guaranteeing the pay-off of the mortgage would make the lender whole and prevent a catastrophic loss. It was this second assumption which led to the present crisis as the Wall Street Wizards came to believe that they could engineer any mortgage package into an acceptable risk using a combination of insurance and interest-hedging techniques. Again, all conditioned on the theory that home prices would continue to rise and that risk could be adequately managed.
Wall Street Creativity …
Whether attributable to GREED, stupidity and the lack of regulatory oversight, the Wall Street Wizards decided to use securities collateralized by mortgage pools to create other securities. By picking and choosing mortgage pools and slicing and dicing mortgages of various degrees of risk, the Wizards created paper based on paper – added more insurance and hedges and then sold these to investors as investment-grade securities that were said to be just slightly less risky than government-issued treasury bonds.
This slicing and dicing process eventually produced the same result as if you took all of the original underlying mortgages, ran them through a shredder and sold the individual strips to investors with the promise of producing an acceptable and safe yield. Should any of the mortgages actually default, the problem was to gather up all of the strips, foreclose on the re-assembled mortgage and settle all outstanding debts – perhaps, in the process, making a claim on an insurance company for any losses incurred by the lender. Bottom line: we are now in a position where the confetti produced by the shredder cannot be easily reassembled to determine the value of the underlying mortgage or the value of any given strip of paper produced in the shredding process.
Greed, pure and simple …
The almost insurmountable problem of re-assembling the strips of shredded paper was compounded by the fact that may investors only invested a portion of their own money in purchasing the confetti. They used borrowed funds to purchase these toxic products in order to amplify their yield.
Some companies used leveraged funds at a thirty-to-one ratio where then entire amount of their purchase exceeded thirty times the amount of ownership capital in the business. With this amount of leverage, $1,000 of the company’s equity assets were used to purchase $30,000 worth of paper. Turning an acceptable loss of 30% ($300 loss in a non-leveraged transaction) into a $9,000 disaster which bankrupts the company.
Compounding the problem: the liquidity crisis …
Considering it is next to impossible to value the confetti strips produced by the shredder and, in the absence of recent sales, to provide some estimate of value, the toxic securities became worthless as nobody had enough confidence to purchase the distressed paper at a fair market price which insured a profit -- instead of a larger loss.
Financial institutions refused to do business with each other because the true value of their balance sheets could not be determined. Not only did the financial institutions refuse to do business with each other, they refused to lend funds to the general public. One, they did not know their own financial strength and thus could not determine how much money was available for lending; and two, they wanted to conserve their cash as loan loss reserves to insure their own firm’s survival in these perilous times. This is the nub of the real liquidity crisis: the loss of confidence in our financial institutions created by their inability to present a true and accurate account of their net worth without relying on potentially fallacious assumptions and computer models.
Business slowly ground to a halt which prompted federal intervention.
Previous government actions …
Realizing that financial institutions, with billions of dollars worth of highly leveraged paper outstanding, would become immediately insolvent if they were forced to account for their losses, the federal government has stepped in to save the day. The Federal Reserve and the Treasury Department collaborated on a series of “liquidity injections” in which the Federal Reserve collectively loaned depository institutions billions of dollars -- secured in many instances by collateral consisting of the toxic paper itself. To avoid unduly stigmatizing the depository institutions, the Federal Reserve created artificial devices called oddly-named “loan facilities” in order to spare the institution the humiliation of appearing at the Fed’s overnight window, hat-in-hand, to borrow funds to meet their core capital requirements which would allow them to stay in business. Adding to the charade, the borrowers were forced to participate in an artificial “auction” to determine a fair market price for the capital they were borrowing.
Expanding the lending program …
This stop-gap lending required ever increasing amounts of capital and continually re-financing the paper at 28-day (now longer) intervals. A Ponzi-like scheme which requires ever more new capital to be injected into the system and benefits only the early institutional borrowers. But the problem was much larger than the depository institutions, so the Federal Reserve then allowed non-depository institutions such as the large brokerages to also tap the Fed funds.
Nothing much has changed. Fundamental real estate prices are still declining and people, many of whom could not afford their homes in the first place, are continuing to face foreclosures. Financial institutions still have no idea of their true balance sheet positions. And counterparties are still reluctant to do business with each other.
The great bailout …
So a lame duck Administration, with less than four months on its watch, wants Congress to provide a blank check from the taxpayers to bailout those institutions and others who defied sound business practices and conventional wisdom and who find themselves technically insolvent were it not for the regulatory agencies letting them slide with a host of financial tricks.
The government is asking Congress to allow an unelected official Henry Paulson, in consultation with other government and non-government people, to use $700 BILLION of the taxpayer’s money to help solve the current crisis.
In my humble opinion, we are headed for an even bigger problem …
One, the fundamental problem of real estate values, which underlie much of the toxic paper, has not been stabilized and nobody appears to have a method of calculating the further decline or how to halt further erosion of property values.
Two, if the financial institutions cannot fairly value the toxic paper, what chance does the federal government (which unaccountably lost billions of dollars overseas) have to derive a fair market value for buying the toxic paper.
Three, if the last sale of toxic paper was made at approximately twenty-five cents on the dollar, why is the government willing to pay much, much more for the same paper?
Four, how does one unwind the losses due to the imprudent use of leverage without causing financial institutions to declare insolvency or be ruled unsound by regulatory agencies. The only answer to the problem is to perpetuate the accounting tricks which are being used today – further injecting fear, uncertainty and doubt into counterparty transactions.
And five, can we really trust the government. Already the democrats are demanding that individual homeowners facing foreclosure receive some unspecified benefit. And expanding the program to include auto loans and credit card debt.
Let’s look at the proposal being submitted to Congress …
Here is the full text of the Paulson/Treasury plan as sent to congress late yesterday. It is deliberately vague, of course, which will makes its Congressional ride a roller-coaster. At least as importantly, the two key numbers: $700-billion and $3-trillion. The former is the amount that Paulson would like authorized for securities purchases, and the latter is the amount by which Paulson would like to "temporarily" increase the U.S. debt limit.
LEGISLATIVE PROPOSAL FOR TREASURY AUTHORITY TO PURCHASE MORTGAGE-RELATED ASSETS
Section 1. Short Title.
This Act may be cited as ____________________.
Sec. 2. Purchases of Mortgage-Related Assets.
(a) Authority to Purchase.--The Secretary is authorized to purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United States.
Two points of contention: one, members of Congress are trying to expand the program from mortgage-related assets to collateralized commercial loans, auto loans and credit card debt; and two, members of Congress are also trying to include foreign-owned banks who do a substantial part of their business in the United States. Thus we are already moving past securitized mortgages and the bailout of American institutions. All with the taxpayer’s money.
(b) Necessary Actions.--The Secretary is authorized to take such actions as the Secretary deems necessary to carry out the authorities in this Act, including, without limitation:
We are investing tremendous authority in an unelected official whose job comes to an end in four months and whose successor is totally unknown at this time. We cannot assume that the next Treasury Secretary will be any more than a political appointee or be qualified to assist in solving the current crisis.
(1) appointing such employees as may be required to carry out the authorities in this Act and defining their duties;
There are no qualifications for such employees and there is no prohibition from hiring politically-connected people or people who were engaged in creating this mess in the first place. This may become the full employment opportunity act for the terminally lame. And the Republican’s are screaming about Barack Obama’s planned expansion of government.
(2) entering into contracts, including contracts for services authorized by section 3109 of title 5, United States Code, without regard to any other provision of law regarding public contracts;
Can you say Halliburton, no-bid contracts?
(3) designating financial institutions as financial agents of the Government, and they shall perform all such reasonable duties related to this Act as financial agents of the Government as may be required of them;
Which financial institutions? The very same ones that created the mess? Or is this the same type of legislation which resulted in chartering the Federal Reserve to perform the functions of a United States Central Bank?
(4) establishing vehicles that are authorized, subject to supervision by the Secretary, to purchase mortgage-related assets and issue obligations; and
Like off-balance sheet vehicles or other abominations like Fannie Mae and Freddie Mac which will be run by executives with multi-million dollar payouts? Or is this simply a conduit for power to be shared by the privately-owned Federal Reserve?
(5) issuing such regulations and other guidance as may be necessary or appropriate to define terms or carry out the authorities of this Act.
This could mean anything from nationalizing the banks to enlarging the lending limits themselves. This is truly an open-ended run around the Constitutional authority of the President and the Legislature. This section must contain better definitions unless we, the people, are willing to accept the government’s Orwellian language that a loss is really a profit and that a bankrupt entities is really a going concern.
Sec. 3. Considerations.
In exercising the authorities granted in this Act, the Secretary shall take into consideration means for--
(1) providing stability or preventing disruption to the financial markets or banking system; and
(2) protecting the taxpayer.
This is sort of a mission statement that means exactly nothing as nothing would be enforceable under the law.
Sec. 4. Reports to Congress.
Within three months of the first exercise of the authority granted in section 2(a), and semiannually thereafter, the Secretary shall report to the Committees on the Budget, Financial Services, and Ways and Means of the House of Representatives and the Committees on the Budget, Finance, and Banking, Housing, and Urban Affairs of the Senate with respect to the authorities exercised under this Act and the considerations required by section 3.
This is not acceptable. Along with the Administration’s ability to classify documents and Congressional ability to hold close door meetings, this is not kosher. We should see a monthly balance sheet on the Treasury’s (Or the Federal Reserve’s) web site showing purchases, amounts, and people involved in the purchases. More transparency in what has been essentially an opaque process up to this point. Reporting to those hyper-partisan committees who did nothing while this crisis developed or progressed is obscene.
Sec. 5. Rights; Management; Sale of Mortgage-Related Assets.
(a) Exercise of Rights.--The Secretary may, at any time, exercise any rights received in connection with mortgage-related assets purchased under this Act.
Like imposing conditions on those who have borrowed significant amounts of money or who have sold their toxic assets to the government?
(b) Management of Mortgage-Related Assets.--The Secretary shall have authority to manage mortgage-related assets purchased under this Act, including revenues and portfolio risks therefrom.
Does this mean that the government is now going to hedge risks in the same way the private financial community did? Or purchase insurance from insurance companies to unofficially extend the bailout to the insurers who got caught short?
(c) Sale of Mortgage-Related Assets.--The Secretary may, at any time, upon terms and conditions and at prices determined by the Secretary, sell, or enter into securities loans, repurchase transactions or other financial transactions in regard to, any mortgage-related asset purchased under this Act.
I do not see the words “fair and equitable price” which means that the Secretary can provide sweetheart deals to the undeserving Wizards of Wall Street and political special interests. Not to mention foreign countries.
(d) Application of Sunset to Mortgage-Related Assets.- -The authority of the Secretary to hold any mortgage- related asset purchased under this Act before the termination date in section 9, or to purchase or fund the purchase of a mortgage-related asset under a commitment entered into before the termination date in section 9, is not subject to the provisions of section 9.
Governmental gobbly-gook. If there is a sunset provision, why is it not stated here? And the section “is not subject to the provisions of section 9” means little or nothing at this point. This is the type of double-dealing loophole found in most legislative documents. We need a return to clear, well-defined and unambiguous language – especially in this bill.
Sec. 6. Maximum Amount of Authorized Purchases.
The Secretary's authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time
I want to stand up and cry bullshit! This appears to be a trick to exceed the $700 BILLION authorization! Am I the only person to see that the Secretary could purchase $700 BILLION in mortgages, sell them off at a low price, return to purchase additional securities, sell them off at a low price … and continue this until they have processed the estimated $1.2 TRILLION dollars worth of toxic mortgages they are too chicken to mention to the public? I this were truly a capped expenditure bill, the Secretary would only have the authority to purchase up to $700,000,000,000 of toxic securities and then return to Congress for additional spending authority or use the money that was received in any sales to purchase additional toxic securities – which could also lead to a government program overrun! What a concept!
Sec. 7. Funding.
For the purpose of the authorities granted in this Act, and for the costs of administering those authorities, the Secretary may use the proceeds of the sale of any securities issued under chapter 31 of title 31, United States Code, and the purposes for which securities may be issued under chapter 31 of title 31, United States Code, are extended to include actions authorized by this Act, including the payment of administrative expenses. Any funds expended for actions authorized by this Act, including the payment of administrative expenses, shall be deemed appropriated at the time of such expenditure.
Another reference to another law which may provide additional “unexplained” latitudes in administering this legislation.
Sec. 8. Review.
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.
Absolute power granted to an unelected offical and his successor. Not even the courts can intervene should something illegal or untoward be encountered. This is the type of unconditional power granted to the President of the United States in a time of war. Certainly, this type of power must be subject to judicial review in order to be constitutional.
Sec. 9. Termination of Authority.
The authorities under this Act, with the exception of authorities granted in sections 2(b)(5), 5 and 7, shall terminate two years from the date of enactment of this Act.
This is not an unconditional termination of authority and as such, should be rejected.
Sec. 10. Increase in Statutory Limit on the Public Debt.
Subsection (b) of section 3101 of title 31, United States Code, is amended by striking out the dollar limitation contained in such subsection and inserting in lieu thereof $11,315,000,000,000.
Very cute. There is no indication of the amount being raised as the original amount as shown in the code section has been modified by many public laws.
Sec. 11. Credit Reform.
The costs of purchases of mortgage-related assets made under section 2(a) of this Act shall be determined as provided under the Federal Credit Reform Act of 1990, as applicable.
More references to additional legislation and thus more loopholes introduced into this legislation.
Sec. 12. Definitions.
For purposes of this section, the following definitions shall apply:
(1) Mortgage-Related Assets.--The term mortgage- related assets means residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before September 17, 2008.
Why would we bailout “commercial mortgages?” Are we planning to save major buildings or just the collateralized lease payments which have turned sour in this economy. This is a non-definition.
(2) Secretary.--The term Secretary means the Secretary of the Treasury.
(3) United States.--The term United States means the States, territories, and possessions of the United States and the District of Columbia.
There you have it. Hastily crafted legislation ceding an unprecedented amount of power to an unelected official whose successor remains unknown at this time. Imagine what would happen if, hypothetically, a President Obama appointed Franklin Raines, the ex-Fannie Mae CEO who cooked the books to insure his bonus, as the Secretary of the Treasury and the appointment was confirmed by a corrupt democrat-controlled Senate. Talk about a worst case scenario?
This is bad legislation or I should say ill-defined legislation which should not be passed in its present form.
We need to wait and see what Congress will do with this Paulson proposal.