Post by Erich on Oct 3, 2008 14:32:11 GMT -5
Can the bailout work? Fat chance
At best, Congress has approved a quick fix that's bound to fail in the long run. Meanwhile, some experts offer solutions -- including $500 billion in tax rebates -- better than the bill just passed.
By Jon Markman
The recent volatility on Wall Street is virtually unprecedented and is likely to remain so until every trader dies of heart failure or the banking system is recapitalized with pixie dust, whichever comes first.
But don't blame Wall Street vacillation for the jumpiness. It should be seen in the context of a decisive, coordinated effort by governments worldwide to manipulate stock markets higher by every means possible without regard to such niceties as fundamentals, the rights of shareholders or the laws of financial gravity.
Few citizens will wish to complain, of course, for U.S. equities actually have a shot at advancing as much as 10% over the next few months. Wall Street veterans call this the "free-lunch trade," and it could be very tasty for a while.
Yet experts say it will likely fail eventually, by running into the usual set of bugaboos that we have discussed for some time: levels of debt deleveraging and slowing growth that no additional amount of monetary or fiscal stimulus can vanquish.
Battle lines for this epic contest between the physics of debt and government efforts to prop up the system with toothpicks and rubber cement can be seen most clearly in the rhetoric in Congress this week. Virtually every respected authority in the world of real capital believes the bailout bill approved by lawmakers won't solve our banks' problems. Yet the nation's political leadership pressed to pass it with the breezy confidence of the captain of the Titanic.
It passed, but it won't work
After it's signed into law, the Federal Reserve will flood the system with additional money, just as it did in 1999 to ward off expectations of a financial meltdown from the Y2K bug. Then markets will lift. But that won't mean all is well, not by a long shot, as eventually the plan must actually work. And every credible expert I've spoken with believes it won't. (The experts also have solutions, though, which I'll share with you in a moment.)
So here's the problem: As explained by John P. Hussman of the Hussman Funds, the financial bankruptcies we've seen in the past six months have come in order of their gross leverage, or the ratio of total assets to shareholder equity. The more leveraged -- Bear Stearns, Lehman Bros. (LEHMQ, news, msgs), Washington Mutual (WAMUQ, news, msgs), I'm talking to you -- the more vulnerable they were.
The reason is that as loans of a financial company lose value because of underpayment, company executives must write down the asset side of their balance sheets and at the same time reduce their shareholder equity on the liability side. Banks are allowed to lend only in proportion to their shareholder equity, so as the equity becomes thinner, banks are less able to lend money to make a profit.
Sophisticated customers then see that the banks are in precarious condition and make withdrawals. And so to satisfy those requests for withdrawals, banks are forced to liquidate more assets at distressed prices, prompting further reduction in shareholder equity. Yow! This process is then repeated in a vicious cycle until shareholder equity goes to zero and the company becomes insolvent. So long, banko.
What the government now proposes to do is to buy the questionable assets to protect the institutions against failure. So far, so good. Yet just taking the assets out of the mix would do nothing to provide additional bank capital, so the balance sheets would be just as fragile and prone to bankruptcy. At best, Hussman adds, you'd be allowing banks to liquidate their bad loans more easily to meet the demands of customer withdrawals.
The only way buying the bad assets could increase capital would be if the Treasury overpaid for them. And that would be so politically unpalatable that it isn't worth even contemplating.
What they should have done
Hussman has this solution, which is a variation on what credit derivatives expert Satyajit Das recommended last week: have the government provide capital directly via a high-interest "superbond." It would be counted as capital, yet in the event of a bankruptcy, it would have a senior claim above stockholders and senior bondholders. That would protect the financial system, Hussman says, while also protecting customers and taxpayers. Bond interest would be deferred until a bank met a certain level of profitability.
This is essentially the route that Warren Buffett has taken with his investments in Goldman Sachs (GS, news, msgs) and General Electric (GE, news, msgs) over the past two weeks: provide capital in return for a financially viable security that is senior to shareholders' stakes, accrues at a high rate of interest and can be called early, as soon as the bank can secure cheaper financing.
That's a great idea, but credit analyst Brian Reynolds of WJB Capital in New York has an ingenious variation that he whimsically calls "Fannie Mae in every IRA."
Reynolds, who has been chronicling the severe bear market in credit all year for his clients in daily e-mails that have grown increasingly strident and fretful, also echoed Das by saying that the best course of action would be to let time and price work their way through the system.
"At some point, corporate bond prices will fall enough and reach a high enough yield that investors who specialize in distressed investing will begin to buy," Reynolds says. How quaint. That's the way things are supposed to work.
Yet it's not quite glamorous or fast enough, so Reynolds thought about what would make investors bolt up and exclaim "I must buy credit!" and came up with a crazy idea that just might work -- and would cost taxpayers a lot less than currently proposed.
He thinks the Treasury should offer $500 billion in rebates to U.S. citizens. But instead of paying with a check, it should deliver new zero-coupon Fannie Mae (FNM, news, msgs) bonds. A zero-coupon bond is one that accrues interest for some specified period, such as 15 years, and then is paid all at once later on. If people wanted to spend the money right away, they could sell the bonds for whatever they could get for them in the marketplace, which wouldn't be much. If they wanted more money, they could hang on to the bonds, and the government would pay the full face value at maturity. Nice and simple.
The genius of this plan is that it would deliver the money straight to the people instead of to Wall Street -- a sure vote-getter. "We'd still be borrowing from our children, but we'd be borrowing less," Reynolds says. Fannie Mae, whose debts are now explicitly guaranteed by the government, could use the money it raised to buy banks' bad assets or provide capital directly. By this plan, citizens would become banks' creditors, not their owners, so you wouldn't have that acrid whiff of socialism.
Waiting, hoping, failing
David Kotok over at Cumberland Advisors in New Jersey gives another reason the Senate plan won't work: It proposes to buy bad assets only from institutions that decide to participate. Any institution that can avoid the bill's constraints -- such as limits on executive pay -- will try to do so. Indeed, only the weakest banks will opt into the program, in an act of desperation, he predicts.
"The others will languish and deteriorate until they, too, become so weak as to leave them without any choice," Kotok says, which may actually come too late.
In summary, we are on the cusp of a historic moment in world financial history. Virtually every country in the world is trying to throw truckloads of borrowed money at a problem created by borrowed money. As listed by analysts at ISI Group in New York, even before the rescue bill hit Congress, in this country we already had short-term interest rates slashed to 2%, bank-collateral quality lowered from AAA-rated securities to boxes of old spaghetti, a boost in conforming-loan limits at Fannie Mae, the nationalization of the nation's two largest mortgage lenders and the expansion of the Fed balance sheet by $300 billion-plus.
Elsewhere, the European Central Bank, Bank of China, Bank of England and United Arab Emirates have all injected liquidity into their monetary systems. Taiwan and China have cut banks' reserve requirements, allowing them to lend more from a lower capital base. China, Australia and New Zealand have abruptly changed course to lower interest rates. Russia has announced a $120 billion stimulus package, and Sweden is cutting taxes. (Come on, Andorra and Zambia, where are your contributions?)
And now we'll just have to see whether their efforts will work out for more than a couple of months and we can all go back to our regularly scheduled lattes, or whether it's time to start figuring out how to sell pencils. Place your bets.
At best, Congress has approved a quick fix that's bound to fail in the long run. Meanwhile, some experts offer solutions -- including $500 billion in tax rebates -- better than the bill just passed.
By Jon Markman
The recent volatility on Wall Street is virtually unprecedented and is likely to remain so until every trader dies of heart failure or the banking system is recapitalized with pixie dust, whichever comes first.
But don't blame Wall Street vacillation for the jumpiness. It should be seen in the context of a decisive, coordinated effort by governments worldwide to manipulate stock markets higher by every means possible without regard to such niceties as fundamentals, the rights of shareholders or the laws of financial gravity.
Few citizens will wish to complain, of course, for U.S. equities actually have a shot at advancing as much as 10% over the next few months. Wall Street veterans call this the "free-lunch trade," and it could be very tasty for a while.
Yet experts say it will likely fail eventually, by running into the usual set of bugaboos that we have discussed for some time: levels of debt deleveraging and slowing growth that no additional amount of monetary or fiscal stimulus can vanquish.
Battle lines for this epic contest between the physics of debt and government efforts to prop up the system with toothpicks and rubber cement can be seen most clearly in the rhetoric in Congress this week. Virtually every respected authority in the world of real capital believes the bailout bill approved by lawmakers won't solve our banks' problems. Yet the nation's political leadership pressed to pass it with the breezy confidence of the captain of the Titanic.
It passed, but it won't work
After it's signed into law, the Federal Reserve will flood the system with additional money, just as it did in 1999 to ward off expectations of a financial meltdown from the Y2K bug. Then markets will lift. But that won't mean all is well, not by a long shot, as eventually the plan must actually work. And every credible expert I've spoken with believes it won't. (The experts also have solutions, though, which I'll share with you in a moment.)
So here's the problem: As explained by John P. Hussman of the Hussman Funds, the financial bankruptcies we've seen in the past six months have come in order of their gross leverage, or the ratio of total assets to shareholder equity. The more leveraged -- Bear Stearns, Lehman Bros. (LEHMQ, news, msgs), Washington Mutual (WAMUQ, news, msgs), I'm talking to you -- the more vulnerable they were.
The reason is that as loans of a financial company lose value because of underpayment, company executives must write down the asset side of their balance sheets and at the same time reduce their shareholder equity on the liability side. Banks are allowed to lend only in proportion to their shareholder equity, so as the equity becomes thinner, banks are less able to lend money to make a profit.
Sophisticated customers then see that the banks are in precarious condition and make withdrawals. And so to satisfy those requests for withdrawals, banks are forced to liquidate more assets at distressed prices, prompting further reduction in shareholder equity. Yow! This process is then repeated in a vicious cycle until shareholder equity goes to zero and the company becomes insolvent. So long, banko.
What the government now proposes to do is to buy the questionable assets to protect the institutions against failure. So far, so good. Yet just taking the assets out of the mix would do nothing to provide additional bank capital, so the balance sheets would be just as fragile and prone to bankruptcy. At best, Hussman adds, you'd be allowing banks to liquidate their bad loans more easily to meet the demands of customer withdrawals.
The only way buying the bad assets could increase capital would be if the Treasury overpaid for them. And that would be so politically unpalatable that it isn't worth even contemplating.
What they should have done
Hussman has this solution, which is a variation on what credit derivatives expert Satyajit Das recommended last week: have the government provide capital directly via a high-interest "superbond." It would be counted as capital, yet in the event of a bankruptcy, it would have a senior claim above stockholders and senior bondholders. That would protect the financial system, Hussman says, while also protecting customers and taxpayers. Bond interest would be deferred until a bank met a certain level of profitability.
This is essentially the route that Warren Buffett has taken with his investments in Goldman Sachs (GS, news, msgs) and General Electric (GE, news, msgs) over the past two weeks: provide capital in return for a financially viable security that is senior to shareholders' stakes, accrues at a high rate of interest and can be called early, as soon as the bank can secure cheaper financing.
That's a great idea, but credit analyst Brian Reynolds of WJB Capital in New York has an ingenious variation that he whimsically calls "Fannie Mae in every IRA."
Reynolds, who has been chronicling the severe bear market in credit all year for his clients in daily e-mails that have grown increasingly strident and fretful, also echoed Das by saying that the best course of action would be to let time and price work their way through the system.
"At some point, corporate bond prices will fall enough and reach a high enough yield that investors who specialize in distressed investing will begin to buy," Reynolds says. How quaint. That's the way things are supposed to work.
Yet it's not quite glamorous or fast enough, so Reynolds thought about what would make investors bolt up and exclaim "I must buy credit!" and came up with a crazy idea that just might work -- and would cost taxpayers a lot less than currently proposed.
He thinks the Treasury should offer $500 billion in rebates to U.S. citizens. But instead of paying with a check, it should deliver new zero-coupon Fannie Mae (FNM, news, msgs) bonds. A zero-coupon bond is one that accrues interest for some specified period, such as 15 years, and then is paid all at once later on. If people wanted to spend the money right away, they could sell the bonds for whatever they could get for them in the marketplace, which wouldn't be much. If they wanted more money, they could hang on to the bonds, and the government would pay the full face value at maturity. Nice and simple.
The genius of this plan is that it would deliver the money straight to the people instead of to Wall Street -- a sure vote-getter. "We'd still be borrowing from our children, but we'd be borrowing less," Reynolds says. Fannie Mae, whose debts are now explicitly guaranteed by the government, could use the money it raised to buy banks' bad assets or provide capital directly. By this plan, citizens would become banks' creditors, not their owners, so you wouldn't have that acrid whiff of socialism.
Waiting, hoping, failing
David Kotok over at Cumberland Advisors in New Jersey gives another reason the Senate plan won't work: It proposes to buy bad assets only from institutions that decide to participate. Any institution that can avoid the bill's constraints -- such as limits on executive pay -- will try to do so. Indeed, only the weakest banks will opt into the program, in an act of desperation, he predicts.
"The others will languish and deteriorate until they, too, become so weak as to leave them without any choice," Kotok says, which may actually come too late.
In summary, we are on the cusp of a historic moment in world financial history. Virtually every country in the world is trying to throw truckloads of borrowed money at a problem created by borrowed money. As listed by analysts at ISI Group in New York, even before the rescue bill hit Congress, in this country we already had short-term interest rates slashed to 2%, bank-collateral quality lowered from AAA-rated securities to boxes of old spaghetti, a boost in conforming-loan limits at Fannie Mae, the nationalization of the nation's two largest mortgage lenders and the expansion of the Fed balance sheet by $300 billion-plus.
Elsewhere, the European Central Bank, Bank of China, Bank of England and United Arab Emirates have all injected liquidity into their monetary systems. Taiwan and China have cut banks' reserve requirements, allowing them to lend more from a lower capital base. China, Australia and New Zealand have abruptly changed course to lower interest rates. Russia has announced a $120 billion stimulus package, and Sweden is cutting taxes. (Come on, Andorra and Zambia, where are your contributions?)
And now we'll just have to see whether their efforts will work out for more than a couple of months and we can all go back to our regularly scheduled lattes, or whether it's time to start figuring out how to sell pencils. Place your bets.