SPEAKING FREELY US on reverse socialism path
By Ronald Solberg
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their say.
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It has been an historic week, with the news coming fast, furious and certainly
profound. The blow-by-blow carnage has caught the headlines, yet we have seen
effectively a mooted policy response to what has been a series of events that
has probably changed the landscape of American finance forever. The proposed US
Treasury bailout plan that Treasury Secretary Henry Paulson is urging congress
to hastily approve raises as many questions as it answers.
Let us first focus on the questions relating to the US Treasury proposal
itself.
Is US$700 billion enough? Certainly the use of these monies will
create a short-term pop as hitherto shunned securities will receive a "bid".
However, whether this amount is enough will be affected by a number of current
uncertainties that will impact the ultimate magnitude of the deadweight loss of
the impaired securities.
Current estimates vary from Paulson's view that predicts taxpayers will make
money, to others that believe ultimate losses will be counted in the hundreds
of billions or even a trillion and more.
Recent events have revealed that the methodology of Wall Street's financial
models used for valuing securitized assets is entirely broken. Furthermore, the
credibility of rating companies on assigning ratings that assess ultimate
payouts for mortgage-backed and asset-backed securities is also bankrupt.
Hence, in contrast to the potentially generous mark-to-model valuations that
banks are currently using, it is anyone's guess as to what the value of Level
lll assets sitting on bank balance sheets are worth. (Level lll financial
assets and liabilities have values typically based on management assumptions or
expectations rather than on market valuations. Their market value is therefore
questionable.)
In contrast to the inherently unknown intrinsic value of these securities and
the putative value currently assigned by the beleaguered investment and
commercial banks, what is the price the proposed Mortgage and Financial
Institutions Trust (MFI), will actually pay for these securities? (MFI follows
to some extent the path of the Resolution Trust Corporation, created in 1989 to
liquidate assets held by insolvent savings and loans companies). In many ways,
this is likely to become a political decision.
The Treasury Secretary's proposal states that "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 the crux of the
distribution of the ultimate costs to bailing out the deadweight loses created
by the bad loans and housing price deflation which is plaguing the United
States.
If the price paid by the MFI is above intrinsic value, then the taxpayers end
up with a losing proposition as they subsidize former banking largesse. If the
price paid is below intrinsic value, then the taxpayer at least has a chance,
perhaps even then slim, to invest in a profitable trade. In this latter case,
however, the banks will be left with a huge gaping re-capitalization
requirement. Please remind me, with whom will they finance this?
Even if the MFI wanted to pinpoint which of these two parties would be the
winner and loser, the uncertainty over the intrinsic valuation makes this
calculus virtually insoluble.
Then there is the issue on how far and wide to cast the bailout net. Does it
extend only to US banks or is the program open to foreign banks holding
eligible securities? There is currently a palpable tension between US and
foreign-owned financial institutions. Foreign institutions sitting on huge
apparent losses on what they thought were AAA (and other rated) securities, are
reeling from the blow to the asset quality of their balance sheets.
As global liquidity shrinks and risk aversion mounts, the infighting
intensifies. Already, the UK regulator, the Financial Services Authority has
demanded that Lehman Brothers repatriate the cash balances recently transferred
to New York from their company's British subsidiary, as this would materially
improve the ultimate financial settlement to UK investors exposed to Lehman
(UK) counter-party risk.
Then there is the issue of resolving unsettled trades in international bourses
that remain outstanding due to the Lehman insolvency. Given the lack of clarity
regarding these trades, a party's ability to trade is, in effect, frozen since
the composition of its book is unknown even to itself and its exchange.
Undoubtedly, there will be many such stories playing out over the next several
months and perhaps years as the carnage is sorted.
A third related issue is how exactly will the $700 billion bailout price tag be
funded. Presumably, attempts will be made to fund it responsibly, which means a
combination of debt issuance and increased US taxation. There have been vague
rumblings of foreign government contributions but this source remains extremely
uncertain.
According to the US Treasury text, they also propose raising the Statutory
Limit on the Public Debt to $11.315 trillion. This approaches 87% of US gross
domestic product, not including off balance sheet and contingent liabilities.
Who will buy this new debt issuance: cash-strapped Americans and American
investors or foreign investors?
If there is any inability or push-back in the willingness of investors to
absorb this new debt issuance, we can expect a steepening of the US Treasury
yield curve, renewed weakness in the US dollar and perhaps even the
unthinkable, a downgrade of the US sovereign credit rating from AAA, ironically
by the agencies that disingenuously rated some of the toxic mortgage-backed
paper AAA.
An initial litmus test will be whether the US Treasury proposal, once finalized
by the US Congress and signed into law by the president, will be accepted by
the financial markets as a real solution. This will be measured, inter alia, by
the TED spread (the difference between the benchmark London Interbank Offered
Rate and US Treasury Bill rates) returning to normal. After all, the recent
spike in this spread was driven by fears of inter-bank counter-party risk,
motivated in turn by concerns over asset quality issues and the opacity of bank
balance sheets. This normalization, indeed, is one of the two objectives of the
US Treasury initiative.
Recall that it took approximately seven years and numerous proposals before the
US Treasury-sponsored Brady Plan finally resolved the early 1980s' defaults by
less-developed countries on syndicated loans and ultimately restored the US
money-center banks to solvency. Hence, there are several remaining issues to
contemplate before judging whether Treasury Secretary Paulson's proposal will
live in fame or infamy.
How quickly will partisan politics in Washington DC allow this proposal to be
finalized? Politics in Washington have not been this polarized for many
decades. The Democrats are still smarting over the blow they received by
supporting the unpopular republican Iraq war initiative. Whilst they would like
to make political hay over this (Republican made) financial crisis, they also
need to avoid being seen as the obstacle to a solution. Hence, the proposal
most likely will be quickly (by legislative standards) finalized and signed
into law. Let us hope that this proposal, unlike those in the 1980s, gets it
right the first time and normalizes capital markets and the banking system on
the first attempt.
Whether this bailout plan comes together quickly or not, it in many ways
already comes too late. The real economic sector in the United States has
already been thrown into recession by the financial sector convulsions. Even
with a coherent and quickly trotted out financial bailout, the US economy will
suffer a recession. The severity could potentially be mitigated by a timely,
insightful plan. However, the magnitude of the deadweight losses resulting from
years of excessive reliance upon debt creation, loan pushing, borrowers' fraud,
rating agency and regulatory incompetence, and misguided monetary policy under
Fed chairman Alan Greenspan suggest that the length and depth of the incipient
recession will be long and deep.
Despite a hopefully coherent bailout package, we are likely to witness a long
economic recession, suggesting that bank balance sheets will additionally
suffer from a further deterioration in credit quality: auto loans, commercial
and industrial loans, credit-card debt and other investments, apart from
mortgages. So we can anticipate the recovery of bank profitability,
re-capitalization and normalization of credit growth to be an extended process.
This missive would not be complete without a brief comment on the implications
from this profound policy initiative for the country that, since World War I,
has been the leading light of laissez-faire capitalism. The scope and magnitude
of state intervention in the private sector that this initiative represents to
stabilize the financial sector is nothing short of mind-boggling.
As a trained social observer holding a PhD in economics and having studied both
the theories of vibrant laissez-faire capitalism of democratic countries and
the inefficient policies of the planned economies in socialist counties, I
struggle to categorize the implications for the paradigm shift that the
proposed policy response to these challenging times catapult us into.
On one hand, Paulson's aggressive state interventionism into the private sector
is little different from the numerous examples in history of the
nationalization of the banking sector with all the implications of moral hazard
and inefficiencies this spawns. Yet there is a further absurd, bizarre twist.
In many of these past instances, the mantra associated with the initiative was
to take from the rich and subsidize the poor. In this current case, the US
Treasury policy is effectively bailing out the rich, corrupt and incompetent on
Wall Street and funding it by taxing current and future generations of the
lesser-heeled, middle class on Main Street and further reducing American real
incomes across the board with incipient inflation.
These wounds will be assuaged only if we demand that all banks that decide to
participate in the proposed MFI bailout refund all paid bonuses over the past
seven years received by all bank officers from the chief executive on down.
Otherwise, this has the makings of a Weimar Republic redux (with hallmark
rampant hyperinflation and massive unemployment echoing the period that saw the
rise to power of Adolf Hitler) and an erosion of the social contract.
Dr Ronald Solberg is vice chairman and lead portfolio manager of Armored
Wolf, an alternative real assets hedge fund.
(Copyright 2008 Ronald Solberg.)
Speaking Freely is an Asia Times Online feature that allows guest writers to have
their say.
Please click hereif you are interested in contributing.
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