Scourge of the bailouts

The scourge of the bailouts is that it helps an addict get deeper into the malaise. First it was the Wall Street Banks, then it’s the Big three and even Biotech companies in Britain that line up with hat in hand. John Grapper in his FT column hollers “it’s time we stop improvising our way out of trouble”.

Steven Horwitz, an economics professor at St. Lawrence University, got it right when he wrote, “There will be short-term pain if we don’t bail out these firms, but that is the hangover price we pay for 15 years or more of binge lending. The proposed bailout cannot prevent the pain of the hangover; it can only conceal it by shifting and dispersing it among the taxpayers and an economy weakened by the borrowing, taxing and/or inflation needed to pay for that $700 billion.”

I look at a basic aspect. Somebody makes a mistake, a very big mistake and everyone is made to suffer. How long can this amnesty go on? Call it moral hazard, but it’s perpetuation of the ineptitude. It’s like serving more booze to an alcoholic.

Take the big three case for bailout. Isn’t it better to float three new car companies with the money that they say they need? Doesn’t that make better sense? Buyout the assets of the existing companies in their bankruptcy proceedings (liquidation) and then rejuvenate them under a new name, minus the union commitments. The only commitment to the organized labor should be just jobs. No huge healthcare excess baggage or other perks for the wily top managements.

The only condition should be make profits and share the loot. I think that sounds more like it. Hank Paulson should be pleased.

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Have no mercy, Junk'em all

Eliot Spitzer in Slate magazine is close to suggesting a serious rethink on the massive US bailouts of giant financial institutions. He asks -

“The CACC story highlights the risk that current bailouts—a remarkable $7.8 trillion in equity, loans, and guarantees so far—may merely perpetuate a fundamentally flawed status quo. So far, at least, we are simply rebuilding the same edifice that just collapsed. None of the investments has even begun to address the underlying structural problems that are causing economic power to shift away from the United States, sector by sector”.

The great irony is that our new place in the global economy is a direct consequence of our grand victory over the past 60 years. We have, indeed, converted virtually the entire world into one integrated capitalist economy, and we must now bear the brunt of serious and vigorous competition. In the immediate aftermath of World War II, the United States was essentially the only nation with financial capital, intellectual capital, skilled labor, a growing middle class generating consumer demand, and a rule of law permitting safe investment. Now we are one of many nations with these critical advantages.

But even more important, from a structural perspective, our dependence on entities of this size ensured that we would fall prey to a "too big to fail" argument in favor of bailouts. In that case, vast sums now being spent on rescue packages might have been available to increase the intellectual capabilities of the next generation, or to support basic research and development that could give us true competitive advantage, or to restructure our bloated health care sector, or to build the type of physical infrastructure we need to be competitive. It is time we permitted the market to work: This means true competition with winners and losers; companies that disappear; shareholders and CEOs who can lose as well as win; and government investment in the long-range competitiveness of our nation, not in a failed business model of financial concentration and failed risk management that holds nobody accountable.”

It’s a refreshingly different take from most arguments that favor a bailout just because America needs its lenders that are too big to fail, no matter how imprudent they were. Here is Spitzer calling a spade exactly that. Have no mercy, junk’em all…

When nations go belly up

Iceland, a tiny economy with a population of just 320,000 and GDP of £14 billion ($ 23.85 billion) has liabilities in excess of $100 billion against annual GDP of just $14 billion. Clearly, a case of a nation going bankrupt. It is starting to adopt extreme measures by forcing Icelandic institutions such as pension funds to repatriate funds to bolster its reserves in defense of the collapsing currency.

As the Economist puts it –

"Iceland’s rapid rise and even faster fall has been viewed from afar as a parable of greed and hubris, in which a nation of farmers and fishermen borrowed too much and are paying the price. But that is to draw false comfort. Although Iceland represents an extreme case of a huge financial system towering over a small economy, other states suffer from similar imbalances. They differ only in scale, but not substance. Kreppa (“in a pinch”) may be an Icelandic term, but it translates."

The only avenue open to Iceland to function economically on a day to day basis i.e. so as to enable Iceland to import resources such as food and fuel is by long-term loans and guarantees from the IMF and other countries such as Russia which has loaned Iceland euros 4 billion. The net effect is that Iceland is likely to experience a severe and prolonged economic recession and will be forced to develop cash generating commercial industries such as fishing to finance the increased debt burden. The expectation is that over time governments will cancel the Icelandic bad debts in exchange for geopolitical influence.

The fact is, in the flat world in which we live in, Kreppa will more likely translate. Not all may have the EU umbrella above their heads...

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What is Paulson’s Plan B, sorry X (by now?)

Quoting Newsweek –

“In the best-case scenario for Paulson's plan, there is real, unrecognized value in the mortgage-backed securities sitting on financial institutions' balance sheets. He hopes that the government, by serving as a committed buyer, will be able to jump-start trading in those securities. Once it's clear to the marketplace that the disdained securities have considerable value, Paulson hopes, the uncertainty over financial institutions' net worth will be dispelled and they will be able to raise capital privately and resume normal lending.

If instead the Treasury purchase plan reveals that the securities really are as worthless as many fear, Paulson and Bernanke will need an urgent Plan B (or are we up to Plan X by now?). Super-low sales prices will force financial institutions to acknowledge they have been carrying assets on their books for more than they're worth. They'll have to write them down, which could leave many undercapitalized. At that point, the government will be forced to take them over and then close them or merge them into healthier institutions.”

Where will they find the $700 billion?

I don’t really know who else read my previous post. But seems folks at NY Times certainly have. Hardly a day had passed, here they throw up an elaborate Q&A…

Read and figure !

Why just the FM twins, why not Lehman?

So the US government okays a $700 billion bailout package for its distressed financial institutions.

I began to think about the nature of the lifeline. What exactly does a bailout mean? Will the US treasury buyout bad assets and refinance the failed lenders so that they can resume business? Will it float a freshly funded SPV to absorb the bad assets, clean up the muck from the rogue lenders’ books and then eventually sell them? Or will the Fed just go and print fresh notes equal to $700 billion and honor the bonds as they come back to collect?

I look up federal bailout history. The handling of the great depression of 1930’s, the savings & loan scandal of 1989 and a few other. Nothing has been this big. Even more were allowed to go under. They were just not qualified for a bailout, bit like Lehman Brothers.

So where did Lehman goof up? Why only the FM twins (Fannie Mae & Freddie Mac), Bear Stearns and Merrill Lynch? What gives?

To be eligible for a bailout, firms must also demonstrate a particular genius for screwing up. Before it went bust, Bear Stearns had a monstrous $33 of debt for every dollar of capital, and hedge funds it owned destroyed hundreds of millions of dollars of clients' cash. It got a bailout.

Financial intermediaries like Bear Stearns and the FM twins function like the heart of the global financial system. If they go into cardiac arrest, the whole body is in danger. Since Bear Stearns was a counterparty to (and guarantor of) trades and financial arrangements with the world's major financial players, its failure would have triggered a cascade of losses. In the same vein, huge quantities of the $5.4 trillion in debt issued and insured by FM twins sit on the balance sheets of central banks and financial institutions around the globe. For the U.S. government simply to let this debt — which it had been implicitly backing for decades — go bad would have meant inflicting severe damage on America's most significant diplomatic and trading partners. Fannie Mae wasn't too big to fail, it was too Chinese to fail.

So now I get it. To be eligible for a bailout it’s not enough to be just too big. Screw it up real bad that it should threaten the global financial system. So much so that the ensuing stress on financial markets should mean massive job losses, devastated retirement accounts, further erosion of asset values and absent loans – not just in your country, across the world.... New world order, period.

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After bailout, comes the default

If it was the massive bailout last Sunday, it seems all that prayers in the Church may not have worked. Now here is what it triggered – a massive CDS default…
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Fannie-Freddie Mae-Mac

This is the third time this year that the US authorities have made a big policy announcement – seizing control of battered mortgage behemoths Freddie Mac and Fannie Mae - on a Sunday. The first, on March 16, provided emergency support by the Federal Reserve to investment banks. It generated a rally in global markets that lasted only two months before grim reality set in again.

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The second, on July 13, signalled that the government’s wallet stood behind Freddie and Fannie. This yielded market relief for just a month. In both cases, the affected segments of the US economy did not have enough time to clean up the debris and start the rehabilitation and reform process.

It just means de facto government control, though the Bush administration had been careful in not using the word Nationalization – in the US they call it `bailout’. Fannie and Freddie have $5,400bn in outstanding liabilities and guarantee three-quarters of all new US mortgages.

The objective - to bring down mortgage rates and ease financial market stress by making it clear that debt securities issued by these firms are safe since the US government will not allow either of them to fail. Outright government buying of new Fannie and Freddie mortgage-backed securities, plus increased government financial support for the companies should bring down spreads on the securities they issue, reducing the cost of mortgages.

These are days like never before. Let’s see if the levees hold!!!

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