A proposal…

In yesterday's London Times, Gerard Baker, their US editor, commented “In the 1930s, the US Congress did more than its fair share in helping to turn a financial crisis into a global depression. Yesterday it looked as though it was auditioning to assume that role again.”

An interesting view. Granted, in the 1920’s Congress passed many near-sighted and, in retrospect, clumsy and often stupid self-serving laws that when looked at in their entirety set up the “Great Depression.” I don’t believe that the non-passage of the administration’s bail-out proposal equates.

However, likely everyone agrees that the markets’ responses to the vote’s failure were not good. But I feel that it was an overreaction, as many of the responses to the ongoing market turmoil have been. The reality is that there are no guarantees for investors. The risk factor is what ROI and interest rates are based on. To take away risk lowers the return. That’s why mattresses don’t pay interest. Part of the problem that lead to the current debacle is that lenders and investors tried too hard to shield themselves from risk. By “insuring” against risk, they avoided proper due diligence and basically increased it.

So, what do we do now? Maybe a bail-out isn’t the right solution. It's really just a Band-Aid on a far larger problem.

The Citigroup takeover of Wachovia’s retail banking operations might be a good prototype for what should be done to solve the situation. Instead of buying the “toxic” loans and bonds, perhaps the Treasury should put a cap on losses through a guarantee program and take preferred equity stakes in institutions that come to its window. Granted, we might end up having a semi-nationalization of the banking industry, but it at least gives John Q. Public a better potential security on taxpayer funds than a straight payout.

As I said yesterday, “mark to market” has become a disaster. A reconsideration of accounting rules for financial institutions should be part of the package.

Maybe Adam Smith's principals should be given a chance to work.

It’s possible that the members of Congress are smarter than they're often given credit for being.

Right now, we’re in a “market correction.” a tough one, maybe as bad as the Great Depression. Hopefully not.

We’re where we are as a result of lack of oversight, greed, and the concept of letting others be responsible for actions. A bail-out isn't a good thing in concept. It lets people and companies get a free pass for the bad decisions that were made. Granted, as a result of the mess that we’re in, something needs to be done quickly to restore faith in the markets. But it has to be done right.

And there are more ramifications to it being "done right."  For instance, as it stands now, three banks hold over 30% of all of the deposits in the U.S.  A perfect recipe for them being classified as "too big to fail."  It's a potential disaster in the making.  Remember the Japanese financial debacle that resulted from too many banks being protected from their own mistakes?  We don't want to see that again.

© 2007, Despair, Inc.

Fortunately, with Congress’ balk, the administration seems to be more open to compromise and making the proposed legislation more of a true “Fix” than the original proposal that hoped that throwing money at the problem it would make it go away. The real issue is to regain market stability is to have depositors and investors again be comfortable. Raising the FDIC insurance limits will go a long way to comfort the former. It’s been stuck at $100,000 for 28 years, far too long. The suggested quarter million limit is a nice round number and will help.

Getting investors comfortable will be another mater. It’s being proposed that the “mark to market” accounting rule be eliminated. This is a problematical issue. Investors want to know what their investments are really worth, so theoretically the concept is a good one. But when there are uncertainties, the question becomes “what is the true value?” In the case of securitized mortgages, many felt that the best way to value the bonds was on a worst-case basis. But is the worst-case the reality? True, there have been many defaults, but over time the value of the mortgages is likely higher than they appear in the short term. Thus, “mark to market” became a rush to judgment that didn't help the situation. An adjustment to the accounting rules may help.

Fool me once, shame on you; fool me twice, shame on me.

Oversight…

Quite rightly, Congress is reluctant to give the Bush Administration a “blank check”, like they did with the Iraq War. While time is of the essence, Congress and the Treasury have to “get it right”. This shouldn't be a bail-out. The banks are big boys and did some stupid things. They shouldn't be rewarded. Actually, maybe they should fail. But I don't think that the politicians (nor the economy) can accept that.

What shouldn’t be done:

    Buy the bad loans at par.
    Give the Treasury a free hand without congressional oversight.

What should be done:

    Negotiate a deep discount for any loans or bonds that are purchased.
    Require that the banks take responsibility for fraud and bad underwriting.
    Have a requirement for them to take back certain loans.

Also, mergers need to be vetted carefully. We’re getting closer to the fabled “one bank” scenario.

Remember, even if this works, It's not going to turn the economy around immediately.

As they used to say on TV, "Stay tuned". It's going to be interesting.

Fannie and Freddie

An interesting development

Treasury Secretary Henry Paulson is putting Fannie Mae and Freddie Mac into a conservatorship.

A bold move.

A conservatorship sounds like a euphuism for a bankruptcy trusteeship, and it likely is. The real question is, which way will the treasury and the Fed go? Chapter 11, or 7?

The former would “clean house,” and likely reduce the equity holders’ stakes significantly, but keep the entities in place with greater oversight. They might even be merged. This could be a good thing.

The latter, which appears to be a "Plan B," if the current option doesn't work out, is a more radical move, as it could result in the entities being converted into a fully-government operated entity like FHA or possibly liquidating them and removing that source of funding from the market. Either is a bold move.

Whichever way it goes, it will be an interesting ride for the mortgage and residential markets.