Why the U.S. needs a rescue plan (part 2)... and why the rescuers need rescuing!
(since some of you were interested, Sebastian wrote a follow up to what he wrote a couple of days ago. He's cute when he gets all professorial:0)
In the previous post, I described what Treasury Secretary Paulson and the Federal Reserve Chairman believe is the problem with the financial system that is choking off the free flow of credit and raising short-term borrowing costs for financial institutions. Essentially, they believe the presence of illiquid hard to value securities is causing financial institutions to not lend to each other choking of the free flow of credit.
Prehaps Illustrative of why this fear exists is the recent case of Wachovia (one of the nations largest banks). Wachovia had several years ago made a bad acquisition of Golden West financial which was an aggressive originator in California of toxic mortgages know as option ARMs. Unfortunately for Wachovia these mortgages have seen record defaults and enormous losses, resulting in losses for Wachovia's. What is most troubling about Wachovia is that just several months it had hired a new CEO, Bob Steel, to turn around the company. Steel was deemed a great hire for Wachovia as he was Treasury Secretary Paulson's right hand man at the Treasury and had an long and successful career at Goldman Sachs. Steel's hire was a vote of confidence not only because of his resume and character, but also because he didn't take the job until after Goldman Sachs had conducted a due diligence on the company to assess the quality of its loan portfolio. One of Steel's first acts was to purchase 1 million shares in the open market at $16 per share with his own money to convey to shareholders that he believed in the company. Unfortunately for Steel and Wachovia the value of the option ARM portfolio last friday was deemed to be zero causing the bank to seek a rescue from the FDIC and Citibank, plunging Wachovia's stock 90%. Without the rescue Wachovia would have gone bankrupt and likely taken the FDIC with it, which would have required Congress to authorize a bailout of the FDIC (likely $100 Billion). What's the lesson? We still live in quite precarious times.
Back to the rescue...it is possible that the "Paulson plan" could work in rescuing the financial system and dealing with the illiquid assets. When the document for the plan was 3 pages, as originally submitted, it was easy to believe that such a plan, if authorized, would convey to the market the U.S. government would do anything required to restore stability to the credit markets. However, given this is an election year and the concept of "bailing out" Wall Street is deeply unpopular among voters many provisions were required to get support among Congress. The document now includes provisions for a bipartisan oversight committee for the administration of the plan, a restriction on executive compensation if company's participate, the option for the Federal government to receive an ownership stake, and the ability for Congress to later claw back any losses in the future. The document is now 110 pages calling into question how will such a plan for all practical purposes be administered and how long will it take and will be enacted in time to prevent a calamity? Unfortunately, we don't know the answers to these questions, let alone will Congress pass the legislation.
The most ironic things about the entire "Rescue Plan" now isn't whether the plan will work (no one knows as we are in uncharted territory), but whether Congress will "rescue" the guys that devised the rescue plan! By rejecting the rescue plan devised by Paulson and Bernanke the House of Representatives essentially repudiated the rescuers themselves who warned that the country may descend into calamity with out such a plan. If you repudiate the rescuers then who do you turn to if a wolf really shows up at the door? It is because of this reason that U.S. markets shaved $1.2 trillion in worth from the stock market when the House of Representatives defeated the bill. This is why it is now critical that Congress passes the rescue plan as it is a referendum on the key stewards of the U.S. economy. The Republican members want to distance themselves from this bill because it goes against their principles of not interfering with free markets and as many members want to distance themselves from George Bush. The Democrats are forcing the Republicans to provide majority support to the bill to make them admit their ideology of deregulation is flawed and that the current crisis is the culmination of 8 years of failed policies. Let's hope that both sides can rise to the occasion, find common ground, and rescue the rescuers.
As I said above, no one knows whether the plan will work. Paulson and Bernanke can see the symptoms (credit markets freezing up, banks not lending to each other, etc.), but they don't know with certainty that the cause of this crisis is the illiquid securities - it is merely their (largely Paulson's) best guess. Sadly, this may not be the only reason why credit markets are frozen. One possible cause of the current financial market crisis may be the consequences of the 1999 repeal of Glass Steagal, a law that had prevented banks from getting into lines of businesses such as Investment Banking and Asset Management. Prior to 1999 there was a natural separation where banks, through their deposits, provided low cost funding to other financial institutions. However, as banks got into these other lines of business themselves they may be less willing to provide that funding to competing institutions,especially in times of stress. For example, Bank of America terminated a credit line to Merrill Lynch, forcing Merrill to seek and buyer and fall into Bank of America's ready hands. Similarly, JP Morgan cut off trading with Bear Stearns forcing into its arms. In short, the large money center banks may be restricting lending to force the weaker financial institutions and those without sources of low cost funding, such as deposits, to fall into their hands at bargain basement prices. As such, the tight credit environment may be related to the industry consolidation that has been enabled by the 1999 repeal of Glass Steagal.
This consolidation could leave the U.S. with just a handful of banks (JP Morgan, Wells Fargo, Citigroup, and Bank of America). Unfortunately, this could mean that we will be paying higher rates in the future as there will be less competition, but it could also mean that all of those banks could end of being great investments as their profitability will balloon on the other side of the downturn... depending on how deep the downturn will be.
In the previous post, I described what Treasury Secretary Paulson and the Federal Reserve Chairman believe is the problem with the financial system that is choking off the free flow of credit and raising short-term borrowing costs for financial institutions. Essentially, they believe the presence of illiquid hard to value securities is causing financial institutions to not lend to each other choking of the free flow of credit.
Prehaps Illustrative of why this fear exists is the recent case of Wachovia (one of the nations largest banks). Wachovia had several years ago made a bad acquisition of Golden West financial which was an aggressive originator in California of toxic mortgages know as option ARMs. Unfortunately for Wachovia these mortgages have seen record defaults and enormous losses, resulting in losses for Wachovia's. What is most troubling about Wachovia is that just several months it had hired a new CEO, Bob Steel, to turn around the company. Steel was deemed a great hire for Wachovia as he was Treasury Secretary Paulson's right hand man at the Treasury and had an long and successful career at Goldman Sachs. Steel's hire was a vote of confidence not only because of his resume and character, but also because he didn't take the job until after Goldman Sachs had conducted a due diligence on the company to assess the quality of its loan portfolio. One of Steel's first acts was to purchase 1 million shares in the open market at $16 per share with his own money to convey to shareholders that he believed in the company. Unfortunately for Steel and Wachovia the value of the option ARM portfolio last friday was deemed to be zero causing the bank to seek a rescue from the FDIC and Citibank, plunging Wachovia's stock 90%. Without the rescue Wachovia would have gone bankrupt and likely taken the FDIC with it, which would have required Congress to authorize a bailout of the FDIC (likely $100 Billion). What's the lesson? We still live in quite precarious times.
Back to the rescue...it is possible that the "Paulson plan" could work in rescuing the financial system and dealing with the illiquid assets. When the document for the plan was 3 pages, as originally submitted, it was easy to believe that such a plan, if authorized, would convey to the market the U.S. government would do anything required to restore stability to the credit markets. However, given this is an election year and the concept of "bailing out" Wall Street is deeply unpopular among voters many provisions were required to get support among Congress. The document now includes provisions for a bipartisan oversight committee for the administration of the plan, a restriction on executive compensation if company's participate, the option for the Federal government to receive an ownership stake, and the ability for Congress to later claw back any losses in the future. The document is now 110 pages calling into question how will such a plan for all practical purposes be administered and how long will it take and will be enacted in time to prevent a calamity? Unfortunately, we don't know the answers to these questions, let alone will Congress pass the legislation.
The most ironic things about the entire "Rescue Plan" now isn't whether the plan will work (no one knows as we are in uncharted territory), but whether Congress will "rescue" the guys that devised the rescue plan! By rejecting the rescue plan devised by Paulson and Bernanke the House of Representatives essentially repudiated the rescuers themselves who warned that the country may descend into calamity with out such a plan. If you repudiate the rescuers then who do you turn to if a wolf really shows up at the door? It is because of this reason that U.S. markets shaved $1.2 trillion in worth from the stock market when the House of Representatives defeated the bill. This is why it is now critical that Congress passes the rescue plan as it is a referendum on the key stewards of the U.S. economy. The Republican members want to distance themselves from this bill because it goes against their principles of not interfering with free markets and as many members want to distance themselves from George Bush. The Democrats are forcing the Republicans to provide majority support to the bill to make them admit their ideology of deregulation is flawed and that the current crisis is the culmination of 8 years of failed policies. Let's hope that both sides can rise to the occasion, find common ground, and rescue the rescuers.
As I said above, no one knows whether the plan will work. Paulson and Bernanke can see the symptoms (credit markets freezing up, banks not lending to each other, etc.), but they don't know with certainty that the cause of this crisis is the illiquid securities - it is merely their (largely Paulson's) best guess. Sadly, this may not be the only reason why credit markets are frozen. One possible cause of the current financial market crisis may be the consequences of the 1999 repeal of Glass Steagal, a law that had prevented banks from getting into lines of businesses such as Investment Banking and Asset Management. Prior to 1999 there was a natural separation where banks, through their deposits, provided low cost funding to other financial institutions. However, as banks got into these other lines of business themselves they may be less willing to provide that funding to competing institutions,especially in times of stress. For example, Bank of America terminated a credit line to Merrill Lynch, forcing Merrill to seek and buyer and fall into Bank of America's ready hands. Similarly, JP Morgan cut off trading with Bear Stearns forcing into its arms. In short, the large money center banks may be restricting lending to force the weaker financial institutions and those without sources of low cost funding, such as deposits, to fall into their hands at bargain basement prices. As such, the tight credit environment may be related to the industry consolidation that has been enabled by the 1999 repeal of Glass Steagal.
This consolidation could leave the U.S. with just a handful of banks (JP Morgan, Wells Fargo, Citigroup, and Bank of America). Unfortunately, this could mean that we will be paying higher rates in the future as there will be less competition, but it could also mean that all of those banks could end of being great investments as their profitability will balloon on the other side of the downturn... depending on how deep the downturn will be.