Federal Government Policy Issues

Discussion and information on selected policy issues concerning tax, foreign relations, energy and other significant policies. The intent is to provide data and analysis that will assist in determining the appropriateness of the policy. Any posts containing rants, personal attacks on officials or other posters or which do not concisely present a point of information will not be published.

Saturday, September 20, 2008

 

FINANCIAL BAILOUT

The current structure of the bailout of the investment and commercial banks being discussed involves the US government purchase of distressed mortgage backed securities which has a cost estimate of approximately $700b. However, it will not be possible to save these institutions without the US government also purchasing perhaps trillions of dollars worth of other financial instruments such as synthetic CDO's (collateralized debt obligations), actual and synthetic CDS's (Credit Default Swaps), auction rate securities, covenant lite loans and foreign transactions. Especially in the case of synthetic CDO's and CDS's, these were instruments that were closer to casino bets than financial transactions.

If the government does not structure the bailout carefully and correctly, there is nothing to prevent these investment banks from using their new found cash and borrowing abilities to create new investments that get us back into the same situation while making some very wealth people much wealthier with only the taxpayer losing.

An alternative to the approach being discussed is to setup a new Government Sponsored Entity (GSE) that would purchase only the financial instruments that will help the US economy. Remember that Fannie and Freddie were initially setup as GSE's and that Fannie was sold to private investors in 1968 to fund the Vietnam war. Let the investment banks go into bankruptcy, the new GSE would purchase at very low prices the appropriate assets required to keep banking and lending operating in the US and the stockholders and managers of the bankrupt institutions would not benefit. The advantages of this approach are:

- The taxpayer would not have to purchase trillions of synthetic instruments.
- The taxpayer would not have to purchase assets that are owned by a foreign country.
- The issue of encouraging this type of action in the future via moral hazard would not be an issue.
- The taxpayer would gain when the GSE was spun off into new financial institutions via an Initial Public Offering (IPO).
- The essential assets held by the banks would be purchased at a lower price.
- The new GSE would not have to be concerned with investor law suits.

The exact same operating practices that required a bailout of Long Term Capital in 1998 created the problem that we are currently facing in the investment banks. The investment banks, many of whom were involved with Long Term Capital in 1998, knew better but failed to act responsibly.

Comments:
TARP FUNDS MISS THE MARK

The $700b of TARP funds is being used to purchase equity in financial institutions. The expectation is that this program will increase liquidity and enable these institutions to begin lending again to consumers and businesses thereby saving jobs and the economy. It won’t work. At best, this plan will temporarily delay the failure of some of these institutions and make some hedge funds and large investors who took a downside bet on Collaterialized Debt Obligations (CDO’s) using Credit Default Swaps (CDSs) very rich. The face value of CDSs at the end of 2007 was $62 trillion, fell to about $55 trillion by 8/08 and currently stands at about $30 trillion as offsetting positions cancelled each other out. A major problem is that since these CDSs are not traded on exchanges and are not reported so we can’t be sure who holds how much potential risk.

Say Joe lends Harry $100 at 6%. Joe buys insurance in the form of a CDS from Steve to protect himself from the possibility that Harry doesn’t pay him back the $100. If Harry doesn’t pay Joe back then Steve, who sold the default insurance or CDS to Joe, will pay Joe $100. So far so good as this is a valid business transaction which reduces Joe’s risk. Now assume that 1,000 other people think that Harry will not be able to pay Joe back so they also buy a CDS that will pay them $100 of Harry doesn’t pay Joe back. Harry loses his job and defaults on his debt to Joe which triggers the CDS insurance payment. The result is that there was a $100 loss on 1 debt but the sellers (think AIG, investment banks and some commercial banks) of the insurance must pay out $101,000 to the buyers of the insurance. At the end of 2007, approximately 44% of all CDS insurance was sold by banks, 32% by hedge funds and 17% by insurance companies.

Even the US government can not print money fast enough to give to the sellers of the CDSs insurance enough money to pay the insurance claims that will result when all of the toxic mortgages are marked to realistic market values which reflect the foreclosure value of the mortgages. The current trend of allowing investment banks (Goldman & Morgan Stanley) and credit card companies (American Express) and others to become commercial banks which can take deposits insured by the FDIC will only dig the hole deeper.

As far as providing more loans to consumers, the majority of consumers who need to borrow more money shouldn’t have been lent the amount of money they have been lent already. If you have 22 credit cards with maxed out credit limits, you shouldn’t be giving them more credit cards.

Perhaps a better plan would have been to:

1) Setup say four regional, commercial banks that would initially be owned by the US government. Remember that Freddie and Fannie were initially established by and owned by the US Government and were sold to private investors at a significant profit after these entities were operating.
2) Provide the $700b to these 4 regional banks and let the investment banks, hedge funds and insurers go bankrupt. These new regional banks would use the $700b to selectively purchase the assets of the bankrupt firms subject to the following constraints:
a) Purchase the defaulted mortgages for the lowest price possible but in no case for more than 80% of the current value of the property. In the case of owner occupied mortgaged homes, write down the loan value of these properties to the cost to the new regional bank of purchasing the mortgage but in no case less than say 95% of the current value of the property. Place a lien on the property such that if the home was sold within say 2 years for any more than the home value at the time that the mortgage was written down that the new commercial banks would take half of the profit.
b) Make loans to commercial firms necessary to help them maintain their operations or expand where these commercial firms can qualify for the loan.
c) Pay the CDS claims only where the buyer of the insurance on defaulted credit was a party to the original transaction. Investors who were not parties to the loan transaction would not be paid.
d) After the financial situation has been corrected then these 4 government owned commercial banks would be sold to private investors via an IPO.

The regulatory situation needs to be addressed immediately rather than waiting until the financial turmoil has settled down as some people have suggested.
 
i like the advantages you've mentioned. well now that obama is in office i hope the bailout plan really works out for the good of everyone
 


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