I’ve been talking about a $700 billion bailout. That’s wrong. It is an UNLIMITED bailout. The $700 billion is just the maximum that the Treasury can hold at any one time. So Paulson and Bernanke can buy unlimited amounts of paper by simply reselling it (at a loss, of course), so long as they don’t have more than $700 billion in inventory at any one time. Outrageous. Some good questions for Paulson and Bernanke.

Quite apart from anything else, the ignorance of the Fed got us into this trouble. What makes anyone think that their ad-hoc antics are likely to get us out?

Sensing pork in the water, the financial services industry is lobbying and jockeying for the biggest possible bite. All the slime wants in. Disgusting.

Even as policy makers worked on details of a $700 billion bailout of the financial industry, Wall Street began looking for ways to profit from it.

Financial firms were lobbying to have all manner of troubled investments covered, not just those related to mortgages.

At the same time, investment firms were jockeying to oversee all the assets that Treasury plans to take off the books of financial institutions, a role that could earn them hundreds of millions of dollars a year in fees.

Nobody wants to be left out of Treasury’s proposal to buy up bad assets of financial institutions.

“The definition of Financial Institution should be as broad as possible,” the Financial Services Roundtable, which represents big financial services companies, wrote in an e-mail message to members on Sunday.

The group said a wide variety of institutions as varied as mortgage lenders and insurance companies should be able to take advantage of the bailout, and that these companies should be able to sell off any investments linked to mortgages.

The scope of the bailout grew over the weekend. As recently as Saturday morning, the Bush administration’s proposal called for Treasury to buy residential or commercial mortgages and related securities. By that evening, the proposal was broadened to give Treasury discretion to buy “any other financial instrument.”

The terms of the bailout, if it is needed at all, should be so draconian that it is a last resort. The rush to participate shows that it is seen as free money, so naturally everyone wants in. The taxpayer is the sucker at the table.

The reality of the Paulson/Bernanke bailout plan is that it will reward the shareholders, executives and bondholders of the firms involved for their imprudent behavior. Their gains will be preserved at the expense of the taxpayers. The reason for doing this is essentially blackmail, that if these firms fail, the financial system will “melt down,” whatever that means. Essentially, Paulson is negotiating with hostage-takers.

Even if this dubious proposition were true, the proper remedy is to put these companies into trusteeship, but allow them to continue to operate. The executives would be terminated, the shareholders and bondholders would suffer losses as their interests appear.

Rewarding excessive risk taking and ruining the free market forever is too high a price to pay for short-term convenience. There needs to be balance. Unfortunately, there is an election close at hand. Both parties will compete to deliver the maximum amount of pork. The loss of free and fair markets will cause great pain, as the cost of capital will be increased and economic growth will be sacrificed. Investors will go elsewhere and the US will lose its status as the financial hub of the world.

Edit: As the government seeks to replace the rules of the marketplace with the arbitrary decisions of bureaucrats like Bernanke, Paulson, and Cox, I’m reminded of Sir Thomas More’s speech from “A Man For All Seasons:”

MORE (Roused and excited) Oh? (Advances on ROPER) And when the last law was down, and the Devil turned round on you-where would you hide, Roper, the laws all being flat? (He leaves him) This country’s planted thick with laws from coast to coast-man’s laws, not God’s-and if you cut them down-and you’re just the man to do it-d’you really think you could stand upright in the winds that would blow then? (Quietly) Yes, I’d give the Devil benefit of law, for my own safety’s sake.

Other than the usual outrage about private profits and socialized losses (entirely justified, but a waste of bits), I haven’t seen much analysis of the likely outcome of the proposals being outlined by the Fed and the Treasury. So I’ll try. First of all, the problem they are trying to solve is the lack of liquidity or reliable valuation of large amounts of debt owned by banks and brokers (and many others). This debt was originally valued by its rating from the various agencies, S&P, Moody’s, etc. These ratings claimed to predict default rates and loss severity, which allowed people to price the paper. The statistical models on which the ratings were built, however, turned out to be nonsense, basically because they assumed ever-increasing house prices. Which was in fact the case, throughout the period covered by the statistical database on which the models were based. Anyway, when the rating predictions had clearly been invalidated, no-one knew what the likely default rates and losses would be, and so no-one wanted to buy the paper without such a huge discount that that the risk was mitigated.

The owners of the paper feel that the bids for the paper are excessively low - and I’m sure they are, the potential buyers want to be confident of making a profit and the uncertainty is great. And if they sold the paper at those prices, it wouldn’t matter because they would be bankrupt. So they transferred the paper to the so-called “Level 3″ category, where they simply make up the valuation, and live in fear that the paper will actually trade, forcing them to mark theirs to the market price. The problem is that, given that large chunks of their balance sheet are of unknown value, almost certainly much less than that at which ithey are carried, no-one wants to deal with these companies because as recent events have shown (Bear Stearns, Lehman, AIG), they can claim financial health one day, and then literally disappear overnight.

So the government’s approach is to buy this paper from them, presumably at a price that leaves the companies in reasonable condition, and have the taxpayer shoulder any subsequent losses. Barney Frank of the House Banking Committee is already celebrating that this purchase of these obligations, together with its purchases of Fannie and Freddie, to say nothing of its takeover of Indymac, will allow the government to slow or halt foreclosures on the underlying mortgages, thus “keeping people in their homes.” Of course, if there is no foreclosure resulting from default, then defaults will surge and further devalue the mortgages underlying not only this paper, but the assets of the other government mortgage providers. Why pay if you can live for free, or at least reduce your payment at will? Not moral hazard at all, just a “business decision.”

We need to remember that we have been in a Ponzi bubble, where increases in debt have been used to service the existing debt, so the amount of debt outstanding has risen to historically unprecedented amounts. Total credit market debt now amounts to $50 trillion, or about 350% of GDP, according to the Fed. Of that, mortgages account for some $14 trillion. So the $700 billion cost of the bailout mentioned is not all that large, 5%, in proportion to just mortgage debt. On the other hand, it is quite large in relation to the current Federal deficit of about $410 billion for 2008. 

• The total amount is of the same order as the total level 3 assets (the most toxic waste) of the largest banks and brokers. It is therefore likely that the measures will allow the banking system to avert a liquidity crisis. This is a good thing. However, new credit will remain constrained and the amounts involved are insufficient to re-inflate the housing bubble. Housing prices will continue their decline and defaults will continue to increase, whether or not people are actually thrown out of their houses.
• Those level 3 assets are almost certainly overvalued in terms of their marks, but whether or not they are overvalued relative to their intrinsic value is unknowable. If you believe, as I do, that losses on this paper will continue to increase, it is reasonable to expect that the measures will be costly and significantly increase the Federal deficit. If other measures, e.g. another “stimulus package” or Mr Frank’s foreclosure moratorium are thrown into the pot for the election, then the cost will soar. This impact will show up in higher rates on government debt and other term credit, including mortgages, as competition increases for a shrinking or at best constant pool of credit.
• The negative impact on consumption from tight credit will continue. There is no scenario here which leads back to the recklessness of the last ten years. As I’ve said before, consumption has been boosted by the increase in credit and that won’t be happening. The impact of these measures will be to modestly slow the decline, not reverse it. This means that employment will continue to decline and incomes in the financial services industry are unlikely to return to the peaks of the Second Gilded Age.
• As the New York Times asks: “Most broadly, what are the long-term costs of the government stepping in to restore order after so many wealthy financiers became so much wealthier through what now seem like reckless bets on housing — bets now covered with public dollars?” No-one knows, but it is clear that the myth of free markets is now thoroughly debunked, and the rent-seeking of the financial services industry clearly exposed to any observer.

I’ve purposely avoided any opinion on the dollar, simply because other countries have similar problems and the outcome in a race to the bottom is hard to anticipate.
 

Bill Fleckenstein’s piece today provided the following quote from the New York Times of October 13, 1998, entitled “Japan Parliament Passes Relief Bill for Ailing Banks”:

“Parliament approved landmark banking legislation today that will allow the Government to nationalize failing banks, and political parties announced that they had reached a new accord to provide several hundred billion dollars in new money to try to revive the banking system and set the country on a path toward economic health. . . . The possibility of a way out of the financial crisis sent stocks surging today, with shares of the nation’s banks jumping an average of 8 percent. The Nikkei index of 225 shares rose 5.24 percent, to 13,555.01, in a big comeback after last week’s plunge.”

Bill goes on to note that, even after a 3.8% gain last night, the Nikkei only stands at 11,920 today, nearly 10 years later.