Monday, April 27, 2009

Bailout Blues: Part II

Continuing our discussion of the big bank bailout...

What is the government doing?

It's all pretty confusing, but there seem to be two prongs to the Obama administration's rescue plan for the financial sector: buying up "toxic assets" and lending money to bail out banks.

The logic behind the government buying some of these risky, devalued assets from financial institutions is that getting this junk off their books will restore the market's confidence in the institutions and that it will allow the banks to keep/resume providing businesses and private citizens with the credit they need to function. This is also supposed to help create a market for these assets which, at present, no one wants to touch with a 10-foot-pole. The big question is what price is the government paying for these assets? The treasury assures us that by including private businesses in the buying process, it is insuring that the government is paying a "fair market price," but a lot of people disagree (and it is a fact that the government overpaid for some of the assets it has already purchased). I think the government's willingness to buy these assets ("creating a market") is necessarily going to drive up their market price. Whereas this initiative basically presumes that these assets are worth something and that they've been devalued in part because of investors' excessive panic and fear, some experts would argue that – no – a lot of these assets are actually going to further decrease in value. Thus, there's a fear that (a) the government is helping to once again artificially inflate the value of this junk and (b) we are essentially nationalizing losses, while keeping profits private – the banks get the worthless assets off their books and the US taxpayer is left holding the bag. Incidentally, these toxic assets are being managed for the Treasury by the BlackRock investment firm under three no-bid contracts whose price is being kept secret.

Together with buying up toxic assets, the government is also injecting capital into "healthy" institutions (i.e. institutions that can survive). In return for these loans, the treasury is mostly taking preference shares which are kind of like debt instruments in that they lack voting-rights but have certain guarantees for a return on the investment in the form of dividends. A lot of people think the treasury is not exercising enough control and oversight over what is actually being done with this money it's handing out. The government wants the recipients to use the money in order to keep lending rather than horde it, pass it on to shareholders, or use it to reward executives. Now, the issue of executive compensation is bit of a distraction since the amount of money involved is relatively small, but at the same time the public outrage over recipient companies handing out employee bonuses and spending funds on things like expensive corporate retreats is TOTALLY justified. How dare these companies keep compensating their employees the same way they did during the boom when they are only staying afloat thanks to government assistance!

Some people argue that the administration needs to grow a pair and start taking more control of these institutions, but assuming direct control would probably raise its own thorny issues. First, there's the conflict of interest I mentioned in Part I (protecting our investment v. doing whats best for the economy as a whole). Also, I could just imagine "zombie banks" controlled by government officials being made to keep lending out money to keep the economy running while they're intrinsically bankrupt.

More recently, given that Congress has made it clear that what with popular sentiment hardening against Wall Street they're unlikely to be approving a lot more funds for the rescue program, the administration has talked about converting a lot of these preference shares into common shares so as to provide banks with much needed equity. If the government is going to become the majority shareholder of some of these institutions is it going to start acting like one and exercising more control?

What's the problem?


Now a lot of the big banks are announcing that they're showing better than expect profits for the 1st Quarter of 2009. But these results are mostly bullshit: they're based on all the money they've gotten from the government and on using new accounting principles that allow them to abandon the market price standard for valuing distressed securities in an illiquid market (This is the opposite of what I said we need to do!). If the banks are going to be all like "yey, we're getting better!" but it's all bullshit, we're setting ourselves up for another fall further down the road.

Obama administration

People who disapprove of the job the Obama administration's been doing can point to the fact that his "experts" all of course come from the broken system which caused this crisis. Treasury Secretary Geithner was President of the NY Federal Reserve Bank where, according to an article in Sunday's NYTimes, he had close relationships with Wall Street executives and "often aligned himself with the industry's interests and desires." Many of the top aides Geithner invited to join him in the Treasury department worked for companies like Citibank and Goldman Sachs. Paul Volckner – another top Obama economic advisor and head of the President's Economic Recovery Advisory Board – used to be Chairman of the Federal Reserve, and Federal Reserve Chairman Bernake is of course a less-skilled disciple of Greenspan. Is it surprising then that critics accuse this bunch of being overeager to save Wall Street institutions from the results of their own mistakes through generous use of taxpayer funds?

Do we trust these people to wield all that power and to make the right decisions on how to overhaul the sector? Are they all too close to the problem to see the solution? Are they of the mindset that what's good for Wall Street is good for America on the whole? Are they perhaps more likely to design a recovery program that leaves THEIR system intact as much as possible and leaves their buddies' institutions with the fewest scratches possible when tougher action might be better in the long run?


Let's not overlook the clowns and corporate flunkies in Congress. Remember when everyone was up in arms about AIG paying out retention bonuses to employees after just getting a multi-billion dollar loan from Uncle Sam? Well, Senator Chris Dodd (D-Conn, former longshot presidential candidate) introduced an amendment to the stimulus bill which purportedly restricted executive pay for bailout recipients, but at some point a clause was inserted specifically exempting bonuses agreed to under contracts signed before a certain date. Dodd is Chairman of the Senate Banking Committee so you can be sure he has lots of ties to Wall Street. Moreover, since the furor exploded over the AIG bonuses, it's come to light that Dodd received big political contributions from a couple of AIG employees.

But again that's all small potatoes. Congress' greatest crime in helping enable this financial crisis happened in 1999 when they overwhelmingly voted to repeal provisions of the Glass-Steagall Act which regulated banking activities and placed limits on speculation. I have no doubt many legislators were motivated in part by the influence of the banking lobby which wanted these "outdated" regulations lifted. Some were also motivated by an ideological belief in deregulation and in trusting in the market to ultimately do what's best when it's left alone. This viewpoint has of course now been exposed as foolhardy.

What is to be done?

I have to say that I am not entirely comfortable with all the power being concentrated in the hands of the Treasury department without much in the way of checks and balances, oversight, or disclosure. Some (like moderate conservative NYTimes columnist David Brooks who was on Charlie Rose the other night) might say that it's actually a good thing that more decision-making power is going into the hands of these knowledgeable technocrats (and out of the hands of those incompetents and idiots in Congress). On the other hand, let's not forget that they are also unelected officials with strong ties to the financial system and to friends on Wall Street.

I guess the bailout question was bound to be a thorny one, and it's almost inevitable that the solution would be messy and involve expending government funds – some of which will inevitably be lost forever and should just be written off now. But I think the next step is even more important. Namely, after the flames die down a little, what sort of new rules and regulations is the federal government going to step up and introduce? Will they start regulating hedge funds and the derivatives market? What sort of accounting principles will ultimately be embraced for assessing the value of what we are now calling toxic assets? I really hope this is where the real Change (with that big "c") will come.

Photo by David Mills/NYTimes

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