What A Fine Mess You Have Gotten Us Into

One week ago, I posted Oppose The Treasury’s Bailout Plan.  Since then, most criticisms of Henry Paulson’s original proposal supposedly have been incorporated into the new compromise bill, including my criticisms.

But my concern at present is whether the bailout will work at all. I think the complexities of the reverse auctions on small illiquid distressed securitized assets will prove difficult.  Further, the talk that the baioout won’t cost anything is highly unlikely.  Of all of the US Government’s bailouts, only the Chrysler bailout made money.  So long as you are in a fiat money system, in a bailout, the job of the government is to prevent contagion and minimize loss, in that order.  Bailouts don’t make money, and that should not be expected.

But hey, if they are going to play for profit, let them play big.  I was joking around when I wrote my article 2300 Smackers, and I am joking a little here as well.  Why not use the $700 billion to capitalize 10 new banks with $70 billion of capital each?  Let them lever up 10:1 — you have $7 trillion of buying power.  Let the public participate along side the government and the power expands further.  With a profit motive, they will buy and finance what makes sense, and five years from now, the government would sell its stakes, and pay down debt.

The rough part is that they have a non-profit-oriented main shareholder, looking to bail out dodgy institutions.  Also, if the risk is smaller than $7 trillion, these institutions won’t do well.  Also, what of the financials who don’t have government sponsorship?  Couldn’t the government just take super-senior convertible bond stakes in institutions that are under duress?  (Oh, that sounds like one-off bailouts?  Could be a lot cheaper than the current plan…)

And what of the borrowing?  Can this be funded at reasonable yields, and with the dollar at current purchasing power levels?  I have my doubts, though the markets have been benign over the last few days.

Consider the actions of the Federal Reserve in concert with the Treasury.  As I pointed out in Entering the Endgame for Monetary Policy,there is a panic quality to the Fed’s actions.  This concept is endorsed by Brad Setser, Randall Forsyth, and Michael Panzner, among others.  With the short term money markets in disarray, we have Asian Central Banks cutting rates, which aids the West, but increases inflationary risk.

Three notes to close:

  • I don’t know what Monday will bring in entire, but a failure of Fortis seems likely.   Note that the ECB is not on the hook here but the Belgian central bank (which probably feeds into their Treasury).
  • What the FDIC did with WaMu affects other banks like Wachovia.  Bidders will let the holding company fail, and bid for the operating bank subsidiary assets.  Holders of holding company securities get hit, as their likelihood of getting reasonable recoveries disappears.
  • We are putting a lot of faith in the health of Citigroup, Bank of America, and JP Morgan.  If one of them fails, the game is over.  Given their complexity, and the recent takeovers, the odds of there being a significant mistake are high.  Consider further that they are counterparties for more than 50% of all derivative transactions, so the synthetic leverage is high as well.

All “solutions” to the crisis at this point in time are bad solutions.  The time to act was 10-15 years ago, where we could have implemented contra-cyclical policies in bank regulation, as well as enforcing a strict separation between regulated and nonregulated financial intermediaries.  (No ownership, no lending, no derivative agreements.)

I don’t know what next week will bring us.  Last week was bad for me on a relative performance basis.  My inclination is to look at companies that have good global demand, and not much debt.  As for bonds, keep them short, unless you are buying long TIPS.