"Tell Them They Are Already On The Hook"

Stocks dropped again today as doubts over the rescue plan mount and uncertainty continues to reign over markets. The Dow Jones industrials ended 161 points lower, or 1.5 percent.

I spent most of the day watching the "Comrades" get grilled on the $700 billion rescue plan by the Senate Banking Committee:

Investors were also taking a wait-and-see attitude to the package. After a steep slide on Monday, European markets closed down again Tuesday, while afternoon trading was moderately lower on Wall Street. Oil and gold prices also retreated. (Page 20)

In Washington, Dodd called the crisis "entirely foreseeable and preventable, not an act of God," and said that it angered him to think about "the authors of this calamity" walking away with the proverbial golden parachutes while taxpayers bore the cost.

"There is no second act on this," Dodd said, acknowledging that speed was important. But it is more important, he said, "to get it right."

Paulson said in response to questions that he shared the senators' exasperation.

"I'm not only concerned, I'm angry" over the events that led to the problem, Paulson said. He blamed an outdated regulatory system for the turmoil and, in an attempt to counter any impression that the proposed rescue plan was for the benefit of fat-cats on Wall Street, said: "This is all about the taxpayers. That is all we are about."

Paulson said that "this troubled-asset purchase program is the single most effective thing we can do to help homeowners, the American people, and stimulate our economy."

He and Bernanke said that the problems in the housing industry were the core of the crisis but that the problems would continue to spread far outside the housing sector if the problems in the mortgage markets were not addressed, and soon.

At one point, Senator Richard Shelby of Alabama, the ranking Republican asked Paulson: "What do I say to my constituents who feel like they are on the hook for bailing out Wall Street?"

In an incredible moment of candor, Comrade Paulson looked at him and said: "Tell them they are already on the hook."

That ladies and gentlemen is all she wrote. When Comrade Paulson uttered "they are already on the hook," he mind as well be speaking in front of the United Nations where Comrade Bush was speaking today.

Another noteworthy testimony today was given by Comrade Cox, the chariman of the SEC who said that said Congress should "immediately'' grant authority to regulate credit-default swaps amid concern the bets are fueling the global financial crisis (read yesterday's entry on better regulation).

In another unusual moment of candor, Comrade Bernanke let the cat out of the bag and said that the the government should buy devalued assets at above-market values to make its proposed $700 billion rescue package most effective in combating the financial crisis:

"Accounting rules require banks to value many assets at something close to a very low fire-sale price rather than the hold-to-maturity price,'' Bernanke said in testimony to the Senate Banking Committee today. "If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.''

WOW! Now that is capitalism at work! Buy the junk at above market rates so these idiots on Wall Street can get off the hook while the U.S. taxpayers (and the rest of us) "are already on the hook."

Bravo Comrade Bernanke! Bravo! [roll eyes!]

Let me quote Paul Krugman on this idea:

As I wrote earlier this morning, the whole “take these assets off the balance sheets” line is fundamentally disingenuous; the key question is what price Treasury pays for the assets. And here we have Bernanke effectively saying that it’s going to pay above-market prices — prices that allegedly reflect “hold-to-maturity” value, but still more than private investors are willing to pay.

This should be read in the context of Brad Setser’s calculations: he finds that if Treasury pays a price that seems appropriate given the poor quality of the assets, “The hit to the banks balance sheet might be too big” — the losses would be much larger than the amounts banks have already acknowledged, so that their capital position would be severely weakened.

So the plan only helps the financial situation if Treasury pays prices well above market — that is, if it is in effect injecting capital into financial firms, at taxpayers’ expense.

What possible justification can there be for doing this without acquiring an equity stake?

No equity stake, no deal.

I have my own conspiracy theories on the possible justification, including the fact that Comrade Paulson has close ties to Goldman Sachs, the "venerable" Wall Street investment bank he once led which is now scrambling to survive as it faces a lawsuit of misleading investors in a $6 billion offering of Freddie Mac stock in November. Could it be that he is helping the new Goldman Sachs Bank to receive full benefit of the bailout?

(Note...this just in: Warren Buffett just dropped a cool $5 billion into Goldman Sachs preferred shares. Buffett knows all about alignment of interests and where Comrade Paulson's interests lie.)

The problems on Wall Street are also impacting the rest of the word. The Times of London reports that the Government of Singapore Investment Corporation (GIC), Singapore's large sovereign wealth fund, has warned that it was now “unrealistic” to expect that the sort of returns achieved over the past two decades could be repeated in future.

In an article in today's FT, Daniel Gross and Stefano Micossi report that "synchronised movements in global markets over the last few weeks have shown that contagion works on the way down and on the way up." The article warns that European banking is on borrowed time:

The crucial problem on this side of the Atlantic is that the largest European banks have become not only too big to fail, but also too big to be saved.

For example, the total liabilities of Deutsche Bank (leverage ratio over 50!) amount to about €2,000bn (more than Fannie Mae) or more than 80 per cent of the gross domestic product of Germany. This is simply too much for the Bundesbank or even the German state, given that the German budget is bound by the rules of the European Union’s stability pact and the German government cannot order (unlike the US Treasury) its central bank to issue more currency. Similarly, the total liabilities of Barclays of around £1,300bn (leverage ratio 60!) are roughly equivalent to the GDP of the UK. Fortis bank has a leverage ratio of “only” 33, but its liabilities are three times the GDP of its home country of Belgium.

With banks that have outgrown their home turf, national treasuries and regulators in Europe are living on borrowed time: they cannot simply develop “road maps” (the only result of various Ecofin discussions of regulatory reform by finance ministers), but must contemplate a worst-case scenario.

Given that solutions for the largest institutions can no longer be found at the national level it is apparent that the European Central Bank will need to be put in charge as it is the only institution that can issue unlimited amounts of a global reserve currency. The authorities in the UK and Switzerland – which cannot rely on the ECB – can only pray that no accident happens to the giants they have in their own garden.

The FT's Martin Wolfson also asks whether Paulson's plan is the true solution to the crisis:

The US public expects action. The question is whether it will get the right action. To answer it, we must agree on the challenge the US financial system faces and the criteria for judging how it should be met.

What then is the challenge? The answer given by Hank Paulson, the all-action US Treasury secretary, last Friday, in announcing his “troubled asset relief programme”, is that “the underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded. These illiquid assets are choking off the flow of credit that is so vitally important to our economy.” The core challenge, then, is viewed as illiquidity, not insolvency. By creating a market for the toxic assets, Mr Paulson hopes to halt the spiral of falling prices and bankruptcies.

I suggest we should take a broader view of events. The aggregate stock of US debt rose from a mere 163 per cent of gross domestic product in 1980 to 346 per cent in 2007. Just two sectors of the economy were responsible for this massive rise in leverage: households, whose indebtedness jumped from 50 per cent of GDP in 1980 to 71 per cent in 2000 and 100 per cent in 2007; and the financial sector, whose indebtedness jumped from just 21 per cent of GDP in 1980 to 83 per cent in 2000 and 116 per cent in 2007 (see charts). The balance sheets of the financial sector exploded, as did the sector’s notional profitability. But leverage, alas, works both ways.

Since US net international debt was 39 per cent of GDP at the end of 2007, virtually all of this debt is an asset of another domestic entity and would net out to zero. But when the gross debt stock is huge and economic conditions difficult, the chances that many entities are bankrupt is high. When people fear mass insolvency, lenders stop lending and the indebted stop spending.

The result can be the “debt deflation”, described by the American economist, Irving Fisher, in 1933 and experienced by Japan in the 1990s.

You know my thoughts on debt deflation. This is where we are heading despite the efforts of Bernanke and Paulson to engineer inflation and another stock market/real estate bubble.

I end this post by quoting Paul Krugman's Good ideas and lies:

Daniel Davies, in one of the great blog posts of this era, laid down a key principle:

Good ideas do not need lots of lies told about them in order to gain public acceptance.

He was talking about the selling of the Iraq war, but it applies more generally.

So, this morning Hank Paulson told a whopper:

We gave you a simple, three-page legislative outline and I thought it would have been presumptuous for us on that outline to come up with an oversight mechanism. That’s the role of Congress, that’s something we’re going to work on together. So if any of you felt that I didn’t believe that we needed oversight: I believe we need oversight. We need oversight.

What the proposal actually did, of course, was explicitly rule out any oversight, plus grant immunity from future review:

Sec. 8. Review.

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

I’m not playing gotcha here. This is telling: if Paulson can’t be honest about what he himself sent to Congress — if he not only made an incredible power grab, but is now engaged in black-is-white claims that he didn’t — there is no reason to trust him on anything related to his bailout plan.

I don't know about you, but I do not trust Comrade Paulson or anyone telling us that this rescue plan is good for the global financial system and the global economy. I know it is good for his net worth and that of his buddies at Goldman Sachs and other Wall Street firms but they are the crooks who made sure taxpayers "are already on the hook."

But despite the rumblings on Capitol Hill today, politicians will sign off on this rescue plan, holding their noses and praying to God that it works. (If it doesn't work, Paulson will come back in the near future to utter: "Tell them they can eat cake").

As I write this and reflect on today's hearings, Lord Acton's dire warning that "absolute power corrupts absolutely" keeps resonating in my head.

***Update:

The FBI has just launched an investigation, probing bailout firms:

Two law enforcement officials said Tuesday the FBI is looking at potential fraud by mortgage finance giants Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500), Lehman Brothers Holdings Inc. (LEH, Fortune 500), and insurer American International Group Inc. (AIG, Fortune 500)

The inquiries, still in preliminary stages, will focus on the financial institutions and the individuals that ran them, a senior law enforcement official said.

Also, read Randall Forsyth's article in Barron's, Shock and Awe? Try Shockingly Awful:

This marks the final undoing of the Glass-Steagall Act, the Depression era law that separated commercial and investment banking. Its repeal in the early 1990s is blamed in some quarters for the crisis in which we find ourselves today.

This is puzzling. The hog-wild leverage took place outside the banks in what has come to be known as "The Shadow Banking System" of off-balance sheet assets funded in the money market, mostly outside the purview of regulation.

In the U.S., the firms that failed were Bear Stearns and Lehman Brothers, neither of which gained new powers under the repeal of Glass-Steagall. Nor was that a factor in Merrill's rush into the arms of BofA.

In the Shadow Banking System, mortgages were purchased, sliced and diced and packaged in incomprehensible instruments such as Structured Investment Vehicles funded by asset-backed commercial paper. Indeed, the SIVs got assets off the books of banks such as Citigroup (C), which let it avoid capital requirements that would be levied had the assets stayed on the balance sheet.

Nor do fans of Glass-Steagall acknowledge the law failed to prevent failures such as Continental Illinois in the 1980s or Franklin National in the 1970s. And any number of major money center banks were technically insolvent in the early 1990s after that real-estate bust.

Arguably, bringing more activities under the aegis of bank regulators would limit leverage and enhance stability of the financial system. It was going to happen anyway, so Goldman and Morgan decided they might as well have the advantage of a stable deposit base. Don't expect the top-tier banks to start opening branches and giving out toasters for new accounts, however. If anything, Goldman and Morgan would more likely look to acquire a bank than build one organically.

Yet, with all these historic changes in the financial system won't change the underlying fundamentals of house prices still declining and the economy contracting. And now the cost of the government's intervention is an added risk.