QUESTIONS GROW OVER PAULSON'S BAIL OUT PACKAGE
September 23, 2008
(NEW YORK, N.Y.) -- In the wake of new reports in the Orange County California Register that Washington Mutual Savings Bank in California loaned millions of dollars to home flippers that had been previously convicted in a fraud scheme and are now under investigation for more illegal loan activities, and the recent revelation that Presidential hopeful John McCain’s campaign manager Rick Davis was paid some $35,000 a month for five years as president of an advocacy group set up by the mortgage giants Fannie Mae and Freddie Mac to defend them against stricter regulations, there is growing public discomfort in many quarters with giving Treasury Secretary Henry Paulson — himself a former Wall Street executive at Goldman Sachs — a blank taxpayer check to relieve major financial institutions of the responsibility of bad loans that now threaten to take many of those institutions down.
There is gorwing discomfort over handing Treasury Secrteary Paulson a blank check to bail out Wall Street
There are historical reasons for questioning an open ended, no-detail bailout not the least of which is concern that Paulson may pay too much to protect Wall Street firms, thus in effect subsidizing giant financial institutions who, it appears in some cases, took on billions of dollars in bad loans as the result of greed, hubris and in many cases shoddy loan practices, while executives at the top of the firms were enriching themselves.
Some economists now argue that taxpayers need to get more in return for their substantial investment other than avoiding what Paulson now pictures as a financial apocalypse; something in return like an ownership stake in the companies on the receiving end of the taxpayer’s dollars.
Various reports out today indicate one underlying source of suspicion about the bailout comes from the very people asking for it. The bail out is essentially being sold to the American people as a must-have emergency measure by an administration with a controversial record - and some would argue little credibility - when it comes to asking Congress for special authority in time of duress.
Dean Baker, co-director of the Center for Economic and Policy Research in Washington is quoted in the New York Times as saying "this administration is asking for a $700 billion blank check to be put in the hands of Henry Paulson, a guy who totally missed this, and has been wrong about almost everything.”
Paulson says the bail out authority and powers he seeks are absolutely necessary to stave off an implosion in the U.S. financial system that would be catastrophic for everyone.
But Paulson's credibility has been undermined by his previous pronouncements that the crisis had been contained when in fact it was not and the fact that some find in his dire warnings, and demands for extraordinary powers, a parallel with the way the Bush administration gained authority for the war in Iraq, suggesting at the time that a “mushroom cloud” could result from Congress’ failure to act quickly.
Allan Meltzer, a former economic adviser to President Reagan, and expert on monetary policy at the Carnegie Mellon business school is quoted in published reports as saying "this is scare tactics to try to do something that's in the private but not the public interest."
One major stumbling block for many is over whether and how taxpayers should benefit if the bailout succeeds in fixing the financial system, which could then send banking stocks soaring upward in price.
In Paulson's plan, the Treasury department would have the right to buy as much as $700 billion worth of questionable investments from the banks, with the taxpayer recouping the proceeds when those investments are later sold.
But many economists, including Douglas Elmendorf, a former Treasury and Federal Reserve Board economist, and now a fellow at the Brookings Institution in Washington, argue that American taxpayers should get more out of the deal, such as securing stock in the banks that make use of a taxpayer funded bailout. The government could then sell that stock when conditions improve thus potentially lowering the financial cost to taxpayers or perhaps even turning a profit for taxpayers.
A similar approach was reportedly used successfully in Sweden in the early 1990s when its financial system was in crisis.
Still others argue that any bailout that would keep millionaire executives on the payrolls of the financial institutions that get government money must be the type of bail out where they feel the consequences of their bad banking decisions.
The general argument is that a bail out must be punitive where necessary under the rationale that if banks sell taxpayer’s junk loans on their books, then taxpayers own the company. In other words the bail out should not be about rescuing huge banks at taxpayer expense so that rich banking executives may continue on in their jobs as business as usual with none of the pain that ordinary Americans experience in this crisis, but should be about keeping them in business so the financial system doesn't collapse.
Another stumbling block goes right to the heart of the financial crisis itself and that is how the Treasury Department would value the securities it plans to purchase since none of the experts seems to know exactly what they are worth.
The problem is, claim most financial experts, that America’s financial institutions arrived at this perilous moment in history by in essence “gambling” huge on real estate by getting themselves involved with highly complex and leveraged “pools” of millions of mortgages tied together, and then slicing that bulk into smaller pieces that were bought and sold and borrowed against.
These complex loan packages - called “derivatives” or “collateralized debt obligations” or “credit default swaps” and the like - lie at the center of the failure of Lehman Brothers, Bear Stearns, Fannie Mae and Freddie Mac as well as others.
These loan investments are so intertwined and complex that no one seems to able to figure out what they are worth, thus no one has been willing to buy them. That is why the big banks have frozen up. With a big question mark as to the value of their assets and their future losses, they have held on tightly to their remaining dollars, thus choking the economy of capital that is necessary to growth.
All was well within the complex derivatives pyramid as long as housing prices continued to climb but when housing prices began plummeting and borrowers stopped making mortgage payments, financial institutions found themselves with huge piles of bad and questionably bad loans.
The initial theory of the derivatives was that risk could be “transferred” to larger institutions that could more easily handle the downside of risk thus allowing weaker firms to get rid of risks they could not take on and, as the theory goes, the financial system should end up stronger as a result of the plan.
In practice, as is often the case, things were much different.
Billionaire investor Warren Buffett, who called the complex derivatives "financial weapons of mass destruction”, worked the numbers on them years ago in a 2002 letter to his Berkshire Hathaway shareholders, and the numbers then were not comforting.
One financial writer said Buffett’s take on the matter is still the “best guide there is” to understanding how Wall Street arrived at today's nightmare.
Complexity in financial derivatives breeds other faults, as Buffett described. Derivatives, because they are extremely difficult to value, make it easier for traders and chief executives to inflate earnings in their companies.
This “easy earnings inflation valve” can exacerbate problems if a company, for unrelated reasons, suffers a credit downgrade that requires it to post collateral with counter parties – "a spiral that can lead to a corporate meltdown," he wrote. They create a daisy chain of risk as the troubles of one company infect another.
Buffett, looking rather like a visionary on the matter in hindsight, made a dour prediction about five years ago of a potential financial Armageddon around the corner because of proliferating derivatives in financial markets.
He wrote, "the derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts."
And once the dominoes begin to fall in a financial Armageddon, the process of unwinding a big derivatives portfolio to see what actually is there is no easy trick. Buffet coined derivatives as “easy to enter and impossible to exit.”
That would appear to be one of the reasons the failure of a company the size of Lehman Brothers presents such a risk to the financial system – investors as well as government regulators simply do not know how many other firms will be brought down as one fatally injured player is carted off the field after another.
So now the government’s plan is to clear the field of bodies and clear the books of ugly numbers, yet still how to value what is on those books is as unknown as ever and many Americans remain outraged that Wall Street, home of the eight-figure pay check and multimillion dollar estates in horse country, may get rescued from the disastrous consequences of its real-estate “drunken binge”, as President Bush once described it, even as millions of American working families turn their houses over to banks in foreclosures.