Paulson and Bernanke come up short

Today was spent with one ear on the phone and the other on the TV listening to Paulson and Bernanke try to get $700 Billion out of Congress. The contrast was remarkable, Paulson the former Goldman CEO the consummate leader/statesman/salesman and Bernanke looking like a geek sitting in the principal’s office after getting caught for participating in a cafeteria food fight.

Every time a Senator asked a question that was WIDE open for a B. S. answer Paulson fielded it and Bernanke tried not to make eye contact with anyone. When the question called for a straight forward definition of some economic principle Bernanke stepped up. If it weren't such a serious moment it might have been comical.

They took all questions, even the stupid ones, and presented a pretty good case for the government intervention in this crisis. They didn't come away with the sweetheart deal they penned on Saturday but hey. . . in negotiations you have to start high because you know they're going to grind you down at the negotiating table.

I caught a lot of both sides asking each other for the impossible. Bernanke and Paulson asking for $700 Billion that they can use for whatever purpose they see fit and to answer to no one while doing it, and Congress asking them to predict the future and tell them that this will work and that they won't need any more money later.

I learned nothing today about how the assets in question will be valued and at what price the government will buy them from troubled banks. The way I see this there are two options:

Option 1 - The government will have to pay more than the assets are worth to help the banks, but that is detrimental to the taxpayer.

Option 2 - The government somehow figures out what the fair value of these instruments are and pays that price, which protects the taxpayer but kills the bank. The problem with this option is that if the bank could afford to sell at that price it would have done so already. Taking that low price means a big write-down for the bank which will waltz through the income statement, march directly onto the balance sheet and punch Capital right in the kisser.

This hit to capital will leave many institutions under-capitalized. . . which is exactly what the government is trying to avoid. So how do you do the un-possible? How do you protect the taxpayer AND take garbage assets off the hands of the banks? In my view the answer is a new government issued Trust Preferred type security. If a bank wants to sell troubled assets to the government it will have to take the fair value price that the Treasury comes up with (it shouldn't be hard to come up with a price for these securities with the right people on board). We know that if the bank hits that low-ball price it's going to take a big write down, and if the write-down takes them below a well capitalized level the government can extend them a loan that counts as capital. . . that should sound familiar because that's what Trust Preferred Securities are.

This path will provide the banks with a way to get rid of their bad assets, it will give the taxpayer a great price on those assets (and one that should allow the taxpayers to actually MAKE money on this deal), the offending bank will be given enough capital to survive and become profitable again, then the bank will have to pay off the loan with interest (the taxpayer wins again). At this point that seems to be the best alternative. All of the plumbing so to speak for Trust Preferred securities already exists, the lawyers that used to do them could probably use the work, and everyone knows how to account for them. The Trust Preferred market has been dormant since last August when CDO's started blowing up Bear Stearns hedge funds. . . they became a dirty word and everyone avoided all CDO's. . . even the good ones.

One other thought that we had today concerned mark to market accounting. It may be that if we suspend mark-to-market accounting we can allow banks to avoid the capital write-downs that will be so punishing. We realize that this stands in stark contrast to the principle that financial accounting should provide the end user with a level of transparency that allows them to make informed decisions about the profitability of the company but there may be a way that both of these ideas can co-exist.

Analysts are concerned about the earnings power of a company. They want to get down to the bottom line and determine what a company’s earnings are. If you allow a company to suspend mark-to-market accounting but require them to shock their earnings statements to reflect say a 25%, 50% and 75% impairment of a certain bucket of assets, you could in theory avoid the capital write-downs that mark-to-market accounting would require and at the same time provide the investor with useful information about the financial health of the company. I in no way doubt Paulson and Bernanke's intentions.

I think they are both smart and capable men who were handed a bag full of seemingly impossible problems and are sorting them out as best they can. They've laid out their vision of what will happen if we do nothing. . . a new Great Depression. If they are correct then it is a very sobering thought. A story that received very little news was that the day after the Primary Reserve Fund broke the buck; investors pulled $89 Billion out of money market funds. The next day the clearing firms that execute these trades called the Fed because they were looking down the barrel of $500 Billion of sell orders. Armageddon was at the door, and they wanted to let the Fed know that they were about to let it in. These firms said we were 500 Trades away from the Dow trading at 8,300.

Here is a link to the story:

http://www.nypost.com/seven/09212008/business/almost_armageddon_130110.htm

that story should be required reading for anyone wanting to understand the severity of the problems we faced last week.

I can certainly say that it was the only time in my career that I've seen "fear" ruling the market. It was one of the few times I've looked around at the people around me and we wondered aloud. . . will we still be here next week? What if OUR liquidity lines get pulled? What do you do? Old and storied Wall Street firms like Merrill Lynch and Lehman were having their lines cut. . . if it can happen to them it seemingly could happen to anyone. . . and this would be the market that did it.

By the end of the day we were thinking that maybe we could get by with less than the $700 Billion plan. After all no money has been spent yet and the markets were calmed, fear was on the back burner. Liquidity didn’t seem to be an issue.

The big wild card at this point is quarter end. This has all the makings of what could be the Mother of All Quarter Ends. That is going to press this issue hard as we move through this week. Many types of financial institutions are looking at write-downs of their Agency Preferred stock now that Fannie and Freddie have been put in conservatorship and had their dividends halted. There were roughly $38 Billion of those securities in existence. Those securities alone will deliver a massive blow to balance sheets at quarter end…and there are many other bad assets lined up behind them.


I think our consensus by the day’s end was that if we leave the money market insurance plan in place, create a government sponsored Trust Preferred plan, and perhaps suspend mark to market accounting we could really minimize the cost to the taxpayer…and still get this job done.

So there you have it...that's what your broker does when he's not calling you. He sits around and thinking up ways to avoid the next great depression and protect the taxpayer at the same time.

I don't want to discourage anyone but after the testimony we didn't get any phone calls from senators, congressman, Treasury Secretaries, or Fed Chairmen asking for our opinion on things.