Agora Financial’s Rude Awakening

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Melbourne, Australia

• The Paulson Bill heads back to the house for Round II,
• A financial Frankenstein even a mother couldn’t love,
• Why no bailout plan in the world can force banks to lend and more…

Joel Bowman, reporting from Muscat, Oman…

Organisms, political theories, markets…all things eventually die.

Even marriage, with its “’till death do us part” clause, provides a convenient glimpse at post-mortem freedom for those faithful to both God and partner during life. (We wonder then if, given the infinitely weightier commitment required from an atheist, they are more reluctant to walk down the aisle?)

Strangely comforted by this fait accompli, we refrain from yet again lamenting capitalism’s inexorable march toward the grave. Today, just for a change of pace, we mourn not the death of that which will eventually come to pass, but for the life of that which never will be. 

Had the process of natural selection in the marketplace been allowed to proceed unhindered, what new species of lending and borrowing might exist today in place of the wealth destroying institutions in line for Paulson’s handouts? In lieu of blatant and forced transfer of wealth from the prudent to the insanely profligate, what path of lesser resistance would this capital now find itself on? Without a protracted period of uncertainty built upon an unsustainable period of exuberance, what solid footing would the moribund currency of the world’s largest economy now stand atop?

In other words, what is the opportunity cost of continually retarding the natural evolution of the economy with self-congratulatory intervention and back-patting do-goodery?

“If we consider the current banking system as a patient on the operating table who has suffered massive head trauma and internal bleeding, it’s easier to see what should happen,” observes Dan Denning, editor of the Australian Daily Reckoning.

“Paulson wants your blood for continuous transfusions. The patient is kept on life support, although his brain is likely to remain permanently dysfunctional and his heart utterly corrupt.

“Meanwhile, in the waiting room, there are private investors happy to buy a liver, a kidney, some corneas, and maybe even a lung or two. But you can see the problem. For the buyers to be interested, the patient has to die.

“Paulson, Bernanke, Bush, and Congress need to pull the plug and let nature take its course. That’s not what publicly elected officials do, though, especially so close to an election. So we will get Frankenstein. And you know what happened to that poor, unnatural creation of human hubris don’t you?”

In today’s issue, Dan offers a few more thoughts on the monumental misadventure of economics underway right now. Please enjoy and send any comments to the address below…

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Why the Paulson Plan Won’t Work
By Dan Denning

$700 billion will flush through the U.S. banking system faster than [insert preferred metaphor here]. In other words; the bailout won’t work.

The crux of the bailout is that it’s designed to keep banks from failing by recapitalizing them. It’s like a massive financial organ donor program where the Treasury, like a live organ donor, replaces the malignant guts of the current system with its own, healthy ones. But of course, live organ donors don’t usually swap their healthy organs for failing ones. The Treasury is breaking new ground here.

Even if Paulson can come up with $700 billion from Congress, many of the banks are going to fail anyway. They borrowed money short term to buy long-term assets (mortgage backed securities and collateralized debt obligations). Now, the money must be paid back but no one wants to lend short term. Why? The assets are falling in value.

When the assets fall in value, it wipes out equity capital. You have a small amount of capital controlling a large amount of assets. If you take a write off on the assets, it wipes out your capital. You’re insolvent.

Here’s the thing…$700 billion is not going to be enough to remove the troubled assets from bank balance sheets. But then, Paulson must know that. He’s hoping that the Treasury’s buying kick starts the market by establishing a price for the stuff.

Then, he’s hoping, private equity, hedge funds, and others with cash come in from the sidelines to make deals with the banks and get the assets off the balance sheet so the banks don’t fail. Trouble is, the price Paulson wants to pay for the assets seems likely to be higher than what the market is willing to pay. Kick-starting the banking system won’t work if the first bidder (the government) comes in and pays a price the market has already said no to.

The financial markets may believe, for a day or two, that the passage of Paulson’s bailout plan fundamentally alters the dynamics of the U.S. financial system. But it does not. Not one jot.

Borrowed money has to be paid back. Assets that were bought with that borrowed money are falling. That is how all credit bubbles end. This one is no different.

The new Senate version of the bailout bill has some new bells and whistles not included in the version that failed to pass the House. Two of the main measures added seem aimed more at shoring up political support for the bill, rather than improving the chances that the plan will actually work. But let’s take a look at them anyway.

First, the Senate wants to temporarily increase Federal insurance on deposits in U.S. commercial banks from US$100,000 to US$250,000. You might wonder what an increase in Federal deposit insurance does to improve the quality of assets on bank balance sheets.
The answer is, “It doesn’t.”

But the increase in what the FDIC can offer is designed to make the Paulson plan more difficult to oppose in the House. Who is against providing ordinary savers more insurance for their life savings? Anyone? There is also the question of confidence.

By increasing FDIC insurance to $250k, you reassure (hopefully) people that there’s no need to remove their money from the bank. Here the Feds aim to prevent a run on banks by depositors that leads the bank to fail. This is what happened first at Indy Mac in July and at Washington Mutual earlier this week.

Depositors took out a whopping $16.5 billion from WaMu between September 15th and the end of the month. That kind of run is a serious drain on a bank’s capital. It’s a scenario the Congress wants to avoid by increasing FDIC insurance. It does nothing to improve bank balance sheets, unless, by restoring confidence, it prevents a huge drawdown in a bank’s assets (its deposits).

Meanwhile, to address the value of those damaged assets that Henry Paulson can’t wait to get his hands on, the SEC clarified its stance on Tuesday with regard to mark-to-market accounting rules. This move is designed to give banks some wiggle room when it comes to valuing their damaged assets. The higher the banks can value the assets, the less likely the banks are to have to take losses on those assets, or to sell them to meet capital requirements. They can stay in the game.

In essence, the new SEC dispensation permits the management’s of financial institutions to legally inflate the real-world values of many balance sheet assets. The new ruling provides a delicious array of valuation metrics that will enable financial firms to elevate the stated value of their troubled mortgage-backed securities far above what any actual human being would pay.

Granting these new powers of deception is good, we are told, because telling the truth would be too darn painful and would put many banks out of business. This process is a little bit like providing a trophy from Little League as collateral for a $1 million loan. No one actually believes that the trophy is worth $1 million, but since the borrower may legally assert that the “fair value” of his trophy is $1 million, the lender cannot foreclose. Everyone is happy, right?

No bailout plan in the world is going to convert a Little League trophy into a $1 million asset…or a defaulted mortgage into a AAA security. And no bailout plan in the world is going to reverse the fall in American house prices (or even arrest in). Therefore, no bailout plan in the world is going to force banks to lend, if the assets on their balance sheets are both overvalued AND falling in value. Until someone comes along with a plan that severs the connection between residential American real estate and the banking system, the system itself remains on the edge of crisis.

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[Rude Endnote: “Paradoxical as it may seem to some, it is just as necessary to the health of a dynamic economy that dying industries be allowed to die as that growing industries be allowed to grow. The first process is essential to the second.”

- From Henry Hazlitt’s Economics in One Lesson, ignored by politicians since 1946.

Please send your thoughts to the address below.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com