Jeanean Gendron, Your Shasta County Real Estate Specialist: September 2008

The last remaining significant resistance in Congress and the Senate has appears to have crumbled tonight and party leaders announced that they believe that the bailout is a done deal with voting in the house starting tomorrow.  At 9:00 EST the Treasury department held a conference call with primary dealers to fill them in on the details and discuss implementation of the plan.  According to reports from someone present on the call the treasury was very pleased with the final bill in that they got their money, with no real checks on their control and only token oversight.  It was admitted it would take two to three weeks to start implementing the plan and start buying assets once voted on.  I think is a flat out admission that the urgency they portrayed to Congress and Senate to ram the bill through was not in fact real.

The bill that will go up for vote tomorrow expanded from it's original 3 pages to 106 pages.  Of course is the usual porkly earmarks that politicians can't help but add to these urgent bills that nobody wants to block, but there were also some very disturbing additions too.

Section 132:  Allows the SEC to exempt selected firms from mark-to-market accounting rules.  Simply the fact these rules are being thrown away is bad enough, the bigger problem is it can be done at only to chosen firms at the SEC's discretion without transparency.  This allows the continuation of cronyism where these government agencies can pick favorites and makes it impossible to read a balance sheet and no what is going on.

Section 128: Fast tracks a that was set to take effect in 2011, that effectively eliminates reserve requirements on banks.  What?!?!  This allows banks to lever up even more when the one of the core problems in this crisis is that banks levered up TOO MUCH. 

There are many other hidden "treats" in this bill but plain and simple if passed this bill will be one of the disastrous pieces of legislation ever passed in this country.

Outside of the bailout bill currently under debate probably the biggest news last week was the failure of the largest thrift in our nation, Seattle based Washington Mutual.  On Thursday, the FDIC took the step of seizing WaMu due to them being vastly under-capitalized.  The deposits and some other assets were firesaled to JP Morgan for $1.9B, depositors were protected while both stock and bond holders were declared wiped out. This represents a marked difference from how previous bank failures have been handled by the FDIC, a change to the game plan if you will.  Not withstanding he potential sweet deal JP Morgan got, there is a disastrous unintended consequence to the rest of the under-capitalized financial system.

Unintended consequences on capital structures

All companies has a capital structure that includes different types of securities.  Lowest in this capital structure is common stock, followed by preferred stock, followed by different levels of debt (bonds).  When a company is liquidated (for example in a bankruptcy or a typical FDIC seizure) the investors highest on this capital structure get paid first.  This means that common stock bears the most risk for the holders, but these holders typically receive the highest risk adjusted returns to compensate.  Usually in the event of a bankruptcy you'll see the common shareholders wiped out, preferred is often wiped out but usually the bond holders at least get something.

When the FDIC came in, waved their magic wand and simply declared the bond holders got zero, they totally changed the rules to the game and set a damaging precedent. Had the Washington Mutual failure happened through more traditional methods it's very conceivable bond holders would have at least gotten something back. How do you spell lawsuits?

So, now we have all these other undercapitalized financial institutions out there that are desparately trying to raise capital.  Do you think big investors are more or less willing to recapitalize a financial institution if there is now a precident set that their investment can be zeroed without any judicial review?  While the regulators keep talking about how critical it is for these institutions to raise more capital, they may have just shot themselves in the foot with this action.

Similar impacts of another regulator change

Another recent regulatory change has the same impact of discouraging recapitalization of the banking system.  The banning if short selling the stocks of financial companies.  Often when a major fund comes in and purchases bonds in a company, particularly one that has known problems they will "hedge" this investment by shorting the common stock of the company.  If the company totally collapses they make money on their short position to compensate for any principal losses they would take on the bonds.  Undoubtedly, many of the big investments you've seen in troubled financial institutions in the last year have included this type of hedging.  Now that these investors don't have this mechanism available to hedge against the company completely imploding, they are even more skittish of making capital investments in financial firms.

The problems in the capital markets today are in fact being made worse by the panic'd game changes by regulators and officials.  Who wants to play in a high stakes game where the rules may change next week?

See Also: Anti-Bailout video that includes discussion of this.

Probably the most vocal and influential critic of the bailout plan being debated this weekend has been Rep. McCotter of Michigan. Great interview/rant...

"Let me put this in the simplistic terms for people like me to understand. Now the Wall-Street crony capitalist have put a 700-pound billion dollar bag of dung on taxpayers doorsteps, rung the bell, and expect you to thank them when you answer it. I think the American people will think otherwise. "

One of the most troubling aspects of the debate going on through the weekend over the proposed bailout bill is not a single independent economist or financial expert has been brought into testify in front of Congress or The Senate.  True, they brought in Warren Buffet to testify the financial system was going to collapse without it to their closed door meeting last night.  I would argue he's far from independent given he just invested $5B in Goldman Sachs last week (why would he do this is the system was in threat of imminent collapse?), has written nearly $5B in credit default swaps and another $5B in long term put options against the S&P 500.

So what do economists think

Well it's pretty much in synch with what I've been writing here.  Almost unanimously they don't believe the bill solves any of the issues either in the credit markets or the broader economy, and in fact believe it will make things worse.  The link below is a plea from nearly 200 of the top economists in the US to stop and think about the plan.

http://faculty.chicagogsb.edu/john.cochrane/research/Papers/mortgage_protest.htm

Economist Nouriel Roubini, who's one of the few economists that has correctly predicted these events years ago, offered up this scathing response today.

Is Purchasing $700 billion of Toxic Assets the Best Way to Recapitalize the Financial System? No! It is Rather a Disgrace and Rip-Off Benefitting only the Shareholders and Unsecured Creditors of Banks

In it he broke down various government responses to 42 past systematic financial crisis and came to the conclusion

"Thus, the Treasury plan is a disgrace: a bailout of reckless bankers, lenders and investors that provides little direct debt relief to borrowers and financially stressed households and that will come at a very high cost to the US taxpayer. And the plan does nothing to resolve the severe stress in money markets and interbank markets that are now close to a systemic meltdown. It is pathetic that Congress did not consult any of the many professional economists that have presented - many on the RGE Monitor Finance blog forum - alternative plans that were more fair and efficient and less costly ways to resolve this crisis. This is again a case of privatizing the gains and socializing the losses; a bailout and socialism for the rich, the well-connected and Wall Street. And it is a scandal that even Congressional Democrats have fallen for this Treasury scam that does little to resolve the debt burden of millions of distressed home owners."

While the main stream media seems to be portraying this bailout as a done deal this morning, from discussions I've been having this seems to be far from the truth and simply pressure mainly by the administration and democratic leadership (strange bedfellows) to push a bill through before Monday with no time for debate.  Thanks to a lot of tireless work by many individual it appears there are several factions in Congress that are now getting a hold of documents and are now actively in contact with some of the independent experts who have been sounding dire warnings about this bill. 

No one will debate how dire the situation is for our economy and capital markets right now, but taking the wrong action for the sake of taking action can produce a much worse result.  While I've stayed out of any types of politics in the past, I've become very involved with this issue because I truly believe taking the wrong path right now could lead to a destruction of our financial markets for decades.

Today there are reports coming out of three massive banks currently on the brink of financial meltdowns.  The situation at Belgium's Fortis bank with total assets of about $780 Billion appears most dire with Belgium's central bank trying to craft a rescue plan before Monday.  Over in England talks to save one of the countries largest independent banks Bradford & Bingley are taking place throughout the night. More than likely B&B will end up being nationalized by the British government by the end of the weekend.

Back in the US the situation at our sixth largest bank Wachovia with assets of $800B (or a little more than twice the size of Washington Mutual) has deteriorated significantly in the past week.  Wachovia's problem is nearly identical to that of Washington Mutual, they are holding huge amounts of option ARM's on their balance sheet, that have been defaulting at insane rates.  Their option ARM portfolio alone totaled around $140B with the majority of these being made in California who's housing market has been one of the worst hit.  While they've reserved only a couple billion to cover losses on this portfolio, it's a pretty good assumption the true losses are in the tens of billions.  They've been hit hard the last several days as concern has caused massive withdrawals of deposits and greatly increased their borrowing costs.  They officially put themselves up for sale on Friday and many suitors including Morgan Stanley, Goldman Sachs, UBS and Citigroup have been rumored to be sniffing around.  Given the demise of Washington Mutual these suitors will probably step back, play the role of the vulture and wait for a forced merger by the FDIC.

Right now the lack of trust and the total freezup of intrabank lending are putting a lot of large financial institutions are risk.  Unfortunately, the current bailout bills being debated in Congress will do next to nothing to restore confidence and unfreeze the credit markets.  The true combined losses on balance sheets of these firms are well into the trillions, so throwing $700B at the problem will simply amount to tossing cash into a hurricane.  Once the dominoes start to fall and people wise up to the fact the balance sheets of many of these financials are a fairy tale, nobody is willing to lend, even if they have the money because they are afraid they won't get it back.

If you can't guess from my previous dozen posts in the last week, I'm referencing what's going on in our financial system right now and the bailout bill.  One of my biggest arguments with much of the government intervention in the past year and in particular the bailout in front of Congress is it attempts to artificially prop up companies who would otherwise have failed.  There are many pundits that will talk about how it's in our interest to support these companies because it's needed to help the economy recover, keep us from loosing jobs, etc.  No, No, No, let me explain why failure is not just important, it's critical for a healthy, long-term recover.

To use an analogy, for several decades our forest service took on the policy of trying to prevent ALL forest fires, both big and small.  Forest fires are bad, right?  What they didn't consider in this policy is forest fires are part of the natural cycle.  They cleared out underbrush making space for regrowth in the forest, and in fact several species of trees actually require fire as part of their natural reproduction process (seed cones open in a fire).  As this policy continued for decades it was discovered the forest fires got much larger, more damaging and the general health of many of our forests began to decrease.  Within the last decade or two this policy by the forest service has been reversed and it is now policy in many cases to proactively set fires in some forested areas.

Recessions and tough economic times serve the exact same purpose in the corporate space.  The weak companies with failed models are cleared out and smaller more nimble competitors move in to fill the void, recreating jobs and helping the recovery.  Yes it's painful for a short time, especially if you're one of those people that works for a failed company but without this process you never get a true economic recovery. 

Look no further than our current auto and airline industries for proof of how critical this process is.  We propped up large, slow moving automakers and airlines who's business plans simply don't work under the guise, of it being good for the nation.  We've done this for decades and it has created two entirely dysfunctional industries.  Had GM failed decades ago, we almost certainly would have seen smaller US competitors move in to fill the void, who would have been more nimble and forward thinking and able to compete with the foreign companies who instead blew past GM and Ford.

This is extremely relevant to the financial, lending and real estate industries of today.  No one will deny they are in a state of disarray right now, but do we want to attempt to avoid the pain and keep them in a perpetual state of disarray or do we want to take our medicine and have a true recovery and a return to a healthy market?

See also: Why I am so Livid About the Bailout

Peter DeFazio - D-Oregon

Thaddeus McCotter - R-Michigan

"Before I was elected to Congress we used to hear that when faced with a crisis, members of Congress would invariably soil themselves, throw money at the problem and hope that it went away.

Unfortunately, in these dysfunctional economic times, we find that this process has continued...."

 

Jim McDermott - D-Washington

Jim Bunning - R-Kentucky

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