Why the US needs a series of bale-outs: Kohler

The relief is palpable this morning that both houses of Congress have agreed in principle to the Paulson bale-out plan, and the market will undoubtedly rally today.

The relief is palpable this morning that both houses of Congress have agreed in principle to the Paulson bale-out plan, and the market will undoubtedly rally today.

The final vote won’t take place till the weekend, with the aim of passing the bill before trading starts Monday, but there seems little in the push-back from Congress that will cause Treasury Secretary Henry Paulson major problems; making it an instalment plan, with the final instalment subject to another vote, putting limits on executive compensation of participating banks and giving the US Government equity warrants on them.

Paulson’s shoulders may drop over having to go back to Congress for the final instalment, but that should not be a deal-breaker.

It would be nice to think that yesterday’s warning from ANZ chief Mike Smith, that there would be a US depression if the bill were not passed, was listened to by US House of Reps Banking Committee chairman Barney Frank and Senate Committee chair Christopher Dodds. (Smith made the comments to Business Spectator in front of more than 850 shareholders during a special on-stage KGB Interrogation at Sydney’s Westin Hotel).

After twin all night negotiating sessions (pizza for the House and Thai food for the Senate, apparently), with John McCain breaking his campaign to fly back to Washington, and Barack Obama phoning in, the recalcitrants in Congress blinked.

Assuming it passes Congress on the weekend, next question; will it work?

There is a lot of discussion to the effect that the $US700 billion bale-out effectively just perpetuates “mark-to-myth” accounting, and is more akin to the Japanese authorities’ mistaken response to the 1990 crash than to the 1989 savings and loan bale-out in the United States, or the Swedish banking crisis of 1992.

But that really depends on its implementation, which is entirely up to the Treasury Secretary – and that effectively means either Barack Obama or John McCain, after January.

The text of the Paulson plan simply gives the Secretary the authority to buy “mortgage related securities” on whatever terms and conditions he or she likes and to take whatever actions in relation to them deemed necessary.

The portfolio can be no larger than $US700 billion at any one time, and the Secretary will have the authority to manage it, including collecting the revenues and trading the securities.

“Mortgage related securities” is defined as “residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before September 17, 2008”.

Basically the fund can buy anything, at any price and do anything with it.

In selling the plan, Paulson has talked about the need to value mortgage backed securities at “hold to maturity” values rather than “mark to market”, but it is not clear what that means.

It’s possible, as many opponents claim, that it means the new Treasury fund will simply pay $US700 billion for $US350 billion worth of mortgage securities, but that would make no sense. It wouldn’t be enough money to save the system. It would make more sense for the fund to become a kind of “federal reserve” for mortgage securities – trading them and holding them in the way a central bank does with cash liquidity.

It’s true that the scheme is quite different to both the Resolution Trust Co bale-out of the S&L crisis of 1989 and the Swedish plan of 1992, but it is also true that it does not necessarily resemble the failed Japanese response to the 1990 crash.

The RTC was used as the basis of a series of equity partnerships, with the private partners managing the $US394 billion in assets acquired. A total of 747 thrifts were closed down and their assets delivered into these partnerships.

In Sweden, the Government recapitalised the banks, but only after the assets had been written down and equity holders wiped out.

Apart from an understandable suspicion of the Republicans in general, and the Bush/Paulson administration in particular, there is nothing so far to suggest that banks and other financiers are going to be given an easy ride by Paulson’s troubled asset relief program (TARP).

Indeed, as my colleague Stephen Bartholomeusz has suggested, there’s no reason why the Obama/McCain administration shouldn’t make some profits from the fund in future. Markets overshoot on the upside and downside – in many cases the mark-to-market values of mortgage securities (10c to 30c in the dollar) are only realistic if the bale-out does not work and there is, as Mike Smith predicts, a depression.

But the reason it must be merely the start of a series of bale-outs and responses is that while the insolvency of banks and financiers is the urgent problem, they’re not the only ones in trouble.

Specifically, the US household sector is also underwater and facing punitive adjustable rate mortgage resets. In 1933, president Roosevelt established the Home Owners Loan Corporation as a “new deal” agency, to refinance homes to prevent foreclosure to turn short-term mortgages into long-term ones.

The HOLC only operated for two years, but it was long enough to keep more than a million people in their homes and stabilise home ownership.

Obama or McCain will need to produce another new deal, which extends the Paulson bale-out far beyond buying up to $US700 billion worth of mortgage securities and includes more new funding agencies and whole new set of regulations.

America’s intellectual and financial capital will be tested as never before.

This first appeared in Business Spectator