Joe Nocera: U.S. govt. has little idea of what it's doing
Submitted by cpowell on 07:15AM ET Saturday, September 20, 2008. Section: Daily Dispatches
A Hail-Mary Pass, But No Receiver in the End Zone
By Joe Nocera
The New York Times
Friday, September 19, 2008http://www.nytimes.com/2008/09/20/business/20nocera.html?_r=1&8dpc&o
It was the end of the worst week for financial markets since 1929, and Treasury Secretary Henry M. Paulson Jr. looked sleep-deprived.
He had begun the week agreeing to let Lehman Brothers go bankrupt, arguing that the government had to stop putting taxpayers' money at risk. Then, midweek, he brokered a deal to rescue the American International Group with an $85 billion loan from taxpayers -- arguing that the risk to the financial system was too high to allow the world's biggest insurer to fail.
Neither move had done anything to stop the financial tsunami. So on Friday morning, just as the markets were opening, Mr. Paulson unveiled the government's latest attempt to stop the bleeding. Maybe it was because he was so tired, but there was none of the glass-half-full blather that is de-rigueur for a cabinet secretary. Instead, his flat, just-the-facts-ma'am voice and weary body language conveyed an unusual sense of urgency.
The core issue, he said -- the mistake that had led to all the other mistakes -- was that "lax lending practices earlier this decade led to irresponsible lending and irresponsible borrowing." True. As for Wall Street, toxic mortgage-backed securities had become "frozen on the balance sheet of banks and financial institutions." He added, "The inability to determine their worth has fostered uncertainty about mortgage assets and even about the financial condition of the institutions that own them." True again.
And that really is the crux of the matter -- the financial system has seized up. But so far, the government's actions haven't helped. Letting Lehman go bust may have sounded good at the time, but it has had disastrous consequences.
It has led to complete chaos in the multi-trillion-dollar market for credit-default swaps and was a crucial reason Morgan Stanley was forced to scramble to stay alive this week. It is also why questions were raised about the viability of Goldman Sachs, a firm with a pristine balance sheet and almost none of the bad assets that are bringing down other firms.
The rescue of AIG further undermined confidence because, within the space of several days, the government did a complete about-face. The bailout suggested the Treasury Department was as confused about what to do as the rest of us.
So rather than help solve the crisis, the Treasury Department has actually contributed to the biggest problem in the market right now: an utter lack of confidence.
Nobody understands who owes what to whom -- or whether they have the ability to pay. Counterparties have become afraid to trade with each other. Sovereign wealth funds are no longer willing to supply badly needed capital because they no longer know what they are investing in. The crisis continues because nobody knows what anything is worth. You simply cannot have a functioning market under such circumstances.
Will this latest round of proposals end the crisis? I know the stock market reacted joyously on Friday, but I'm not hopeful. One solution being promoted by the Securities and Exchange Commission -- to make life more difficult for short sellers -- is a shameful sideshow. A second solution, which Mr. Paulson announced Friday morning, requires money market funds to create an insurance pool to cover themselves against losses.
That may provide comfort to investors who equate money funds with savings accounts, but it is fraught with moral hazard.
And the third solution -- the big megillah -- is Mr. Paulson's plan to create a new government mechanism to buy mortgage-backed securities from big banks and investment houses. Once they are off those companies' books, life can return to normal -- or so Mr. Paulson hopes.
He acknowledged that it would likely cost taxpayers "hundreds of billions of dollars." I think it will cost more than $1 trillion.
It is a weird tribute to the scale of this crisis that Mr. Paulson felt he had no choice but to rush this proposal out, because as the day progressed it became increasingly clear that the Treasury Department didn't yet know how this mechanism was going to work. It is an idea of a plan more than an actual plan. In football, they would call it a Hail Mary pass. Sometimes, of course, a Hail Mary pass is completed for a touchdown. But most of the time they fail.
Let's take a closer look at the government's latest response.
Kill the short sellers: It's understandable why people get upset at short sellers in tough times. As President Bush put it Friday, short sellers are "intentionally driving down particular stocks for their own personal gain." But that perception is more myth than fact, and in any case, it's not the dynamic here. Stocks are falling because companies made huge mistakes that have caused them a heap of trouble. Indeed, in July and August, short interest in financial stocks declined by 20 percent. Why did the stocks continue to go down? Because there were too many sellers and not enough buyers: It's that confidence thing again. Blaming the shorts is classic blame-the-messenger behavior.
The SEC jihad against short sellers, which includes the banning of short selling on 799 stocks and forcing disclosure of large short positions, is nothing more than playing to the crowd. It is simply appalling that as one firm after another vaporizes -- firms, let's remember, that the SEC was supposed to be regulating -- the only thing the agency can think to do is flog the shorts.
There were so many better moves it could have made. After Bear Stearns fell, it could have sent SWAT teams into all the other financial firms to assess their mortgage-backed paper. It could have then announced to the world the health of each firm, which would have helped the market regain some confidence. It could have forced firms to disclose their mortgage-backed holdings so that counterparties could evaluate them. It did none of these things.
Then again, maybe the SEC is trying to cover up its own culpability in this crisis. Four years ago the agency pushed through a rule that allowed the big investment banks to take on a great deal more debt. As a result, debt ratios rose from about 12 to 1 to more like 30 to 1. Guess what Lehman's debt ratio was when it went bust? Yep: 30 to 1.
Save the money market funds: The precipitating event here was the news that the Reserve Fund, a money market fund that caters to institutions, had "broken the buck" and was paying investors 97 cents on the dollar. That is only the second time that's ever happened, and it had to scare investors, because most of us have come to think of money market funds as being the equivalent of bank savings account -- perfectly safe.
In the aftermath, investors in the various Reserve money market funds pulled $58 billion out in the space of a week, leaving the firm with only $7.1 billion. If that same fear had spread across other money funds, it could well have led the funds to stop accepting short-term commercial paper. That would have been a disaster, because big companies rely on the commercial paper market to finance their day-to-day needs.
Under the circumstances, insuring the money market funds probably makes sense. It will calm investors and keep the commercial paper market functioning. But think about the moral hazard! It bails out poorly managed money funds -- the ones most likely to break the buck -- at the expense of funds that haven't taken the extra risk that causes a sudden drop in value.
And then there's this: If you have your money in a bank account, only $100,000 is insured. But if you have it in a money market fund -- which usually has a slightly higher yield precisely because it has a small element of risk -- you now have unlimited insurance. It's the world turned upside down.
The big megillah: For the last few weeks, a growing chorus of voices has called for the establishment of a new Resolution Trust Corp., the entity the government devised in the wake of the savings and loan crisis to take over, and eventually selloff, the assets of failed S&L's. On Wednesday that chorus got its most powerful voice, when Paul Volcker, a former Federal Reserve chairman, co-authored an op-ed article in The Wall Street Journal.
That crisis, however, was very different from this one. Most of the assets in the S&L crisis were real estate -- which are always going to have value. And the government didn't have to acquire them; it simply took them over and, over time, sold them. This time, the assets are complex derivatives of uncertain value that the big firms will actually be selling to the government.
But how is the government going to assess these securities -- and what price will it pay for them? In many cases, these securities aren't being sold because they are still overvalued on a firms' books. That is, their mark-to-market price is unrealistically high. Will the government buy it at the too-high price? If it does, the firms won't have to take additional write-downs -- but it will constitute a huge, unjustified bailout of Wall Street. (More moral hazard.)
But what if the government drives a hard bargain, and gets the securities for what they are really worth -- 20 cents on the dollar, say, instead of 50 cents? In that case, the firms would have to take yet more enormous write-offs, which would further damage their balance sheets, and they would have to raise billions more in capital. Maybe the removal of these bad assets would allow the firms to raise the capital. But maybe not -- meaning one or more could conceivably have to file for bankruptcy, creating yet another spasm of financial turmoil. It's a huge roll of the dice by the government.
Finally, there is the question of how much it will ultimately cost. "Institutions so far have written down $550 billion globally of bad debt," said Daniel Alpert, managing director of Westwood Capital. "We think that when you add up all the problems in the residential housing market still to come -- further erosion of housing prices, mortgage foreclosures, and so on -- we are going to need another $1 trillion of write-downs."
In other words, for all the toxic securities that Wall Street has acknowledged holding, there will be yet more mortgage-backed paper that will go bad as the housing market continues to fall. As much as we all hope the worst is over, it's probably not.
And as much as we might hope that the government finally has the answer, it probably doesn't.