The Bailout -- another perspective (part 1)

First, I want to thank Bob Lawless and the rest of the Credit Slips folks for having me back yet again -- I'm getting to be like the guest who would not leave.

Second, while it might make me part of the "establishment," I'm going to say right from that start that I join those who favor the bailout.

I also think we need to avoid a whole lot of knee jerk reactions that are floating around out there -- like the SEC's ban on short selling, which is quickly becoming the Bad Management Protection Act of 2008.  Of course, the notion that the administration can open the door on this issue "just a little" is also equally suspect.

I view the economy and the larger financial system as being at a Titanic like moment:  post iceberg, per submersion.  It is certainly reasonable to disdain those who got us into this situation, but I'm not going to let my feelings for them get in the way of saving as many people as possible.

That said, I understand why there is a good deal of skepticism about the bailout.  In part chapter 11 is to blame -- there has been almost no effort to explain why AIG is different from Enron, United Airlines, or any other really big corporation that has recently failed.  And the financial industry needs to fess up that it blew its chance to self-regulate the credit default swap market -- too many people, even myself to some degree, bought the "trust us, we're experts" line from ISDA and other market players.

No wonder people aren't buying that line in connection with the bailout -- especially when the administration has its own credibility problems in this regard in connection with other big, complex projects in the non-financial area.

More on the chapter 11 issue, and why I think the administration has done a terrible job of selling this but still generally support the bailout, after the jump.  I'll save my thoughts on the CDS market for another post.

One of the reasons why I believe that the bailout has been greeted with such widespread skepticism is the complete lack of explanation by the Fed/administration.  Yes, they're starting to talk to Congress, but who is going to speak directly to the rest of the country?  And, as Bob has previously noted, there is a serious lack of transparency here.  We still don't know what the precise terms of the AIG warrants are, the only clear information coming from a cryptic 8-K that says almost nothing.

In this environment, I think is fair to ask why this is not just more of the same kind of panicky talk we've always heard from executives that get themselves in too deep.  The Penn Central executives pleaded for a bailout, auto industry executives have pleaded for bailouts (with occasional success) for three decades.  Yet today it is quite common for big corporations to enter bankruptcy without the world coming to an end.  Why are AIG et al. any different?

The short answer is that chapter 11 is much more suited to "real economy" firms.  Even before 2005, financial firms were going to have a tough time reorganizing under chapter 11.  The Code really can't force people to trade with a debtor unless they are under contract -- hence the much talked about "critical vendor" motions in big chapter 11 cases.  The 2005 amendments to the Code made a financial firm's entire business the subject of a critical vendor motion:  even folks under contract don't have to continue trading, because most financial instruments are now outside of the Code.

So Congress might want to rethink some of the 2005 amendments -- no news flash there.  But I think we also need to think about how much of our economy is presently "financed."  Retailers, car dealerships, mortgage lenders, and major trade creditors have all gotten used to the notion that they can quickly free up their capital by moving these credits into the financial market.  The entire private equity concept relies on debt finance.  Leverage is a pillar of our financial system.  Forgoing the bailout likely means freezing up the financial system for a good, long time -- are we really ready to say no home or car loans until 2010?

To be sure, the financial market and its cheerleaders (ISDA and others -- more in my next post) really seem to have believed their own "it will never rain again, the sun will shine forever" rhetoric.  That's why this bailout needs to be a tool for ripping the Band-Aid off and forcing the market back to reality. Diluting shareholders might be a good way to start the process, while also protecting against a windfall to the industry -- if shareholders don't like it, they should hold their elected directors accountable.

The financial industry also needs to be told this is the a gun buyback program -- turn in your bad stuff now, in the future we show you no sympathy and you get the Lehman treatment.  This avoids the holdout problem that some have talked about.  But we still need the bailout, and the American public needs to be told exactly what is at stake.

In part 2 I'll talk about the implications for the CDS markets.

(edited for grammer and clarity)

Comments

[Patches]

You know I have been listening all morning and I still can’t for the life of me understand what is exactly at stake or how the plan will all work. Paulson says we need oversight, we need regulation and that the regulation they have now is outdated. BUT…. he says they don’t need it now! So we write a blank check now and institute regulation at a later date. What is up with that? So we buy up all of that bad debt, how much do we pay for those “swaps” or “CDO’s”. Are we going to put money in the pockets of CEOs “golden parachutes”? So if we pay too much, “John Q public” puts money into the Corporations pocket with no hope of return. There is almost no way to put a price tag on those things. Right now all they want is 700 billion with oversight to come later probably sometime after the break and no help for the “Tax Payers” who are the ones paying or not paying their mortgage and paying the federal taxes that are going towards bailing them out. Now they say that regulators did make mistakes and they did not use the regulation they did have. So deregulation the fed says is the reason we are where we are and “NOW” they need more or “updated” regulation. Now, after all of this? Ohh. my bad they “welcome” oversight but we need the check first because it will take to long to hammer it all out.

Arrrggg... Bernanke… To stop foreclosures he says we need more jobs, better paying jobs… duhh. Stop foreclosures thru bankruptcy and then the CDOs and Credit Swaps would be less likely to fall below a certain point. Instead of having this uncertain thing.

Thank you Bob Casy D-Pennsylvania for bringing up the subject of Mortgage Modification thru Bankruptcy. And Paulson says…. doesn’t like it and thinks it a mistake. His solution is to get lending going again and says that it would be counter productive by detering lending. Bernanke “takes no position”. OK I'm going to lunch....

[Joe]

... And wipeout the bond holders before the tax payers pitch in. Maybe going cold-turkey on the loans would be good thing since we are so addicted to credit. To tell you the truth I really can't afford a new car or house.

[Cere Davis]

Why are we bailing out the big banks sub prime problem post-leverage? That would seem to cost way way more money than just bailing out homeowners directly. It always amazes me how we can find money out of thin air for Wall Street but can't seem to figure out health care or world hunger for a small fraction of the price.

So here's an idea:
Why shouldn't we just use the roughly 700billion dollars to pay for Americans mortgage directly (before all the ridiculous leveraging) as an effective method of backstopping the losses. If you assume that there are roughly 50million homeowners in the US with mortgage debt, divide 1trillion by the 50million, you get $20,000 for each homeowner to pay there mortgage and "save" a better part of the sub prime mess. There would have to be more to this plan and a kick back to renters as well to be fair but this strikes me as a more patriotic, fair and effective solution that may, in fact stimulate the economy and satisfy out creditors (which are largely foreign entities these days). Is there something I am missing here?

[Frank]

That's a very careful analysis, but I challenge one premise. Would everything really seize up? Joe Sheehan, a finance professor at Notre Dame, does not think that a certainty. Neither does David Cay Johnston:

http://poynter.org/forum/view_post.asp?id=13611

"Are the credit markets really about to seize up?"

"If they are then lots of business owners should be eager to tell how their bank is calling their 90-day revolving loans, rejecting new loans and demanding more cash on deposit. I called businessmen I know yesterday and not one of them reported such problems. Indeed, Citibank offered yesterday to lend me tens of thousands of dollars on my signature at 2.99 percent, well below the nearly 5 percent inflation rate. That offer came after I said no last week to a 4.99 percent loan."

"If the problem is toxic mortgages then how come they are still being offered all over the Internet? On the main page AOL generates for me there is an ad for a 1.9% loan (which means you pay that interest rate and the rest of the interest is added to your balance due.) Why oh why or why would taxpayers be bailing out banks that are continuing to sell these toxic loans?"

[Stephen Lubben]

Frank -- thanks for the comments, but it seems to me that a study like the one you describe suffers from the reality that the Fed has bailed out AIG and is attempting to bail out the larger market. The banks arguably don't fear a credit freeze now -- but they might if the bailout legislation failed (the bailout of AIG alone didn't seem to do the trick, so failure would seem to return us to the status quo). The interbank LIBOR rate before the bailout -- the rate banks charged each other -- was very high, which certainly suggests a fear of lending.

[Wina]

I am so upset with our government. I am a single 40ish woman. I was put on disability and almost lost my house. Now for over a year I have struggled to make my house payments on time and know that soon any money reserves I had will not be available to help me stay on top of my payments. I have contacted several companies and was told by each of them to let my payment get behind so I can get help saving my home. Now I ask you what is wrong with this picture? How did our country get to this point. I was a hard working woman, working several jobs at once so that I could have nice things. Now I am told to let my payments get behind so I can get help. Should I move to any of the war zones to get help also? Since we are helping all those people abroad, but it seems to help clean our own door steps is forbidden. It's very sad! I am beginning to feel ashamed to be American. Thank goodness that I am a christian and I know God will take care of me.