Sunday, September 21, 2008

Things to ask your Congressman

With elections just six weeks away and the government in frenzy, planning the biggest bailout since time immemorial, you might want to ask your Congressman a few questions before you head out to the polls. So here is my imaginary dinner conversation with Charles Schumer, our New York Senator, based on what we know and (the countless things we still) don’t know.

Hey Chuck, what’s all this madness out there?

Chuck: Madness, Chevelle, that’s exactly what it is. We are experiencing a truly historic event, a bedlam, people rushing to take out whatever they can… I must say, it breaks my heart to see the Yankee stadium go!

Chuck.. I meant the bailout!

Chuck: Oh that!
You know, in panicked times like this it is important to step back and dissect the problem. That’s what Hank and Ben did the other day—and, let me tell you, it sounded ugly!

First, a good number of households are insolvent—over-indebted guys who shot too high for their wallets and are now verging towards foreclosure.

Second, we have a large chunk of the financial sector plagued with impaired balance sheets. They have too little equity capital to survive further losses; and the value of many of their assets is highly uncertain, because they are illiquid.

Illiquid? As in “garbage”?

Chuck: In a manner of speaking. Illiquid really means banks cannot sell these assets—the market for them has evaporated. Of course this can mean two things: Either they are garbage and nobody wants them; or economic uncertainty, the market chaos and fire sales by distressed banks have made potential buyers think they may be/become garbage. So nobody buys them, banks keep them in their books and this clogs new lending to good, productive firms or responsible homebuyers… like yourself.

I see..

Chuck: And then we’ve had a third problem: Unmitigated insanity in the markets! A complete collapse of trust; speculative attacks on one bank after the other; and panic withdrawals ($89 billion!) from money market funds. Money market funds! The savings of the ordinary man at risk! We had to stop this!

So it’s time for the “Super Bazooka?

Chuck: Bazooka?? Haha! This is the atomic bomb! “Maximum impact,” as Hank put it. Look, we’re still working out the details but, basically, the objective is to address the three problems I just mentioned.

Reestablish trust first and foremost. So we immediately threw in $50 billion from the Treasury’s Exchange Stabilization Fund to insure investors in money market mutual funds. And Ben also massively expanded the Fed’s liquidity facilities for those who need it—just last week he lent nearly $60 billion to investment banks and around $30 billion to commercial banks.

Sounds good I guess... it did get pretty scary out in the markets last week. But what about that $700 billion Hank is asking for?

Chuck: That’s to address problem No. 2… We'll be setting up a new institution to buy those illiquid assets I was telling you about. Take them off banks’ balance sheets, so that they can resume lending, help the economy grow.

And what exactly will they buy?

Chuck: Obviously, mortgage-backed securities (MBS) are the focus. I mean, after all, we want to get the mortgage market going again, stop house prices from falling. That’s why we've also summoned Fannie and Freddie to go out and buy more MBS. Problem is Fannie and Freddie can only buy the “better” stuff (whatever that means!), whereas the new company could buy anything, subprime, Alt-As, what have you

I see… a giant garbage bin..

Chuck: Well, not everything is garbage… Can’t be.. Don’t you think???

Can I steal some of your fries?

But Chuck... banks’ illiquid securities are not just linked to mortgages.. they have other stuff too—all the acronymed securities linked to credit card loans, car loans, commercial loans. If you want to unclog banks' balance sheets, wouldn’t you need to buy those too?

Chuck: (on the phone) Get me Hank on the line, will you?
Hank is your man for that one. We are about to grant him full discretion over what securities will be eligible for purchase. He’ll be the king.. Our King of Bad Assets! Haha! What a legacy for a believer in free markets… for the entire Republican party… at least we’re not even pretending..

At least the government will buy these at a massive discount?

Chuck: The model we are contemplating is the so-called “reverse auction.” In effect, the government will be asking the banks to place quotes for the assets they have for sale. And, in principle, it should be taking the offer of the lowest bidder. This helps drive prices down—so the government gets a good deal.

I don’t get this. If there is no market for these assets, who decides what’s a fair price? How will the government know that even the lowest price offered is not too high? And how do you determine the"lowest bidder" if these guys are selling different stuff?

Chuck: Hank.. are you there?..
Still waiting. These fries are great… got ketchup?

So who will be the “lucky” banks?

Chuck: Ha! They should be sooo lucky! We’re planning to include curbs on executive pay for the companies whose assets the government will be buying. Teach these guys a lesson.

But coming to your question. Surely we want to help the “living”. Commercial banks, investment banks, get them to lend again. But look, the dead (and near-dead) also have assets for sale. Loads of them. And if we want to support the mortgage market, leaving those out would defeat the purpose, right? As they liquidate, they would drive prices down, hurting the living again.. And then you have the insurers.. the AIG’s of this world. They also have junk for sale.

So, am I reading this correctly? Banks may have to take further losses? Selling their assets at a discount? But can their equity capital really take it? And if not, will you let them fail? Or is the government also planning a massive package to recapitalize banks?

Chuck: Hey hey, relax… Have a beer. And how about that ketchup?

But, Chuck, what makes you think $700 billion will be enough? I read reports that the illiquid assets of just six big banks (the so-called Level 3 assets) are $500 billion. And that nobody really knows how much bad debt is out there. In fact, Capital Economics wrote that at the height of the mortgage market boom there were about $2 trillion securities issued annually. Two trillion annually! How much will Hank need to buy?

Chuck: Chevelle... we’re talking $700 billion here. “Maximum impact.” Hank said it. Trust him.

But that’s what they’d said about the RTC—the company set up in 1989 to clean up the garbage from the savings and loan crisis. At the time they’d said the RTC would only need to take on $200 billion of assets. But it ended up taking on $394 billion! And that was on top of another $125 billion taken on by its predecessor, the Federal Savings and Loan Insurance Corporation.

Chuck: Yes, but that was not us.. It was Bush senior, remember? “Plus ça change…” Haha! (Pardon my french!) At least, if it doesn’t work, we’ll know who to blame.

So how about those overindebted households? You said you’ll be helping them too?

Chuck: Of course! Can’t be seen just helping greedy bankers. I mean, it’s not really kosher… six weeks before the elections! Sure, they’re financing our campaigns, BUT… I’m telling you, my heart has always been with Main Street.

So we’re hoping to include a plan to stem foreclosures… help people modify the terms of their loans. And, if we play it well, we might be able to slip in a second stimulus package with infrastructure funds, low-income energy aid and Medicaid assistance.

So where will all this money come from?

Chuck: Well, we’re raising our debt ceiling by $700 billion, so you can imagine...

And what will this do to my mortgage payments?

Chuck: Hey look, I am not an economics pro here but even a six-year old would tell you that higher debt is bad for you, bad for the economy, bad for interest rates. Well… unless we convince the Chinese to keep lending us at near-zero interest. But think of the alternative… A depression! To do nothing is to risk the kind of economic downturn this country hasn't seen in 60 years!

And now excuse me, I need to rush… bid my farewell to the Cathedral!

Glossary: reverse auctions, Resolution Trust Corporation, illiquid assets, the Yankee Cathedral, plus ça change...

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