So the word is that Bush is planning a prime-time address to the nation tonight about the financial crisis. Better late than never in terms of talking to the public, I suppose, but I think it goes without saying that whatever he has to offer might just as well go without saying. His credibility these days is somewhere south of the average late-night infomercial host, after all.

Meanwhile, McCain is trying to use the situation as an excuse to back out of Friday night’s debate with Obama. Because, you know, in times of crisis it’s not like people need to hear from those who aspire to make decisions for them, right? Somehow I don’t see this move gaining much traction with the public.

At any rate, here’s where things stand:

There is a real risk of a broadening credit freeze that would weigh down businesses and jobs across the country. Not a guaranteed outcome, by any means, but a legitimate risk.

However, the fact remains that the parties most directly on the brink of disaster—and in line to benefit most directly from a bailout—are not “Main Street” businesses or banks, but the big Wall Street financial houses (like Hank Paulson’s alma mater Goldman Sachs) that are overexposed to the kind of unregulated “toxic waste” securities that they themselves and their political allies worked enthusiastically to create.

Thus, the finance industry’s bargaining position here amounts to putting a gun to its own collective head and saying “give me what I want or I’ll shoot!” If it wants cooperation, especially in the face of tremendous pushback from the general public, the industry—and the administration, both personified by Paulson—really has no choice but to accept the kind of reasonable quid pro quos that economists and politicians are talking about, including but not limited to:

  • Equity shares in any companies getting help, to keep the reigns in the hands of the government and help make the taxpayers whole
  • Strict limits and “clawbacks” on the compensation of the millionaire executives who created this situation
  • Stringent oversight of how and where public funds are spent, rather than just handing carte blanche to Paulson (or anyone else)

However, these are not the only conditions that should be imposed. It’s worth remembering that the grand total of “toxic waste” securities out there on the balance sheets has a nominal value in the tens of trillions, even as its actual value is impossible to determine; in comparison $700B is a drop in the bucket, and indeed it’s not at all clear how Paulson even arrived at that figure. Thus, the open question is whether any version of this proposal will actually work to stabilize the markets (in contrast to earlier and smaller band-aid efforts over the past year or so)… or simply turn into more money dumped down a hole, its only effect to bankrupt the treasury and cripple the federal government.

In light of that paramount concern, there are several other prerequisites that should be imposed as part of any bailout legislation. (A hat tip here to Karl Denninger at the site FedUpUSA; the site’s rhetoric may be a bit overheated, but the quiality of the research and analysis is impressive.) It seems clear that one of the key underlying causes of the current crisis was the SEC’s 2004 move to deregulate the debt-to-net-capital ratios firms were required to maintain, which until that point had a cap of 12-to-1. In the intervening years firms pushed their ratios to unprecedented levels—as high as 40-1 at Merrill Lynch, 80-1 at Fannie and Freddie—creating a situation where even a slight drop in underlying values could topple the whole highly leveraged house of cards. Another factor was allowing firms to use controversial “mark-to-market” pricing for Level 3 assets (the kind of securities under discussion), despite the fact that there was no liquid market for such assets, essentially inviting inflated, frankly imaginary nominal valuations.

The combined result was trillions of dollars (supposedly) of assets on balance sheets, with no regulated exchange, no central clearing house, no margin supervision, to keep things in line and ensure a minimum level of trust between parties in financial contracts. Under those circumstances, it’s understandable why people are unwilling to lend, buy, or sell. The case can be made that no matter how much money you pump into the system at this point, it won’t circulate effectively unless and until a basic level of trust has been restored.

How can that be done? Where can one look for underlying value? Paulson seems to be looking at the top of the market: to prop up the value of the questionable assets themselves by providing a buyer of last resort. As already discussed, though, the government doesn’t have enough revenue on hand to do this in any comprehensive sense, and even if it did it would just be propping up a collective fiction.

On the other hand there’s the bottom of the market, the real estate that underlies most of these derivatives (beneath multiple levels of leverage). The problem there is that housing prices are falling for real and legitimate reasons. Many people simply can’t afford to pay their mortgages, in the wake of lost jobs or health-care emergencies or adjusted ARMs that they can’t refinance as expected. Others, upside-down on properties they bought at the top of the market, are simply making the rational decision to walk away rather than continue paying more than their homes are worth. And as noted in my previous post, most experts agree that housing values still have some way to fall. Even now, in most parts of the country median prices are well above the traditional “three times household income” rule of thumb that has traditionally marked the affordable middle-class mortgage. Even if it were possible to keep housing values artificially high, then, rather than letting them revert to the historical mean, doing so would only serve to exacerbate the real problem.

The true solution is to find a way to deleverage the “toxic waste” that writes its value down to rational levels without causing a downward spiral of panic selling and bankruptcies. What Congress should do to achieve this, before approving any bailout funds, is threefold:

  • Insist on a return to the 12-1 leverage ratio, stepped down gradually over a period of months leading up to a hard deadline, with frequent progress reports. This will help restore public confidence, especially in those firms that are (relatively) less excessively leveraged.
  • Eliminate the mark-to-market fictions used to hide losses, and require all firms to make full disclosure to CUSIP (the securities clearing system) of the formulae used to value their Level 3 assets, so that prospective investors can judge the legitimacy of any claimed values.
  • Require all over-the-counter derivatives to be moved to a formal exchange, cleared by the Options Clearing Corporation or an equivalent, again by a date certain—or written down to zero.

These steps would gradually but decisively reduce the uncertainty about the value of the questionable securities out there—while still providing the opportunity to recapture and declare as much legitimate value as possible, rather than simply imploding the system with a rush to the bottom that may let that value go to waste and create undesirable ripple effects. This approach would get the bad debt out of the system, preserve the good debt, and put the credit markets back on a rational footing. And it would prevent taxpayer money from being invested in any securities that are genuinely worthless.

There may be even better, or additional, steps that Congress could take toward the same ends. If so, I have yet to read about them anywhere. There’s been considerable talk about the need for new regulation, but very little discussion of what kind, or how or when it should be imposed. Thus far, the steps outlined above seem to offer the best available answer.

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2 Responses to “Shorter and simpler, yet more detailed”
  1. Might help if you included a link!…

  2. michael says:

    Here’s Roubini’s 10-step plan. It has the considerable virtue of framing a macro-economic solution in individualized terms—and vice versa. Elegant, poten and just.

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