On Economic Recovery, Or, They Got The Bailout, So Why Aren't Things Better?

Every morning lately, we have turned anxiously to the news to see if financial markets are in freefall...and some days, they actually are.

Governments across the world have responded over the past two weeks--including a massive commitment by the United States Treasury that is, to say the least, highly controversial to the American voter.

As this is being written markets are opening in Asia. At the moment things are somewhat stable, and except for Shanghai and Taiwan, they’re heading upward. During the writing process, Europe has opened, and there are gains there today as well.

The US credit markets did not open today (although the stock markets did) because of the Columbus Day holiday—but anyone who recalls Mr. Dow’s Wild Ride last Friday is quite nervous ahead of the Tuesday opening.

Despite all that bailout stuff we’re hearing about, confidence doesn’t seem to be returning to the markets. Why?

Excellent question, Gentle Reader, and I have a few helpful answers.

So for those of you who want to avoid reading today’s entire story, here’s the extremely short and sweet (and overly simplistic) answer: asset holders are still having to sell into the market at historically low prices to meet their customer’s needs, virtually everyone who is managing assets is engaged in a “flight to safety”, and the Treasury, who has now been authorized by Congress to begin the bailout, has not yet made any actual asset purchases or capital injections.

“I don’t care to belong to any club that will have me as a member.”

--Groucho Marx

“Counterparty Risk” is a phrase you may be hearing bandied about lately...and it’s a fancy way of saying: “I don’t want to do business with you because I’m afraid you’ll go broke and leave me hanging”.

The idea behind Treasury purchasing assets is to remove “risky” securities from the system, so that banks and other investors, who will no longer be holding the riskiest assets, can trust each other again (“counterparty risk is reduced” would be the fancy way to say it), and, hopefully, commercial lending can begin returning to a more “normal” state.

The thing is, this does not happen overnight. The US Treasury must first hire asset managers and a “custodial banker”.

Asset managers might advise Treasury on how to value individual assets they seek to purchase, they might advise on the purchase process itself, and in situations where case-by-case decisions need to be made, they’ll likely be the one working those problems. Treasury’s role here is likely to be a policy-setting and supervisory one, leaving the asset manager to...well, manage the assets.

Custodial bankers provide the “clearing” and “custodial” tasks associated with these types of purchases. They physically hold the securities certificates in a vault somewhere, they provide the services associated with receiving new assets and transferring sold assets to new buyers, and they provide information about the assets and their income streams.

How soon will all this happen? The Treasury wants us to know that...

Due to the paramount need for expeditious implementation of the Secretary's authorities under the Act, Treasury anticipates that a number of contracts will be awarded through other than full and open competition...

In other words, this is moving ahead at high speed...and the estimates I hear suggest the first asset purchases might occur as soon as November 1st.

This could be done in a couple of ways: buying the assets directly from the asset holders, or “reverse auctions” where Treasury buys assets at the lowest price offered, then keeps paying more until they reach the limit of what is to be spent in that auction.

Repeat the process over and over (buy $100 billion today, the same next week, and on and on) and pretty soon taxpayers own the assets, and, hopefully, things get better.

Another way to reduce counterparty risk: guarantee interbank lending. If JP Morgan lends $500,000,000 to Bank of America overnight, and either goes broke, Treasury would pay the other party. This is not likely to cost the taxpayer much—in fact, I can’t recall a situation ever where payment on these guarantees would have been required.

The goal of these guarantees is not to have to cover losses...instead, the goal is to make both parties more confident in each other, which would, hopefully, lower the all-important LIBOR rate that controls not just lending between banks, but also the rates you pay for your credit cards, adjustable rate mortgages, and personal and commercial lines of credit (which are all based on “LIBOR plus something”).

The Treasury is also authorized to buy stock in banks, and it looks as if they are preparing to do that as well. The reason they would do this is to provide immediate cash to banks that are today, essentially, broke. The US version of this program, for the moment, appears to be voluntary, and would presumably involve purchases of preferred stock, which may give Treasury a better position to get our money back if the banks fails—or it might not, particularly if a bank fails because they had a “run” on deposits (a “run” means everyone wants their money back all at once. Think “Miracle on 34th Street”).

This offer would come with some sort of restrictions on “executive compensation” and some degree of political risk—for example, how will Congress and the American public (of whom most are taxpayers, and a few are actually voters) feel about Treasury directly owning companies?

Greek philosophy seems to have met with something with which a good tragedy is not supposed to meet, namely, a dull ending.

--Karl Marx

The enormous unknown in all of this is what prices will be paid for these various assets. This could be a series of prudent investments that generate taxpayers a decent return over time...or it could become a giant process of rewarding friends and punishing enemies that does the taxpayer more harm than good.

Public vigilance is going to be mandatory going forward...and the willingness of Treasury, in the next Administration, to be open and transparent about this process will be crucial.

The Federal Deposit Insurance Corporation is authorized to raise the insurance limits on US bank deposits from $100,000 to $250,000...which means those of you with $100,001 to $249,999 in the bank will be sleeping better tonight. (This should actually help small businesses, to be fair, and it should be at very little cost to the taxpayer, as banks—up until today—have rarely failed without someone else taking over the deposit accounts.)

Next, a few words on forced asset sales. If you have a 401-K or other money market asset, you may have chosen to take your money out rather than chance losing it. Lots of others have made the same choice, all at once. These are companies that tend to have less cash and more “assets at work”. As a result, many of the companies in this business are being forced to sell some of those assets to pay you back your money.

Here’s a rule of markets: when you’re selling into a falling market, or you must sell today, no matter what the asset, you will get less than you wanted—and probably less than you need. Both have applied to many companies these past few weeks; and as they sell assets at bargain-basement prices, it drags down the Dow and the NASDAQ averages...along with averages all over the world.

Part of the idea of injecting assets onto the books of asset holders is to stop this forced selling (which may stop the Dow from falling 600 points daily)...but keep in mined that “injecting assets” means “buying stuff”; and all the cautions regarding pricing we talked about a few paragraphs ago directly apply to this conversation as well.

The “Money Market Guarantee Program” is also intended to help resolve this problem by providing temporary Federal insurance on those deposits.

Short selling, which allows you to make money off future declines in stock prices, has been blamed for exacerbating the problems of rapid price declines (rightly or wrongly, we don’t yet know), and is currently under restrictions in the US. Those restrictions, at some point, will end...and the effect on future prices is, today, unknown.

“Mark to market” rules require companies that are trading assets to mark them at some “fair value”—and in a time of frozen markets, those asset values might turn to zero. This has caused great pain for asset holders, who are trying as hard as they can to end the fair value requirements.

Those with a sense of history will recall that these rules were established because of abuses that led to the last Savings and Loan Scandal...and there will be a great fight over this issue, in this Congress and the next, as well as enormous lobbyist pressure on the next Administration.

So that’s where we are: the Dow is moving wildly according to how much risk is perceived to be out there, the credit markets, even more so.

Coordinated efforts over the weekend and over the next few weeks may have stabilized the situation...or at least that’s what today’s markets are telling us.

There will be asset purchases and direct investments made over the next few weeks—and the prices paid will determine whether this is a “taxpayer positive” deal or a giant taxpayer hustle.

When someone on CNBC or Bloomberg says “Treasury has to overpay for assets for this plan to work”...watch your wallet. If that same someone wants us to pay “hold to maturity” values? Well, that is a virtual guarantee the taxpayer will not make money—and it probably means we won’t break even.

There will be efforts to change regulations. My personal opinion: short selling gets more abuse than it deserves, and mark to market the same. Keep ‘em both, but since they can both be abused, regulate ‘em carefully.

Finally, the most important question of all: will the credit markets begin to thaw?

Credit markets in the US open tomorrow, but today’s activity in the European and Asian markets (and the US equity market) suggests good news—and from a LIBOR perspective, things have been worse—but we’re a long way from the easy money of 2004...and that’s probably a good thing.

UPDATE: A quick thanks to pragprogress over at DailyKos, who reminds me that the short selling ban was lifted last Thursday; which has had a currently unknown effect.