Necessary but Not Sufficient

Now for the bad news. The Rescue Plan was necessary but not sufficient to fix the crisis. There is going to have to be more heavy lifting, I am afraid. Let me offer a few ideas about what possible actions might be taken in the future. I am not advocating these actions, I am simply telling you what might happen. These are possible, because authorities will do whatever they deem necessary to avoid a systemic economic meltdown and a potential depression.

If you are a large investor or sovereign wealth fund which put money into banks last year, you are down anywhere from 35-50% (unless you invested in Washington Mutual, and then you are down 100%). You are unlikely to invest more in any financial institution without some very real understanding of what is on the balance sheet of the bank that is asking for your money. What the Paulson plan potentially does do is remove the questionable debt. The bank may have to write down assets in order to sell the debt to the government, but they end up with a transparent balance sheet with hopefully known risks. Then they can go to the market and try and raise capital. Shareholders will get diluted. Such is the way of the world.

Sidebar: taxpayers really must demand that someone like Bill Gross of PIMCO and/or other savvy market specialists run this new government operation. He offered to do it, and I think we should take him up on his offer. Taxpayer losses should be kept to a minimum, and I believe someone like Gross would do his best to see that would be the case. The point of this exercise is to restart the frozen credit markets, NOT to bail out banks. Some banks may get bailed out in the process, but it should be at a cost to their shareholders and management, not to the taxpayer.

I am asked, why can’t private money solve the problem? Because there is simply not enough private money. Buffett offered to take 1% of the new government pool. If that is all the largest pile of free money in the world can take, why does anyone think there is enough private capital to take the other 99%? Insuring the mortgage bonds is not sufficient, because there is not enough money to buy them in this market. When things have sorted themselves out in a few years, I think the bonds can be insured and sold, and likely at a profit if bought correctly. But we do not have the luxury of waiting a few years.

Between the relaxation of the mark-to-market rules and removing ambiguously priced loans from financial institutions at prices which allow the government pool to make a small profit, if held for five years, that part (the lack of a known price) of the problem can be solved. Banks can hopefully buy themselves time in which to work their way out of the problems they created.

It is much like 1982, when every major US bank thought it was a good idea to loan lots of money to Latin American countries. It was a most profitable business, right up until the countries decided to default. Then every US bank was more than just technically bankrupt. In a mark-to-market world, every large US bank would have collapsed. It would have been the end of the world as we knew it.

What did they do? The Fed let the banks keep the loans on their books at face value. Over time, they worked their way through the debt, making enough money to be able to write down the loans. That was done simply to give the banks the ability to buy time.

We are in a very similar situation. We have to buy some time in order for financial institutions to heal.

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