2008-10-01 — ml-implode.com
by Aaron Krowne for The Implode-o-Meter.
The bailout bill currently under debate isn't the first attempt to "just do something" to "fix the crisis". Many interventions have been concocted over the past year, with each seeming to trump the previous in heft, but pitched as the "bailout to end all bailouts" and finally fix the economy.
Yet, these interventions have all failed -- all the underlying metrics of the market (spreads, share prices, bank lending) have continued to deteriorate. In this piece we examine why. The implication is: this latest "bailout to end all bailouts" will be, well, anything but, and should be vigorously opposed.
1. They've increased leverage.
Fannie and Freddie had their core capital requirements reduced by 30% in early 2008. This was a complete about-face for OFHEO chief Lockhart, which suggests it was a pure panic move to prop up the housing market -- not a logical, considered decision.
It certainly aided the cause of pushing most housing market activity through the GSEs. But sure enough, within a few months, even the government had to admit the two were insolvent.
Another example is how FASB rules intended to transition to a mark-to-market of bank assets -- meant to go into effect in 2008 -- were postponed, and will likely be modified or postponed for longer. Since it is obvious that under the current model, the assets are significantly over-valued, the postponement has generally bred distrust of financial companies, and has caused them to hoard cash, and has turned away potential outside investors.
Yet another example is how in the latest batch of hasty Fed rule changes, long-standing restrictions on using deposits for speculative activities were eliminated. Now, banks can raid their core depository capital as long as they plop some collateral in place -- which of course means dodgy collateral that cannot be otherwise monetized.
To be clear, some financial institutions have raised capital and lowered leverage. But most have not, and all the government interventions have had the effect of giving them no reason to do so.
2. Implementing "solutions" geared towards short-term liquidity rather than long-term solvency.
All of the Fed's alphabet-soup facilities (the TAF, the TSLF, the PDCF, and even the trusty 'ol discount window) presuppose that the problem is just that of near-term "liquidity" -- in other words, a brief cash crunch.
While the introduction (and periodic expansion) of these facilities has kept the banking system afloat -- and engendered some impressive bear market rallies -- they don't really get to the root of the problem.
By analogy, this situation would be like when you or I fail to accurately track our monthly expenditures, and end up overdrafting as a result.
But as anyone paying even a little attention knows, the problem is more like a Wall Street version of what millions of homeowners are facing: they are underwater on their debt and just cannot afford to support it at the initial loan values anymore.
The loans (and derivatives) must be marked down. The financial companies must raise capital, or go into bankruptcy or conservatorship. A price must be paid for fresh capital that brings it out of the private market woodwork -- in other words, not relying on largesse from the tapped-out government (which is realy just the taxpayers).
3. Elimination of market rules.
The government has created a precedent of arbitrary interventions over the past year. This has accelerated as time has progressed, and expanded to touch more and more of the market.
It should not require much explanation to understand that markets do not do well in an environment of shifting or uncertain rules. In fact there is a word for that: chaos.
Disturbingly, only two groups do well in chaos: criminals, and the government.
(Or maybe that's one group.)
Remind you of anything you're seeing lately? Like the same people responsible for the mess riding to the rescue with an unprecedented power grab under the mantle of government, all the while invoking economic mushroom clouds?
We should deal with bankruptcy and financial fraud in the traditional ways, and not go beyond lifelines direct to home and business owners in the extension of government assistance -- and do so in ways largely external to the market to the greatest extent possible.
4. Actively destructive interventions like the short-selling ban.
This one is just really bad. Banning short sales instantly does two very damaging things to the markets: it shuts down convertible debt issuance (one of the last decently-functioning holdouts), and it makes genuine hedging very difficult to do. Both are super-destructive for the markets.
Indeed, it is hard to figure out how the short-selling ban even makes sense, unless you look at what probably truly inspired it (which is political grandstanding).
You see, short sales, while causing initial selling pressure, also cause eventual buying pressure. A dodgy stock which has been sold short eventually will get a boost as all of those short sellers will have to buy back the stock to close out their positions. And if the short sellers turn out to be "wrong", you get a massive rally called a "short squeeze", as they all rush to buy.
Banning short selling in general creates what are informally called "air pockets" in stock values. That is, with no shorts needing to close out their positions, normal selling has nothing below it to counter-balance the price decline. In the case of UK lending bank HBOS, very few people dared to sell it short (ony 3% of shares outstanding), so when some holders started selling it, it quickly turned into a free-fall.
The "argument" seems to be that short selling causes a self-fulfilling condition whereby initial short sales inspire a pile-on, which can quickly collapse a stock (in which case the short-sellers would never need to buy back). True, in theory. But with an "uptick" rule, shares can only be sold short if they are rising, making this dynamic impossible.
We used to have an uptick rule. But the SEC eliminated it in 2007, and (bizarrely) did not restore it amidst this crisis. If they wanted to make short-selling completely harmless, all they'd have to do is restore the rule. Or maybe they just don't believe their own rhetoric about short-selling being responsible for the collapse of all these financial stocks...
[Note: Some will doubtless bring up "naked" short selling (a "loophole" whereby sellers could get out of buying back the security sold short). But this practice was (rightly) eliminated in July, so it couldn't have been causing any recent problems.]
5. Continually giving hope of an even bigger government bailout.
This is the big one.
Why in the world would anyone fess up, admit their mistakes, go into bankruptcy or pay punitive costs for private-market capital, when they could simply have the government alleviate most of their woes at the taxpayer's expense?
It is hard to argue that that is not what we've been seeing all year. Banks like WaMu and Wachovia continued to make ridiculous assertions about their loan quality, until one day it could be denied no more, and they went "poof". They couldn't keep the con going long enough to make it to bailout valhalla, but others are still trying!
In fact, even their FDIC-brokered suitors, JP Morgan and Citigroup, obviously are banking on some sort of general bailout reminiscent of the Paulson plan. Warren Buffett came out and said as much regarding his own $5 billion investment in Goldman Sachs, and now for $3 billion more in GE.
Other evident behavior, such as lack of follow-through from interested parties when these banks tried to find suitors, is also very suggestive. The seller held out for unrealistic terms, and the buyers held out for government intervention.
So deals that could have been done earlier, cheaper, and much farther from crisis have not been done. It's because the "big" bailout is always "just around the corner".
Congress needs to step up to the plate and make a rock solid statement that there will be no general bailouts of derivatives and structured financial assets or the companies holding them.
It should be stated unequivocally that the only help which will be considered will be towards homeowners and businesses directly.
In fact, if we had passed a reasonable housing bill last year with real teeth forcing loan modifications, we would have taken our lumps then and been much better off now. Banks would have had to write down loans, break apart securitizations and raise capital, and fewer homeowners would be in distress now.
Enough support has already been provided with the Fed temporary facilities -- Congress should just end the guessing game and outlaw any permant public expenditure on structured financial assets.
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