My View on the Bailout de Jour

I appeared on Business News Network November 24,2008 to talk about how the U.S. tax payer got shafted by the deal to save Citigroup.

While there is no doubt that federal intervention was necessary, the terms of the deal were terrible for the government. The real cost is not just this deal but the precedent it sets.

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The shroud of Citigroup

It wasn't that long ago that Citigroup was considered a "good" bank.

Remember October 1, 2008? Citigroup announced it was acquiring Wachovia with the help of the FDIC. You had to be strong to do a favor to the government like that.

Citi was also a recipient of $25 billion in the first tranche of the $125 billion TARP money.

However, we know now Citi was not healthy. On Friday, Citi stock closed at $3.77 implying an approximate market cap of $19 billion  -- just a few weeks after the Treasury had injected $25 billion in capital.

This implied that the government was throwing $25 billion at something that was worth -$6 billion! It is the classic throw of good money at bad.

I am fully aware that some type of intervention was necessary. Citi falling would have created even worse chaos in markets.

But the recent injection of a further $20 billion and huge government guarantees on troubled assets is a spectacularly bad deal for the American taxpayer.

We need another flip-flop (seriously)

The TARP has failed to stop the meltdown in credit and equity markets. Almost all of the big nine banks that received the TARP injection are in worse shape now than before TARP.

Take Goldman Sachs. Around the time of the TARP equity injection announcement, it was trading for about $120 per share. It is currently below $60.

That’s not as serious as some others. Citi’s current market cap is about $25.7 billion and they received $25 billion from TARP – so the TARP cash is 97% of their market value! They are not alone. Morgan Stanley’s market cap is $10.2 billion and they took $10 billion from TARP.

TARP has not worked – as implemented.

It is urgent that we move to a different strategy.

Children in the candy store

The bad news keeps piling in:

• $150 billion commitment to a non-bank, AIG
• GE Capital (which is not a bank) gets FDIC Insurance backup for $139 billion
• American Express and CIT Group are now banks – I guess everyone is a bank
• Wachovia shareholders being urged to reject the Wells Fargo deal so Wachovia could apply for Treasury dough
• Hartford Financial agrees to buy Florida bank for $10 million to get access to $3.4 billion in TARP funds (now there’s a return on an investment)
• Autos looking for some loot too

It is like children in the candy store – ironically, as our economy accelerates its downward spiral.

Hurdles the new President faces

President-elect Obama wants to avoid the Herbert Hoover scenario. In this scenario, many economic initiatives are tried but fail to bring the U.S. out of recession. The high expectations are not met. The result: a single term.

Of course, there are differences. Herbert Hoover was inaugurated in March 1929. The stock market crashed in the last week of October 1929 and the economy fell into recession and depression shortly thereafter.

It is clear that the initial economic damage precedes President-elect Obama. Even though he inherits this mess, the American public fully expects a recovery during his administration. If the recovery does not happen, the Obama administration will be viewed in the same way as Hoover’s – a failure.

Who deserves to be bailed out?

I appeared on Business News Network to discuss: the missteps in implementing TARP, who should be bailed out, alternative plans to regenerate credit and the implications for the real economy.

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Bank earnings are impossible to interpret

It is earnings season and many banks will be reporting their earnings. What are we to make of these earnings? In usual circumstances, it is hard to decode earnings. Today, it is next to impossible.

By the way, why did Goldman Sachs and Morgan Stanley change their status to bank holding companies? One major factor was the flexibility they got to report their earnings.

The key to a basic understanding is FASB 115:

Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost.

Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings.

Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders’ equity.

This became effective on December 15, 1993.

The D-word

The credit crisis is 13-months old. Unfortunately, policy makers have been late to the game. In addition, the game plan has changed so many times that it is not surprising that there is a general lack of confidence that we can fix the problems.

Recent actions (equity injections, purchasing troubled assets) will take a number of months to implement. These actions are too late for the real economy. The damage has been done.

The relevant question is how deep of a recession will we see?

Given we are at the beginning, many Americans cannot understand what the big deal is. “Why do we need these bailout measures?” “I have a steady job and that’s not going to change.” “Why is all the focus on Wall Street?”

Equity injection is not enough to get us out of this mess

The government doled out $125b of equity injection to 9 banks yesterday. It is a dramatic change from the original TARP proposal (to pay a premium price for toxic assets). I have advocated for weeks an equity injection (along with other measures).

However, there are serious problems with the government’s implementation.

1. There is no guarantee that this money gets into the credit system. Indeed, some institutions, like Morgan Stanley, might use this to reduce their risk rather than increase their lending.

2. What about the other 8,000 financial institutions? If they are healthy, they will not apply for the government equity. If they apply, people will assume they are troubled. There is a stigma effect. Hence, the government money will go to the most troubled institutions — exactly the institutions that are unlikely to use these funds to increase loans. So the multiplier effect (capital injection leads to loan creation that is a multiple of the initial injection) is muted when capital goes to troubled institutions – or borderline institutions that just want to reduce their risk.

The fall of the House of TARP: Time for Plan B

I am not surprised that the Troubled Asset Relief Program (TARP) failed.

The paper that I put out on Friday detailed the numerous problems with the TARP.

My paper argued that the TARP had at least three major flaws.

1.Buying these toxic assets at ‘hold to maturity’ prices is throwing away taxpayer money – it is tossing good money at bad. I argued that the assets should be purchased at a much lower price consistent with a three-to five-year holding period and an assumed recovery in market conditions. At these prices, financial firms would be pleased to sell – and the taxpayers get to buy at a price where we can make a positive return.

2. I pointed out that the subcontracting of the $700 billion program is a mistake. There are too many conflicts of interest – it is best for the Treasury to manage this internally.